Using Due Diligence to Predict Transaction Success

Due Diligence 2

Failing to conduct intangible asset due diligence has led to deal makers losing millions they didn’t need to.

Research shows that today, intangible assets account for over 90% of company value of the S&P500. However, many due diligence processes are still focused on tangible or fixed assets, which is ironic given how little of company value today is attributed to these assets.

If you are acquiring or entering into a capital arrangement with another business, or are considering an acquisition, merger or joint venture, ensuring that you have undertaken proper due diligence is critical. Given the critical role of intangible assets in generating value this necessary includes due diligence of both the target’s tangible and intangible assets.

Do Your Homework

Intangible assets can present at least two unique challenges for due diligence.

First, unlike physical products, intangible assets (especially those that are unregistered such as trade secrets) being literally intangible are often difficult to inventory or audit and so even bare identification can be problematic.

Second, accounting standards such as GAAP and IFRS almost completely ignore intangible assets. They are either off the balance sheet entirely, lumped under the amorphous term “good will” or recorded solely at cost. This was acceptable in the 1970’s when intangible assets only accounted for 17% of company value and tangible assets did all the work. Today with that ratio inverted, this will no longer suffice. Too often because intangible assets aren’t effectively captured within the balance sheet or P&L they are overlooked when it comes to major transactions or are not treated with the respect they deserve given the financial performance they drive and the risks they can give rise to.

Rules of Engagement

With little attention directed towards intangible assets during many due diligence processes, opportunities and issues can easily be missed. To avoid this situation, directors and management teams need to establish whether they are asking the right questions and if the right assets are being assessed.

To begin it is important to recognise that intangible asset due diligence is not: “Does it have a patent?” Yes / no, tick… move onto IT due diligence. Comprehensive intangible asset due diligence involves:

  • systematic identification and assessment of all material intangible assets relevant to the company and / or transaction;
  • assessment of how those intangible assets are managed (what are the systems, processes and policies in place to administer these assets) to ensure their value is maintained or increased;
  • identifying future opportunities and current risks that may impact the value or viability of these assets; and
  • assessing the potential impact of these assets (and attendant risks and opportunities) on the transaction itself.

A Warning Shot for Directors

Given the overwhelming dominance of intangible assets in most company’s value stack these assets literally have the potential to become “deals of the century.” We have seen both scenarios: tears and cheers among both large and small companies. It is important to note at this point that company directors and officers have a “fiduciary obligation to generate a return on, and manage risks to, all assets under their stewardship and control”. The key word here is “all” – this specifically incudes both tangible and intangible assets. In a transaction if the focus is solely on tangible assets and there is a failure to undertake due diligence on intangible assets, it is a breach of this fiduciary obligation and will expose directors and officers not just to business risk but to personal liability also.

Valuation May Be Required

Depending on the outcomes of your due diligence, it may also become necessary to value some or all of the intangible assets to gain a better idea of how these will impact on the overall transaction. In the case of intangible assets (much more so than tangible assets) a) the quality and strength of the asset should not be assumed, b) it is important to recognise their value will bear virtually no relation to whatever value they are recorded on the balance sheet and c) their value can change materially faster than traditional tangible assets such as land, plant and equipment where value tends to be more stable.

Conclusion

The good news is that if intangible asset due diligence is carried out early in the investment process it is relatively inexpensive. And when looking at the big picture, any costs associated with intangible asset due diligence are a positive bargain compared to losing millions on a deal because key risks or opportunities were ignored or overlooked.

As one senior investment banked remarked to us recently: “My whole career I spent 80% of my time diligencing the 20% of tangible assets. I left a lot of value on the table and took a lot of unknown risks. I now realised I got this 180 degrees out of alignment. If I knew then what I know now I would have made and saved a hell of a lot of money.”

In short it is no longer advisable or acceptable for due diligence to focus on tangible assets, there needs to be a rigorous and robust focus on intangible assets.

 

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