Hypotenuse Enterprises, Inc.


M&A Today
The Role of 
phantom due diligencesm

Volume 10
Number 8

August 2001

Reprinted by permission from M&A Today

   The divestiture of a business may be the most important economic event of a seller’s life.  Unleashing the value which has been built up over a period of years may be an owner-seller’s only opportunity to provide for future income and retirement, and to build an estate.  Even a company divesting one of its own businesses is responsible to the shareholders to maximize the value which has been created.  Yet most sellers, in spite of the importance of the event, miss a significant opportunity in the divestiture process to enhance the value they will ultimately receive.

Typical Process

The typical divestiture process involves thousands of hours of work.  First, there is the analysis leading to the decision to sell, examination of the potential market for buyers.  Then a seller may make a significant effort to choose a representative intermediary in the transaction process.  There will be the inevitable valuation process, pricing decisions and preparation of an offering document.  Potential buyers will be targeted, suitable approaches decided, confidentiality agreements executed, a data room prepared, due diligence scheduled and conducted.  Bids will be evaluated, negotiating strategy and deal structure will be decided. Then, when the field of buyers is narrowed, numerous drafts of selling documents will be prepared, financing issues addressed when necessary, government approvals secured when required, and ultimately a transfer of title and purchase price.  And each transaction will have its own variants of the above, requiring creativity, flexibility and responsiveness at each stage.

  Buried in this process, between the transmission of offering documents and the final due diligence, is the prospective buyer’s first encounter with the selling management who intends to remain with the company after it has been sold. Often this first encounter is during a series of presentations by management in a day long meeting, rehashing the offering memorandum, showcasing management’s own capabilities and vision, and responding to the inevitable zinger questions from prospective buyers.  It is during this part of the process – the management presentation – that tremendous value is built or destroyed in the buyer’s eyes.  Yet, sadly, very little appropriate preparation is done by most sellers to maximize the value they can achieve by preparing well for the management presentation.

The Problem

The individuals who participate in the selling management presentation are usually the head of the business and his or her direct reports, or at least those in the most crucial roles.  Depending on the nature of the business, the key management may include the head of Research & Development, Marketing/Sales, Manufacturing, and/or the CFO.  Often the Human Resources head, Legal Department, or Controller’s office will also attend, although most sellers will make an effort to limit the number of participants.  

  Beyond limiting the number of attendees, our experience is that most sellers do very little overall strategy development for the management presentation.  The presenters are usually seasoned business people, qualified in their areas of expertise, and possibly even with superior presentation skills. Therefore, it is tempting to rely on them to just draw on their own capabilities to make an effective presentation.  Such reliance usually results in a rehashing of the offering memorandum, which often has been read in advance by the buyer’s attendees.  This results in the buyer’s “half-hearing” the words of presentation, as they wait for the appropriate time to begin questioning.  The occasional seasoned buyer will throw a team off completely by stating that they do not want to hear a presentation, they just want to ask questions.  The selling shareholder thus loses a tremendous opportunity to do a true “selling” presentation, which builds on and is consistent with the offering memorandum, which anticipates the buyer’s questions and provides an answering presentation in a proactive rather than reactive mode, and which showcases the capabilities of the selling management, rather than just their presentation styles.

  To understand why this problem exists, one needs only to focus on how particularly difficult is the position of selling management, torn between loyalty to the selling owner, yet wanting to be attractive to the potential buyer.  For most selling managers, their usual business and trade presentations are very much different from the kind of presentation which will be required in the situation of selling a company.  Questions will be asked which they have never had to answer before, and a dress-rehearsal rehash of an offering memorandum does not prepare selling management for a question such as “If you think this business is so terrific, why aren’t you leading a management buyout?”

What is Phantom Due Diligencesm?

There is another approach to preparing the management team for success.  We have developed a process called Phantom Due Diligencesm to enhance the results of the management presentation.  With preparation only from publicly available information and the offering memorandum, our team “appears” as a buyer would in order to hear the management presentations, and to react as prospective buyers would likely react.  Of course, we are identified as “phantom” buyers, but that does not prevent consistency and continuity in role playing.  The benefits to the selling management are significant:

1) Phantom Due Diligence brings a fresh view to the process.  It is difficult for anyone engaged in the process, including the intermediary who wrote the offering memorandum, to conduct any more than a dress rehearsal.  The intermediary becomes so intimately familiar with the property that it is difficult to ask questions to which he or she knows full well the answers, and it is difficult to create questions that are meaningful when the questioner is too close to the trees instead of viewing the forest.

2) Phantom Due Diligence protects the buyer resource in a small auction population.  If a business which is for sale has dozens of potential buyers, a poor management presentation may scuttle the interest of the first two or three buyer-attendees, but many more remain.  Where the interested parties are far more limited, however, each buyer resource is crucial to maintaining an auction environment, and shouldn’t be wasted on what could become a poor management dress rehearsal.

3) Phantom Due Diligence builds the confidence of managers before the crucial presentations.  Having learned from the Phantom Due Diligence experience and critique, the remaining management presenters (some do occasionally get dropped during the process) will be far more confident in answering the prospective buyer’s tough questions.

4) Phantom Due Diligence results can be tested against and integrated into the entire transaction process, from valuation expectations to negotiating strategy and from deal structuring to handling of the remaining due diligence.  For example, if in the presentation session a “buyer” focuses on how to merge sales forces because the valuation is greatly affected by expense reduction, the presentation will likely be revised to indicate how a buyer would go about merging  sales forces, and the due diligence room would likely contain a good deal of information on sales force expenses and structure. 

Additional Enhancements to the Management Presentation

We believe that Phantom Due Diligence is the single most important action that selling managements can take, beyond the usual deal process, to enhance the financial results of their selling efforts.  There are, however, other specific actions which a selling company can take to prepare the management team for the selling effort.  

1) Communicate the selling decision to key management.  Clearly, to the extent that key management is aware of the selling decision, they can be of assistance in marketing the company effectively, and keep the company stabilized during a challenging period. The selling owner is usually well advised to consider stay bonus contracts, spelling out the obligations of management, what they will and will not do during the selling process in order to better delineate the line between current loyalties and future opportunities.  Management can then be enlisted to identify strengths to leverage and weaknesses to deal with, before such issues are surfaced by the prospective buyer.

2) Write the offering memorandum to provide the unique value proposition that buyers will find attractive, and discuss at least in general terms any issues that would keep buyers from perceiving full value.  For example, if a patent is about to issue, it is better to state that a patent issuance is imminent and is expected to have a favorable impact on market share, than to have the offering memorandum leave the impression that the technology is not patentable.  Further details can be provided during the management presentation or during due diligence. 

 3) Add unique value in the management presentations.  It is better to assume that the buyer has read the offering document and to give powerful presentations which enhance the content of that document, than it is to rehash what the prospective buyer has already read.  Anticipate questions.  It is better to say in a presentation the reasons that the gross margin should increase, rather than wait for the question and then respond defensively.  The management presentation should show-case the company primarily, and the management secondarily.

4) Assemble the data room and perform all the internal due diligence in advance of the first buyer’s beginning due diligence.  A surprise in due diligence, found by the buyer instead of the seller, can be a very expensive error that diminishes value and credibility.  When a company conducts its own due diligence in advance, it has the information to be able to leverage its strengths and proactively address the weaknesses or business challenges.  To wait for the issues to be raised by the prospective buyer is to yield the advantage of proactive discussion for the passive answering of questions.  Best practice would be to have the results of the seller’s due diligence and data room preparation available before offering memoranda are distributed.

  As an extension of our phantom due diligence work we are sometimes asked to  comment on our response to the offering document, and if it is at a draft stage we are often able to point out what was confusing, irrelevant, misleading or diminishing of value.  After the management presentation, we have been asked to evaluate the presentation results from a buyer’s viewpoint, suggest areas to strengthen the presentation, especially the answers to questions. We have also given input regarding information a prospective buyer would expect to find in the data room, based on a review of the offering document and the management presentation.  Such supplementary assistance in Phantom Due Diligence further enhances the positioning of the business for sale.  Sometimes the selling owner is our client, sometimes an intermediary advisor is our client.  In either case, the goal is the same:  to prepare efficiently and effectively for the selling process to maximize value.

Diane C. Harris is Founder, President and CEO of Hypotenuse Enterprises, Inc., 1545 East Avenue, Rochester, NY 14610 (716-473-7799 and after January, 2002 585-473-7799), www@hypot.com.  (Phantom Due Diligence is a service mark of Hypotenuse Enterprises, Inc.)  As Vice President of Corporate Development at Bausch & Lomb, Diane C. Harris led the global corporate growth program through the completion of over 230 deals – including 47 acquisitions and 25 divestitures – with a total value of over $1 billion.  Her tenure at Bausch & Lomb was one of expansion, new sector entry and roll-ups.  Half the company’s year to year growth for ten years came from corporate development initiatives.  In 1996, she founded Hypotenuse Enterprises, Inc., a mergers and acquisitions consulting and advisory firm that works closely with companies to negotiate, structure, and implement transactions.  Hypotenuse has completed over a half-billion dollars in transaction value.



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