In this
age of acquisitions, hardly a day goes by without an announcement of
a merger, large or small. Yet many deals are based on big-picture
assessments of value, without all the parties involved knowing all
the details.
Quite often, a proposed merger or acquisition gets canned or
valued down following conflicts over intellectual property rights,
personnel, accounting discrepancies or incompatibilities in
integrating information technology systems. The process of
researching, understanding and, in some cases, avoiding these risks
is known as due diligence.
"Due diligence is going in and digging a hole in the ground and
seeing if there's oil, instead of taking someone's word on it," says
Joseph Bankoff, a partner in the intellectual property and
technology practice at law firm King & Spalding in Atlanta. "If
you don't do a sufficient amount of due diligence, you don't really
know what questions to ask."
In the case of a technology acquisition, a due diligence
investigation should answer pertinent questions such as whether an
application is too bulky to run on the mobile devices the marketing
plan calls for or whether customers are right when they complain
about a lack of scalability for a high-end system.
Meeting Expectations
Due diligence entails taking all the "reasonable steps" to ensure
that both buyer and seller get what they expect "and not a lot of
other things that you did not count on or expect," Bankoff explains.
The process involves everything from reading the fine print in
corporate legal and financial documents such as equity vesting plans
and patents to interviewing customers, corporate officers and key
developers. It helps to identify potential risks and red flags.
Greg Faragasso, an attorney at the Securities and Exchange
Commission (SEC) in Washington, recommends examining public filings,
especially the 8-K, which the SEC requires public companies to file
when an auditor resigns. The document must state the reason for the
departure. "The reason an auditor resigns is very often benign and
due to legitimate disagreements," Faragasso says. "But an 8-K filed
by auditors that quit could be interpreted as a red flag."
Increasingly, IT systems and professionals are playing a
significant part in understanding the viability of a proposed merger
or technology acquisition for two reasons: Incompatible systems
often take considerable time and resources to integrate, and
conflicting intellectual property rights can potentially curb a deal
before it takes off.
According to John Haven Chapman, an attorney and general partner
at Dignitas Partners LLC, a strategic venture-capital firm in New
York, many deals hinge on intellectual property ownership and key IT
personnel. "Who has the rights to the intellectual property in a
spin-off situation or making sure the rights stay within a venture
when an employee leaves" is critical, he says.
Every company handles intellectual property rights and patents
differently, but for the most part, technology created by an
employee during his tenure at a corporation belongs to the
corporation, even though an individual's name appears on the patent.
San Francisco-based UCSF Stanford Health Care killed the
2-year-old proposed merger of four teaching hospitals partly because
of IT integration concerns, auditors reported. In 1998, MedPartners
Inc. in Birmingham, Ala., and PhyCor Inc. in Nashville halted a
proposed $6 billion merger after discovering significant IT
incompatibility issues.
"It's never as simple as it looks on paper," says analyst William
Fiala at Edward Jones Co. in St. Louis. "There is a tendency to
underestimate the complexity of integrating two systems or changing
over to a new system entirely."
Fiala cites Tomahawk missile maker Raytheon Co. in Lexington,
Mass., as one example of a company that underestimated IT
integration's potential impact. Last October, Raytheon officials
stunned investors with much lower than expected earnings and pretax
charges totaling $638 million. Part of the revenue shortfall stemmed
from difficulties encountered in consolidating defense units from El
Segundo, Calif.-based Hughes Electronics Corp. and Dallas-based
Texas Instruments Inc.
"Raytheon had 45 general ledger systems after the acquisitions.
They are now trying to get down below 30, but that's still a lot,
and (it) will take them years to implement a new SAP (enterprise
resource planning) system to simplify their accounting even more,"
says Fiala.
Protective Measures
Warranties and assurances can be written into a merger document
or software contract to protect those involved. For example, a
potential buyer may discover problems in a technology under
consideration after testing and interviewing customers during the
due diligence process. As a result, the customer may withhold part
of the purchase price in an escrow account until the bugs get fixed
or custom code is written to solve the problem. If the problems
aren't resolved in accordance with specifications, this reserve
money could be used to address problems or be returned to the
purchaser as a sort of rebate.
But many times, walking away from a deal is a better option than
employing risk-shifting mechanisms.
"Deal paper will only protect you so far," Bankoff cautions. "In
this economy, where the average life cycle of a product is only 18
months from launch to death, arguing about someone's warranty in
court for five years is not productive."
Chapman concurs: "It's the kiss of death to make an improper
acquisition or investment. Not only are you buying a dog, but the
dog can kill your company."
To Buy or Not to Buy: Points to Consider
Evaluating an IT purchase is a type of due diligence referred to
as risk management. The big accounting firms and IT consultancies
such as Compass America Inc. in Reston, Va., and Quantitative
Software Management Inc. in McLean, Va., tackle technology risk
management.
When determining if a software system or new technology fits
business goals and the supporting IT shop, Compass America senior
consultant Syd Hutchinson recommends considering the following:
Early adopter risks. Is your company going to be the first to
use the technology in great volume? It may perform well in
restricted scenarios, but are there customers using it at the
capacity your company would?
Life-cycle costs. When buying or acquiring a technology, the
purchase price is only one part of the equation. Consider the
maintenance and upgrade costs of running the technology for the next
10 years, not just the costs of getting it in the door.
Skill sets. Does your IT shop possess the in-house skills to
support the technology, or will adopting it require retraining the
whole staff or signing an outsourcing contract to get proper
coverage?
Douglas Putnam, vice president of services at Quantitative
Software Management, is wary of "egregious buy-ins" and "super
conservative bids" on time and materials in proposals because often
"the customer gets stuck picking up the costs." He suggests writing
warranties into the contract to ensure that conditions are met and
specifying quantitative measures because "reliability can be a
nebulous concept."
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