It hasn’t been a good week for Hewlett-Packard.  On Tuesday, their stock tumbled nearly 12% to a ten-year low after they announced an $8.8 billion write-down, the majority of which is related to HP’s acquisition of Autonomy, the analytics software company they bought for $11 billion last year. 

It looks like Autonomy is worth about maybe a quarter of what HP paid for it last August.  How did that happen?  HP says it’s because Autonomy was engaging in accounting fraud.  They allege that Autonomy was cooking the books - for example, reporting the cost of goods sold as a marketing expense - and reporting revenue that hadn’t yet come in, such as revenue from software-as-a-service subscriptions that hadn’t yet been renewed.  Setting aside the question of whether there was any fraud, it’s clear that HP drastically overpaid for Autonomy.  In the world of fast-paced high-profile mergers and acquisitions, how can a buyer make sure this doesn’t happen to them? 

Step one is to articulate why you’re buying a company - any company - in the first place.  Just because a company is for sale, and you have the money to buy it, doesn’t mean you’ll be worth more post-transaction.  However, because public corporations face such huge pressure from their shareholders to constantly increase corporate value, when growth isn’t happening organically, it can be very tempting to buy a company just so it looks like the Board of Directors is doing something.  This is especially tempting when all your competitors are making acquisitions in a hot new industry.  But it doesn’t make good business sense. 

Assuming that there’s a valid strategic reason for buying a given company in a given industry at a given time, let’s take a look at 5 elements that are essential for conducting thorough and effective due diligence.

Earnings.  Verifying the seller’s earnings through audited financial statements isn’t good enough anymore; buyers need to go a step further and get a Quality of Earnings (QOE) report.  Audited financials make sure the numbers add up and verify that the finances are being handled according to GAAP (Generally Accepted Accounting Principles).  But those statements just report what company management says they’re doing, so if management is lying and the company is engaging in the kind of fraud and misreporting HP is alleging, audited financials normally wouldn’t catch it.  By contrast, a Quality of Earnings (QOE) report validates the company’s profitability with detailed, forensic-style analysis.

Backlog.  Sellers generally can’t tell you enough about how much business is in the pipeline, and a responsible buyer must dig deeply into these claims of future business.  Are those customers already contractually committed, or might some of that business in the backlog disappear once the deal is done?  Pick up the phone and call some of these customers.  If they’re going to choose another provider, you need to know why!

Liabilities. Be diligent in understanding the company’s potential liabilities, commitments, and obligations.  Has it made promises of future product to its customers, are there outstanding warranties or maintenance contracts on its products, are there internal promises to the organization such as expected benefits or salary increases?  These things often don’t show up on balance sheets and can be a big surprise to the buyer when the deal is done.

Representations and Warranties.  Ordinarily, a selling company has no obligation to point the buyer’s attention to its downsides, just like you don’t point out every little flaw in the used car you’re trying to sell.  However, there’s a limit to how much outside information a buyer can reasonably find.  So, for the buyer’s protection, the buyer requires the seller to make certain representations and warranties - for example, that there are no lawsuits pending against the seller that haven’t been disclosed.  The seller puts a certain amount of money into escrow to cover the possibility that these representations and warranties might be breached.  (Arguing over how much money goes into escrow is a not-insignificant part of the transaction process.) 

Assets.  To ensure that the company’s assets truly exist in the way they’re represented on the balance sheet, you have to actually get up from behind your computer and physically walk through the seller’s warehouse.  Balance sheets can hide outright lies - my favorite example of this is a scrap-metal company I once worked with, where two tons of the metal listed in their inventory turned out to be in the form of the owner’s personal yacht!  Sometimes the accounting hasn’t yet caught up with reality.  State-of-the-art manufacturing equipment may be validly listed on the books as worth $15 million one day, but then plummet in value the next day when a faster, cheaper model becomes available. 

One final note: the buyer must be willing to walk away.  Due diligence happens before the final buying decision is made, not afterwards.  If management has already decided to make the purchase, their due diligence team will just glance at the seller’s numbers and rubber-stamp the decision, leading to all kinds of unpleasant surprises down the road.  The level of complexity in buying or selling a company today is staggering.  A buyer simply can’t afford to buy a company without verifying that the numbers on paper match up with reality.