Merger and Acquisitions Series - Due Diligence Questions For the CFO

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Introduction:

Due Diligence is the verification process of information and its associated documentation to ensure a reasonable individual "that they get what they are paying for". When buying, selling or forming a joint venture it is very important that the books and records are verified and tested to ensure the historical financial results are validated. If your company has a team of professionals who have experience in multiple transactions and a detailed checklist to follow that is probably an exception to the rule, most companies due these type of transaction infrequently. Therefore, it is recommended that due diligence be a coordinated effort with members of the company and an outside firm who has experience with the due diligence process.

The following are examples of questions to ask during the interview of key management staff when following the due diligence checklist.

QUESTIONS FOR CFO

Organizational Structure
o Who owns the company in what percentages?
- Are there any outstanding warrants, options, convertible debt or any other plans that allow for the issuance of shares?
o How is the company organized (S Corp., C Corp., LLC, partnership, etc.)?
o Who are the officers of the company?
o Does the company have divisions or subsidiaries?
- Where are they located?
- What % is owned?
- If not 100% owned, who else is an owner and what is their relationship to the company?
o Under what names does the company do business?
o Is the company part of any joint ventures?
o Are there any inter-company loans?
o Any recently discontinued operations?
o Who is the company's accountant (what type of statement)?
- How long has the company used the accounting firm?

Capital Structure
o Senior Debt
- Who is the company's bank/bank group?
- How much and what types of senior loans does the company have?
- What are the terms of those loans?
- When do they mature?
- What is the collateral?
- Does the company have any other senior debt?
- Are there any letters of credit outstanding?
- Are all facilities fully drawn?
- How are decisions made within the bank group?
- What are the voting requirements?
o Leases
- Does the company have any leases?
- How are the leases broken down by operating and capitalized?
- What are the monthly/quarterly payments associated with the leases?
- What is the liability amount associated with the capitalized leases?
- What is the collateral for those leases?
o Junior Debt
- Does the company have any junior financing?
- How much and what types (Mezzanine/Preferred Stock)?
- What are the terms of those investments?
- When do they mature?
- Are those investments secured?
o Contingent Liabilities/Other Debt
- Does the company guarantee any debt?
- Any other significant off balance sheet financing?
- Are there any liabilities we haven't discussed outside of trade debt and other liabilities incurred in the ordinary course of business?
- Does the company accrue for any contingent liabilities?
a. Should accrue if loss is likely and loss can be reasonably estimated.

Management
o What is the background of the management team?
o Have any been replaced or hired recently?
o What are the shortcomings and strengths of the current management team?
o Do you recommend any changes?
o Are there employment agreements in place for the current management team?
o Who comprises the board of directors?
o What are officers' salaries?
o Do the owners take out any dividends?
o Have the officers lent money to the company?
o Have the officers borrowed money from the company?
o Are there any family members involved in the business?

Revenue Recognition
o Revenue should be recorded after the earnings process has been completed and an exchange has occurred.
o Questionable revenue recognition procedures include:
- Recording revenue when future services remain to be provided.
- Recording revenue before shipment or before the customer's unconditional acceptance.
- Recording revenues even though the customer is not obligated to pay.
- Selling to an affiliated party.
- Giving the customer something of value as a quid pro quo.
- Grossing up revenue.
- Recording sales that lack economic substance.
- Recording cash received in lending transactions as revenue.
- Recording investment income as revenue.
- Recording as revenue supplier rebates tied to future required purchases.
- Releasing revenue that was improperly held back before a merger.
- Barter sales.
o Has the company been stuffing the channel? Do you have visibility into the inventory and sales of your customers?

Gross Margin

o What is the break-down among the different categories of COGS?
- Material

a. Which materials

b. Which vendors
- Direct Labor
a.Seasonal
b. Full Time
- Overhead
a. Indirect Labor
b.Indirect Material
c. Other

Other Assets

o What deposits, prepayments refunds, and credit balances exist in favor of the company?
o Can funds be freed and become available to the company?
o Are any of these funds subject to setoff, attachment or execution?
o Are there assets of value not on the balance sheet?
o Is balance sheet value for any assets substantially lower than market value?

Other Contract - Executory Contracts

o Other than those contracts with customers, vendors, equipment lessors or real estate lessors already mentioned, does the company have any executory contracts?
o These contracts may include lease, franchise or license agreements.
o Are they beneficial or burdensome?
o Are there defaults?
o Can the defaults be cured?
o Is there danger of termination of important contractual arrangements?
o What is the nature of the debtor's obligation under each contract?

Other Insurance

o What coverage does the company have for property insurance?
o What coverage does the company have for general liability?
o Does the company have business interruption insurance?
o Does the company have an umbrella policy?
o Does the company have product liability insurance?
o Are coverage levels adequate (at lease loan size)?
o Is lender loss payee?
o Are premiums current?
o Has the company discontinued/cancelled/non-renewed any policy recently?
o Any significant claims recently?
o Does the company have any insurance with respect to warranty obligations or product liability?

Taxes

o Are all taxes current?
- Federal taxes
- State taxes
- Local taxes
- Payroll taxes
- Sales taxes
- Real estate taxes
- Personal property taxes
- Franchise taxes
o Is the company scheduled to receive any tax refunds?

Government Licenses, Permits and Certificates of Authority

o What licenses, permits or certificates of authority are necessary for operations?
o Is there danger of revocation or sanction from any regulatory authority?
o What effect would the filing of a bankruptcy have with respect to the license, permit or certificate of authority?
o Is the license, permit or certificate of authority transferable?
o What are the conditions of transfer?
o Is the license, permit or certificate of authority valuable?
o Does it create a competitive advantage?
o What food safety audits has the company undergone over the past 5 years?

Financial/General

o What are company's break-even sales (operating and with debt service)?
o What are primary cost and revenue drivers or the company?
o Explain any significant extraordinary adjustments to P&L?
o Is the acquisition a part of a larger company?
- If so, have all expenses necessary to run the company been allocated to the financial statements provided? If they haven't been allocated, how much would the accounting, IT, etc. functions cost on an annual basis?
o Is the company under accrued in any expense categories?
o Any significant expenditures in the near-term?
o How long after month-end are the books kept open?
o Is the company's cost structure relatively fixed or variable?
o Does the company pay dividends of any kind?
o What is the company's operating account structure?
o Any significant recently capitalized expenses that weren't capitalized in the past?
o What is the company's accounting period (FYE, 4,4,3)?
o Any outstanding litigation? If so, does the company have any judgments against it?
o Does the company have any patents/trademarks (important for branded products)/other intangibles? When do they expire?
o Does the company have any other valuable intangible assets?
o Are there any fixed assets that may have appreciated in value?
o Is the company over or under funded on its pension?
o Does the company have any foreign currency risk?
o What's the company's SIC or NAICS code?
o Does the company receive any income from equity in earnings? If so, how does it compare to dividends from that investment?
o Has the company has any significant one-time gains in the past several years? Where were these gains reported?
- Gains from over-funded pension.
- Sale of assets.
o Were any of these gains used to offset operating expenses or to increase revenue?
o What is the detail of "other income?" Is it mixing income and expenses?
o Has the company made any acquisitions recently?
- Was a reserve created when the acquisition was made (has income been released post-acquisition from the reserve)?
o Are there any "non-recurring" recurring expenses?
o Has the company created a large reserve recently? Is it releasing it into income on a periodic basis?
o Has the company capitalized any marketing, R&D or start-up costs?

QUESTIONS FOR CFO OR ACCOUNTS PAYABLE MANAGER

Supply Chain/Accounts Payable

o Explain the supply chain in which the company operates?
o What is the company's level of horizontal and vertical integration relative to its competitors?
o How is the margin in the supply chain distributed?
o Does the company have any licensing arrangements?
o What terms do your vendors grant you?
o Have there been any recent changes in the vendor terms?
o What is the overall DPO?
o What is total AP?
o How much is over 90 days?
o How stretched is the trade?
o Is the company receiving the product it needs on a timely basis?
- Are you COD with any vendors?
- Are calls being returned to vendors?
- Do you have open terms with your large suppliers?
- Are you bumping up against any credit limits with suppliers?
o What has been the trend in AP (over 90 days now vs. one month, three months, one year, etc.)?
o How many vendors in total?
o Do you have commitments in place to pay down vendors' past due balances?
o Are there significant held checks?
o Are there significant checks in the float?
- Is the company playing the float?
o Have all invoices been put into system?
o Do you have any supply agreements? Are any long-term?
o Are there any future purchase commitments?
o Who are the company's most important/largest/most powerful vendors?
o What does the company purchase from those suppliers?
o Have there been any recent changes in the vendor base?
o How many sole source suppliers does the company have?
o How concentrated in the AP base?
o What are disbursements that do not run through AP (payroll, commission, etc.)?
o What are the major raw materials purchased from outside vendors?
o Does the company have seasonal periods of high utility costs?
o Are volume discounts taken from suppliers?
o Are there any commodity supplies with significant price fluctuations?
o Can you hedge commodity risk?
o Are there any non-arms length transactions with suppliers?
o Are all invoices sent directly to the AP Manager or do various people in company receive invoices?
o Are all invoices supported by purchase orders?
o Who approves purchase orders?
- What are that person's approval limits?
- Who else must sign off?
o Are bids typically received before a purchase order is approved?
o With respect to fringe benefits, union dues, or any times for which it is the responsibility of the debtor company to withholding amounts from wages or to make payment for the benefit of employees or retirees, has the company defaulted in its obligations? Items include:
- Life insurance
- Health and accident insurance
- Pension fund
- Charitable contributions
- Vacation pay
- Withholding taxes

QUESTIONS FOR CFO OR PURCHASING MANAGER

Inventory

o What is the company's inventory?
o How is it broken down among RM, WIP and FG?
o What is the company's DIO?
o Does the company have a perpetual inventory system?
o What are the bank's advance rates against inventory?
o Have you had a recent appraisal done on the inventory?
o Does the inventory have intrinsic value (can is be sold outside of a going concern)?
o Does the company build-to-order or build-for-inventory?
o Is the RM commodity in nature?
o Is it stored in such a way that it could be easily sold (for example a half full paint can couldn't be sold)?
o How quickly and how expensive would it be to convert WIP into FG?
o Are FG specialized for a specific customer?
o Would other customers purchase the FG?
o Would current customers purchase FG at discount?
o Does the company have any consigned inventory?
o Do any customers provide tooling or other materials?
o Where is the inventory located?
o Does the company own those facilities?
o If not, did the bank receive landlord waivers?
- If no waiver, need to come up with plan to control the RE post-closing to sell assets.
o Is there any excess/obsolete inventory? If so, who could it be sold to?
o Is the company appropriately reserved for slow moving inventory?
o What is the company's reserve against obsolete/slow moving inventory?
o When is the last time the company took a reserve for slow-moving inventory or any other adjustment?
o What category is slowest turning?
o Do you have the right inventory for what you're current selling (are you out of "white bread")?
o What is high and low point of inventory during season?
o From where is product distributed?
o How often is a physical inventory taken?
o Does the company typically have significant variances resulting from the physical inventory?
o Can the company return inventory to its vendors?
o Are there particular problems with respect to the disposition of excess inventory having to do with brand names of customers, market conditions or distribution problems?
o Is the company's space adequate for its inventory?
o Does the company have any private label inventory?
o Any vendors with a purchase money lien on the inventory?
o Any other creditors with liens on any of the inventory?
- Grower's Lien
- Lien for Grower's Lender
- Producer's Lien
- Livestock Seller's Lien
- Lien for Warehouseman of Alcoholic Beverages
- Depository Lien
- Logger's and Lumberman's Lien
- Mechanic's Lien
- Warehouseman's Lien
- Lien of Carrier
- Landlord's Lien
o Does the company account for the inventory using LIFO or FIFO or some other method? If FIFO, what it the LIFO reserve?
o Has the inventory costing method changed recently?
o Has the company been liquidating LIFO layers over the past two years?
o Is the inventory of a stylistic nature or subject to technological obsolescence?
o Do you have a build plan? Is it based on purchase orders?
o How much of a reserve does the company have against inventory?
- Has the reserve changed in dollar or % terms?
o Inventory items most banks consider ineligible
- WIP
- Obsolete goods
- Damaged goods
- Slow-moving goods
- Custom goods
- Private label goods
- Packaging material
- Perishable goods
- Samples, demos, prototypes
- Costs capitalized for tax purposes
- Consigned goods
- Goods not on company's property - landlord's waiver or bonded warehouse is OK.
- In-transit goods (may be considered OK)
- Foreign inventory
- Samples
- Inventory at job sites
- Inventory at locations where less than 10% of total goods are located
- Goods located in US foreign territories
- Bill and hold inventory
- Goods encumbered by other liens
- Goods where there is questionable title

Conclusion:

The due diligence process is very financially oriented, but professionals in legal, tax, human resources, insurance & risk, sales and operations are typically involved in the process and responsible for difference areas of the validation process. Do not take the process lightly and do not assume the information being provided is correct without a through vetting and analysis to validate the accuracy.

It takes an experienced, cross functional team to perform due diligence, remember this is also part of the negotiation process as the final purchase price usually is adjusted based on the information from due diligence. Be sure to ask the right questions, then validate!

Keith McAslan is a Partner with CxO To Go a national professional services company headquartered in Denver, Colorado that provides on-demand C-Level expertise and best practices to client companies on a part time, flexible, and affordable basis. Keith is sought after to provide advisory services as the Trusted Advisor to Owners and CEO's. By utilizing his extensive experience as a successful financial and operational C-level executive, Keith brings a results driven leadership style to complex situations.

McAslan's expertise includes: financial advisory; management consulting; part time, interim & virtual CFO, COO and CEO; debt and equity financing; turnaround management; acquisition and divestiture advisory. Most recently Keith, was instrumental in the successful sale of Western Forge to Ideal Industries. As the interim CFO with finance and private investment transaction experience, he guided the management team through the complex sale and due diligence process completing the sale from prospective buyer presentation to close within 60 days. Please contact Keith at 303-520-2493, http://www.cxotogo.com, or kmcaslan@CxOToGo.com to discuss your business needs.