Avoiding M&A Pitfalls in SMEs

Economic recession results in closure of few companies and the others who survive the downturn look for opportunities to consolidate in the market. Mergers & Acquisitions (M&A) is the natural process of clean-up and consolidation in an open market; increased M&A activity normally indicates signs of economic recovery. Post the economic downturn of 2008 & 2009, in the year 2011 we have witnessed signifcant amount of M&A activity in the UAE, especially in the Small & Medium Enterprise [SME] segment. It is a well acknowledged fact that SMEs form more than 90% of UAE's non-oil economy base. While these M&A activities continuing to increase as we enter 2012, we thought it may be useful for SMEs to understand the key pitfalls M&As face.

M&As among large corporates are normally administered and supported by professionals and experts in accounting, law and operations. This ensures that the M&A deal is well structured and the transaction progresses with adequate documentation, with milestones and withdrawal points identifed at key stages.

However, typical SME based M&A in the UAE is driven mainly by the two business owners (the buyer and seller) based on mutual trust and with minimal documentation. While, it is prudent to keep 'simple maters simple', a focused due diligence done during such M&As would ensure that deal breaking situations are minimized and post M&A integration is smooth.

While we acknowledge that each M&A deal is very unique by itself, this article discusses a couple of interesting cases which gives very useful learning points in handling such transactions. We have summarized the aspects which went right and those which went wrong, with probable remedial steps which should have been taken in the pre M&A stage itself

Case 1: Acquisition of a manufacturing entity

What went right…	What went wrong..
Accounting policies and systems at the target company was appropriate and well understood prior to commencement of due diligence	Memorandum of Understanding (MOU) was not signed prior to commencement of the due diligence which resulted in following issues: Focus and approach of the due diligence work had to be continuously reoriented Lack of co-relation between the shareholders intent and the management responsibilities in the acquired entity, with respect to the deal
Intention of M&A was clear between the Buyer and Seller, though not signed of formally.	Cut-of dates were not fxed resulting in delay in the deal being concluded
Internal controls within the acquired entity was well established, which gave sufcient assurance of the statements put forth by the management team	Resultant issues in post due diligence integration both from the fnancial and human resources angle

What should have been done prior to MOU stage

Signing-of a formal MOU prior to the due diligence would have ensured the following:

Roles & responsibilities are clearly stated from the buyer and seller perspective
Communication with the management team would have been smoother and beter co-ordinated
Cut-of dates were fxed and due diligence completed on time
Focus and approach of due-diligence would have been clear

HR Due diligence could have been included as part of the scope with the following key objectives

Conduct Work Force Census – to provide a glimpse into the overall stafng model and throw light on whether stafng levels are adequate or in excess based on benchmarks of the industry
Audit the recruitment process - to understand the fairness of recruitment process and compliance to statutory requirements
Review the employment contracts – to establish changes / modifcation required as part of the post M&A integration within the buying entity's ethos and HR framework
Competency Assessment of key personnel – to establish whether the acquired employees pass the minimum criteria set out in the buying entity's operating framework

Case 2: Acquisition of a chain of small retail outlets

What went right…	What went wrong..
Pre-Due Diligence Memorandum of Understanding (MOU) was well drafted and clearly outlined the deal terms and the assets & liabilities which would be acquired by the buyer	The item master / product database of the acquired entity was not studied and mapped to the existing database of the buyer, even though 60 – 70% of the products were common with same barcode. This resulted in signifcant amount of manual entries during stock count and subsequent diferences in the inventory valuation from the seller and buyer perspective.
Cut-of date basis for each outlet and for the central warehouse was pre-stated in the MOU and both the seller and buyer were ready for the same. The inventory check date for each outlet was agreed, rightly, as the cut-of date basis and all the retail outlets were acquired over a period of 15 days, one at a time.	The accounting policies and systems at the acquired entity were not understood prior to the deal, which emerged as a signifcant issue during due diligence. While it was known before the deal that the acquired entity was not having Audited fnancials, the buyer was not aware that the entity was following weak single-entry accounting methods. This fact was revealed only during the initial stages of due diligence, the result; the scope and approach of due diligence had to be completely changed and the time taken to complete the deal was extended.
Take-over and post acquisition integration mechanism was well defned and understood by the buyer; and the seller was in concurrence to the same, though not documented

What should have been done prior to MOU stage…

While the buyer did avail the services of a professional frm to conduct the due –diligence, involving the frm in the pre-MOU stage to get a high – level understanding of the processes, systems and business model of the target entity would have ensured that the potential botle-necks expected during the M&A transaction are identifed and dealt with prior to MOU signing and approach of due – diligence is planned, accordingly

Ofine mapping of the inventory master databases prior to inventory check would have reduced time spent on inventory check and also would have ensured that the subsequent diferences in the inventory valuation was avoided.

Integration of the database and geting the post acquisition operations
smoothly started would have been made easy through the Ofine
mapping of the inventory master databases.

Companies use mergers and acquisitions to build market share, broaden product oferings, and enter new markets. However, the process of M&As, however small the deal may be, should be well thought out and planned. The key steps, if well planned and executed, which normally lead to a successful M&A deal are:

Step 1: Understanding the Regulatory Framework for the industry in which the acquisition is planned. Normally not an issue when the buyer is already operating in the same industry and jurisdiction. However, special licensing requirements from an acquisition perspective and the time involvement and botlenecks, if any, from an M&A perspective needs to be understood.

Step 2: Pre – MOU stage discussions and agreements with the seller are well documented, including the purchase consideration basis. This ensures that the MOU drafting is easier and sign-of is quicker. At this stage it is also recommended that a high-level understanding on the business model, processes and systems of the target company are obtained. The MOU should draw points from the same.

Step 3: Scope out a due diligence using the MOU as a basis and including post incorporation challenges expected as part of the due – diligence. Identify Deal breaking red-fags which may emerge through the due diligence process and immediately discuss the same with the seller as and when such red-fags are encountered.

Step 4: Discuss and fnalise the deal using the due – diligence report as a reference point and commence on the post acquisition integration planning

Step 5: Formalise the fnancial & legal closure of the deal. The use of professional advisors such as technical specialists (if the acquiring industry is new), fnancial specialists and legal specialists, though not always necessary, would serve in ensuring objectivity and timely completion of the deal.

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