The ownership and quality issues discussed in the previous articles in this series can definitely have a financial impact, but sometimes it’s not easy to quantify. In this installment we’re going to discuss items that can be discovered during IT due diligence that have a very quantifiable related expense.
Probably the most common and potentially most significant is software licensing. For any number of reasons, not all of them intentional, TargetCo may not have properly licensed all of the software it uses. Sometimes it IS done intentionally to avoid the expense, but more often it’s due to a lack of understanding or appreciation for the way software licensing works. Regardless, assuming that the goal is to run AcquiringCo as an honest business, any improperly licensed software needs to be brought into compliance.
Besides being the right thing to do, without proper licensing, AcquiringCo opens itself up to whistle blower lawsuits via software industry organization programs which promote proper software licensing.
A real world example I experienced was a company that, instead of properly licensing a particular software package used by its employees, used a single shared copy through a desktop sharing server. This was identified as an issue during IT due diligence, and the $200,000+ it took to acquire the proper licenses was paid by TargetCo as a condition of the deal closing.
Lack of Maintenance
Another common expense that can be identified in due diligence is lack of maintenance or outdated equipment. You might discover that TargetCo has been more profitable because its web and database servers are old, and that the hardware required to handle the expected increase in traffic after the transaction closes will be a significant go forward expense. Or, all of the TargetCo desktop and laptop computers might be running an outdated version of Windows, and bringing them up to AcquiringCo’s corporate standard would mean a significant outlay. These are typical issues in a family-owned or lifestyle business where keeping expenses low is part of the DNA.
Supplier contracts are something to be carefully considered. You may find that TargetCo is tied into an expensive contract for the next three years, and the financial model of the deal counted on a related expense reduction that isn’t really there. You can’t assume you’ll just terminate an existing contract and move TargetCo under the umbrella of your better contract after the deal closes. Telecom contracts are notorious for this. They often contain provisions that require full payment from the remainder of the contract term if they’re cancelled. It’s important to work closely with the financial and legal due diligence teams on issues around the contracts and assumptions.
Employee salaries at TargetCo also deserve careful review. If TargetCo has kept employee salaries low to enhance profitability, the staff may need to be brought up to industry or AcquiringCo standard levels. Having lower salary levels for the newly acquired TargetCo employees won’t be a viable long term solution – people will always find out one way or another. This expense needs to be taken into account when considering future profitability and the multiples used in the deal valuation.
The last article in this series will focus on employee issues.