Due Diligence Pitfalls and Solutions

Mergers and acquisitions continue to occur at a very fast pace, despite COVID-19, election results, unemployment, natural disasters, etc. After price and terms are negotiated, and a letter of intent is executed, then it is time for buyers and their advisors to perform due diligence. This article highlights some of the key areas to be aware of if selling or acquiring other firms.

What is Due Diligence?

In general, and for this article, due diligence is defined as the process that a buyer takes to research, obtain and analyze all of the meaningful information related to the seller’s business. The purpose is to allow the buyer to understand the risks involved with the acquisition.

Some buyers, especially local/peer-type buyers, will perform the work internally. Others, such as buyers backed by private equity money, will hire an outside firm for an independent assessment.

Usually, a lengthy checklist is sent, and a place is established for the seller to download various files for financial statements, leases, bank records, carrier statements and a myriad of computer reports (employee records, book of business breakdown, new and lost accounts, legal documents, etc.).

Timeframe of the Data

The first problem that occurs is getting the data sent for the right time period. Let’s say the effective date of the letter of intent is October. By the time things are signed and moving forward, it is likely that the due diligence would be based on the 12 months ending in December. There is a good chance things could have changed.

There could be additional new and lost business (of material size), staff changes, carrier changes (commission rates, appetite, etc.) or changes to the market that might have occurred in a couple of months. All of this should be reviewed and explained.

Verify Commission Revenue

One of the most important purposes of due diligence is to verify the revenue. There can be many issues with an agency’s stated revenue. The timing of when things are recorded can distort the “true” 12-month revenue generated by the agency.

For example, it is possible that 11 or 13 months of direct bill commissions can be recorded. Or a large agency bill client can be invoiced well before the effective date to overstate accrued agency bill commissions.

The standard process to verify the commission revenue is to obtain carrier statements, bank statements, client invoices, carrier invoices and premium finance statements for the period being analyzed. Usually, a limited selection of the larger accounts and larger carriers are made, rather than sending in everything. These documents are cross-referenced, along with the general ledger and the production report, to establish a certain level of confirmation that the revenue is correct or to determine what adjustments need to be made.

Account Ownership

One thing that some sellers don’t consider is the impact of account ownership. If a producer owns their business, the agency cannot sell those accounts. Sellers will insist that the producer is going nowhere and has been happily employed for years. From a buyer’s perspective, they would love to keep that revenue stream, but they need to “lock it up” prior to closing the deal. Two common options for the seller are to buy the book before the agency sells, or the buyer can directly purchase the book from the producer in conjunction with the agency acquisition. There are other options as well, such as excluding the revenue from the purchase price but keeping it in for any bonuses based on profitability.

Changes to Compensation

When we work with a client that is selling, we often make changes to compensation for owners, producers, and sometimes, service staff to reflect an optimized situation for staffing and compensation. Often, the assumption is to keep the agency as a stand-alone business. However, if a regional or national firm is acquiring, then we can often remove accounting and some administrative people. We look at removing any “deadwood,” including producers that are not performing well. When payroll records are sent in for due diligence, all of those changes need to be accounted for as the past does not equal the future.

Buyers understand that any decreases in compensation could mean an exodus of employees, therefore, compensation rates often are kept the same, including bonuses and benefits. However, the number of staff may be cut. There can be more flexibility to producer compensation, especially if the seller or buyer offers a one-time bonus or grandfathers old compensation rates for existing accounts.

Other Expenses

Some sellers try excluding as many expenses as they can get away with since many deals are based on the agency’s profitability. Buyers and the due diligence provider will look at historical spending levels as well as general reasonableness to assess the pro forma expenses. For example, an agency might attend an annual trade show as part of its marketing. The seller might insist it is not needed, but an astute buyer would leave that expense in the pro forma. Owner-related expenses, such as auto, meals and entertainment, have the most flexibility in spending adjustments and are often discretionary.

Legal Review

Buyers will also review the corporate documents, leases, carrier contracts, membership in networks, HR matters, open and pending litigation and any errors and omissions (E&O) claims as part of the review. It is important to have full disclosure on any issues, even if it looks bad. Deals can be structured so that the buyer will only take on certain liabilities, which allows for the deal to close. The seller can then resolve any issues that the buyer did not accept as part of the deal.

Due Diligence Results

There is a good chance that financial due diligence will result in differences from the pro forma used in the letter of intent (LOI). This can be the result of the loss of a large account after the LOI was signed, the discovery of non-recurring revenue, expenses that were not considered or just different pro forma assumptions. It is not always negative for the seller — sometimes the revenue or profits increase.

Depending on how large the difference is, or who the buyer is, the two parties might need to re-negotiate the deal. In some cases, the buyer will honor the original terms, even if there is a noticeable decrease to revenue or profits. If the buyer tried to hide or not fully disclose key information, such as lost business, this can be a deal killer.

Summary

The process of due diligence is a necessary step in the sale of a book of business or agency. Try to stay focused and provide the correct information when asked. The use of a consultant to prepare the profile and pro forma from the beginning and to negotiate the sale price and terms is a good step. The adviser can also help a seller rectify the due diligence results against the original offer in the letter of intent. For a sample due diligence checklist, email catoak@gmail.com.