Due Diligence: War Stories and Best Practice

Getting due diligence right isn't always easy. Listen as Andrew Sherman, Partner at Jones Day, shares his insights on due diligence best practice.

Comprehensive due diligence is essential to any successful M&A deal, but getting it right isn’t always easy. Some of the biggest companies in the world even make mistakes. Andrew Sherman is a Partner at Jones Day, a global law firm with over 2,700 lawyers, and has seen it all! Andrew sat down with the CEO of Firmex, Joel Lessem, to discuss some best practices for ensuring a smooth due diligence process.

Joel Lessem, CEO & Co-Founder Firmex
Andrew J. Sherman, Author & Partner at Jones Day


Joel: Hello, my name’s Joel Lessem and I’m the CEO of Firmex. I’m delighted to have with me today Andrew Sherman, who’s a partner at Jones-Day in Washington. Andrew is a renowned author of over 23 books on capital formation, M&A and entrepreneurship, and that’s what he practices at Jones-Day. He’s also been a guest speaker on the major networks in the U.S., including CNN, Bloomberg, CBS and a host of others. He’s been lauded as a top 10 mind in entrepreneurship. He’s also a teacher at both Marilyn and Georgetown universities. So I’m very honored today to have Andrew Sherman talk about M&A and the due diligence process. Thank you Andrew.

Andrew: Thank you all, and thank you Firmex for having me this morning.

Joel:The first question I have for Andrew is how should the seller prepare for M&A ahead of time and what kind of mindset should they have?

Andrew: Well it’s a very good question. Let me go to mindset first because there’s a lot more psychology on the seller side in due diligence than people realize. One of the probably most important things to avoid in a mindset is what I call ‘Don’t call my baby ugly syndrome.’ You know, the truth is, many babies are ugly. Every company has warts. And the buyer’s job and the buyer’s counsel’s job is to find those warts and negotiate them and protect against risk accordingly. So, the mindset you need to go in is that you’re about put your entire business under examination and the less defensiveness and the less ego that you have, the more smooth the process will go.As far as preparation, begin early and begin often. It’s very important in this environment to be well prepared and diligent, to have a well populated, well organized and easy to navigate data room, but also to be ready for some of the inputs of due diligence that will augment that data room.Today’s buyer is a fickle buyer. They are a buyer that wants to avoid problems. They are a buyer that wants to avoid inheriting liability. And they’re expecting seller due diligence to be top notch.

Joel: Well that’s a good segue to our next question. How should a seller approach negotiation for negotiation to go smoothly?

Andrew: Well the first thing is to develop a game plan, develop a framework, develop parameters. For example, let’s say that a seller has a lot of highly proprietary intellectual capital. They may want to phase the due diligence into two or three different stages. And understanding those stages; deciding who’s going to get to see what when, when will they get to see it, under what conditions will they see it, what you get pre-NDA, what you get post-NDA, what do you get during phase three due diligence? That game plan needs to be clearly communicated to buyers and their advisors and understood in advance, because if the buyer thinks that you’re holding something back, they become suspicious and that influences risk and ultimately influences valuation. So I think it’s very important to establish those parameters in advance and then everybody’s clear and nobody thinks that the seller’s playing due diligence games.

Joel: Speaking of which, can you give an example of – in your experience – when a deal really fell apart because the due diligence wasn’t handled properly by the seller?

Andrew: Yeah I was just on a panel last week with a very large general counsel of a defence and aerospace company. He was sharing a story where a seller had not properly organized its due diligence around a regulatory problem that it had. By not properly organizing its information and having a game plan on how and when that investigation would be shared with prospective buyers, the deal ultimately derailed not only for that particular buyer that was on our panel, but all buyers were turned off.I mean remember, we’re in a very interconnected world. A problem gets out quickly. It’s much more difficult to hide things under the rug if that’s your intent, in our web 2.0 driven interconnected world, and in this particularly regulatory environment, especially in the United States. As this general counsel said, even a whiff of a problem will be enough for us to turn up our tails and walk away.And you know, that’s a pretty low standard, even a whiff. You know, if I were thinking about selling my company and that’s the type of due diligence standard that buyers are clearly communicating, now is the time to really get organized.

Joel: When you talk to a seller who perhaps has never gone through this process before, what are the three top things you advise him going through the diligence process, which could be quite rigorous and challenging at times?

Andrew: Well I think you’re right. Rigorous and challenging I guess would be the first thing I would tell them – that this is not an easy process. You know, some sellers who have never been through this before or where they’re closely held family businesses, they think that they’re just going to have their secretary pull a bunch of files out of the cabinet and throw it into a data room, and that’s the end of it.You know, that is not what due diligence is about. I mean due diligence is an exploratory process where a buyer is trying to get to know everything there is to know about the seller, and it’s not just about dumping a few files into a data room and thinking you’re done. It’s a dynamic process. It’s a holistic process. You need to be ready for it. And probably the best advice I can give to sellers is to do what I call a mock due diligence session. Go through the process well before buyers are going to get involved and pre-identify where the issues are. You know, put on your hat as a buyer. Say: if I were buying this company today, what would be at turn off to me? You know, what would I be worried about?And then you give yourself plenty of time to address those issues, to anticipate them and ideally to fix them in advance, if you want to fix them. Now some people decide, “Hey, I’m selling the business sort of as is,” you know, kind of like selling a home as is. You know, yeah, there’s a hole in the wall the kids punched in two years ago. I’ve decided not to fix it. If that’s your decision that’s fine, but that needs to be fully disclosed to the buyers.

Joel: And speaking of the buyers Andrew, when you advise buy side folks especially those buying a family business or private business, what advice do you give them?

Andrew: Well a couple of things. Number one, due diligence today on the buy side needs to be multidimensional. So many companies have so many moving pieces. I mean just in this area, I was talking to a client yesterday about this. In the area of big data, data analytics, data forensics, I mean today’s due diligence teams cannot be just, you know, an ordinary general corporate M&A lawyer, an ordinary general corporate CPA and think that you’re going to have all bases covered.It could be that, you know, the database of their customer relationship management database is a much more important due diligence item in some cases than even the legal or accounting reviews. And so, be multidimensional, multidisciplinary in your tasks.Number two, look at it very holistically, you know. As important as the aggregation of data and the population organization the data room is, I get concerned sometimes that we’ve become – and I know this is not necessarily, you know, consistent with – well, I’m sure it’s consistent with your philosophy and focus – but I’m worried sometimes data rooms become a crutch instead of the strategic tool that they need to be, particularly among younger lawyers. Younger lawyers do due diligence. They’re so used to getting everything online, everything being available via their PDA or their laptop that they forget to augment data room due diligence with in person interviewing.You know, there’s still no substitution for looking somebody in the eye and asking them the serious, hard questions and see if they start sweating or squirming or fumbling. And you know, if you’re on the buy side and particularly if you’re watching this and you’re younger in the profession, be careful to, you know, to use the data room for everything that it is and can be, but also make sure that you augment that with on site and in person interviewing. It’s a comprehensive process. It always has been. And it’s my hope that it always will be.

Joel: Well that leads I think to my final question Andrew. Companies aren’t data. And that’s a great segue into the importance of culture in a company and other sorts of intangibles that you may not see in a data room. How do these play in the equation of a successful acquisition?

Andrew: Wow, get comfortable. I could probably talk for hours about this. Culture is not only one of the most important things that you are acquiring, or inheriting I should say. You know, you can’t really buy culture per se but you can certainly inherit it. And so the due diligence process needs to be highly driven on the efficacy of the culture, on the history of the culture. And that’s not something, as you correctly point out in your question, you can examine in an online data room. It’s something you have to go and feel and touch and experience.But the other reason your question is so astute is because culture is also one of the great barriers to effective post closing integration. You know, most studies have shown that for all the deals that do not integrate as effectively as they should, among the top three issues are culture, information systems, and compensation and reward systems not integrating. So you know, if you’re doing a deal where you really need to integrate your seller’s culture into your own, some of the top things to be looking at are what is that company’s existing culture? How much will it need to change or be shaped into your own? Number two: Is there alignment and communication by and among the information systems in the company? And three: Doing the compare and contrast on how people are motivated, incentivized and rewarded, because that’s another common area where things seem to fall apart after closing.

Joel: Wonderful. Thank you Andrew. I much appreciate your words of wisdom. You have a great day and we’ll be talking again soon.

Andrew: You too and thank you for your whole team’s coordination of this.


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