Due Diligence

FRAMINGHAM (03/03/2000) - Definition

Due diligence is the process of examining the financial underpinnings of a corporation as one of the first steps in a pending merger, equity investment or large-scale IT purchase, with the goal of understanding the risks associated with the deal. Issues that could be reviewed include corporate capitalization, material agreements, litigation history, public filings, intellectual property and IT systems.

In this age of acquisitions, hardly a day goes by without an announcement of a merger, large or small. Yet many deals are based on big-picture assessments of value, without all the parties involved knowing all the details.

Quite often, a proposed merger or acquisition gets canned or valued down following conflicts over intellectual property rights, personnel, accounting discrepancies or incompatibilities in integrating information technology systems. The process of researching, understanding and, in some cases, avoiding these risks is known as due diligence.

"Due diligence is going in and digging a hole in the ground and seeing if there's oil, instead of taking someone's word on it," says Joseph Bankoff, a partner in the intellectual property and technology practice at law firm King & Spalding in Atlanta. "If you don't do a sufficient amount of due diligence, you don't really know what questions to ask."

In the case of a technology acquisition, a due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a high-end system.

Meeting Expectations

Due diligence entails taking all the "reasonable steps" to ensure that both buyer and seller get what they expect "and not a lot of other things that you did not count on or expect," Bankoff explains.

The process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers and key developers. It helps to identify potential risks and red flags.

Greg Faragasso, an attorney at the Securities and Exchange Commission (SEC) in Washington, recommends examining public filings, especially the 8-K, which the SEC requires public companies to file when an auditor resigns. The document must state the reason for the departure. "The reason an auditor resigns is very often benign and due to legitimate disagreements," Faragasso says. "But an 8-K filed by auditors that quit could be interpreted as a red flag."

Increasingly, IT systems and professionals are playing a significant part in understanding the viability of a proposed merger or technology acquisition for two reasons: Incompatible systems often take considerable time and resources to integrate, and conflicting intellectual property rights can potentially curb a deal before it takes off.

According to John Haven Chapman, an attorney and general partner at Dignitas Partners LLC, a strategic venture-capital firm in New York, many deals hinge on intellectual property ownership and key IT personnel. "Who has the rights to the intellectual property in a spin-off situation or making sure the rights stay within a venture when an employee leaves" is critical, he says.

Every company handles intellectual property rights and patents differently, but for the most part, technology created by an employee during his tenure at a corporation belongs to the corporation, even though an individual's name appears on the patent.

San Francisco-based UCSF Stanford Health Care killed the 2-year-old proposed merger of four teaching hospitals partly because of IT integration concerns, auditors reported. In 1998, MedPartners Inc. in Birmingham, Ala., and PhyCor Inc. in Nashville halted a proposed $6 billion merger after discovering significant IT incompatibility issues.

"It's never as simple as it looks on paper," says analyst William Fiala at Edward Jones Co. in St. Louis. "There is a tendency to underestimate the complexity of integrating two systems or changing over to a new system entirely."

Fiala cites Tomahawk missile maker Raytheon Co. in Lexington, Mass., as one example of a company that underestimated IT integration's potential impact.

Last October, Raytheon officials stunned investors with much lower than expected earnings and pretax charges totaling $638 million. Part of the revenue shortfall stemmed from difficulties encountered in consolidating defense units from El Segundo, Calif.-based Hughes Electronics Corp. and Dallas-based Texas Instruments Inc.

"Raytheon had 45 general ledger systems after the acquisitions. They are now trying to get down below 30, but that's still a lot, and [it] will take them years to implement a new SAP [enterprise resource planning] system to simplify their accounting even more," says Fiala.

Protective Measures

Warranties and assurances can be written into a merger document or software contract to protect those involved. For example, a potential buyer may discover problems in a technology under consideration after testing and interviewing customers during the due diligence process. As a result, the customer may withhold part of the purchase price in an escrow account until the bugs get fixed or custom code is written to solve the problem. If the problems aren't resolved in accordance with specifications, this reserve money could be used to address problems or be returned to the purchaser as a sort of rebate.

But many times, walking away from a deal is a better option than employing risk-shifting mechanisms.

"Deal paper will only protect you so far," Bankoff cautions. "In this economy, where the average life cycle of a product is only 18 months from launch to death, arguing about someone's warranty in court for five years is not productive."

Chapman concurs: "It's the kiss of death to make an improper acquisition or investment. Not only are you buying a dog, but the dog can kill your company."

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