Today’s mergers and acquisitions landscape involves more transactions between companies of difference in sizes (in terms of assets, capitalisation etc)[1]. But if you are a Goliath, a giant in your industry, looking to buy over a David, a startup or small medium enterprise, some understanding of the nature of such transactions and the risks this entails is fundamental.

In the first of a two-part series, we will explore the risks that Goliath will need to know before assuming such transactions and some of the steps that Goliath will need to consider prior to doing so. In our subsequent series, we will investigate ways in which David should get itself ready for such a transaction.[2]

Before we delve into the main consideration points, it is also important to highlight that we have assumed for the purpose of this article that the acquiring company (which is the larger company) (“Acquiring Company”) has done all financial due diligence and that not acquiring the target company (which is the smaller company) (“Target Company”) is not an option; otherwise some of the points listed here may be a deal-breaker which the acquiring company should consider as part of its decision whether to proceed with the deal.

We have assumed for the purpose of the article that the nature of the transaction is an asset sale rather than a share sale given that in most instances, the Acquiring Company will only look to certain assets of the Target Company as that is the real value to the Acquiring Company rather than taking on the entire Target Company.

DAVID LOOKS DIFFERENT FROM GOLIATH

In conducting due diligence of a Target Company, the Acquiring Company will usually draw out a list of questions and requests for information and documents which are consistent with the expectations of the Acquiring Company without realising that given the smaller size of the Target Company, there are documents and/or information which the Target Company do not prioritise in keeping as records.

To sample a few problems, this can take the form of:

In taking a pick of the problems above, it should be noted – these issues are actually more endemic and problematic than might appear at the outset. Multiple months, quarters or years to remedy before value can be realised.

Without the benefit of the above information and documents, it will be difficult to understand the full value of the assets (or the lack thereof) that the Acquiring Company will be assuming.

However, at the same time, given the lack of any processes and/or internal structures to maintain such information, it will be futile to insist from that the Target Company provides everything that is requested.

It is at this stage that the Acquiring Company will have to consider other alternative methods to conduct the valuation process or to protect itself from the transaction turning bad.

Another aspect of this risk can be in the form of compliance structures.

Upon commencement of the legal due diligence process, the Acquiring Company may realise that the Target Company does not have or only have minimal compliance framework.

This can be a potential red flag for the Acquiring Company especially if the transaction involves acquiring assets that require strong compliance program to demonstrate accountability with compliance of legal and/or regulatory requirements.

For example, if the assets to be acquired involve personal data of data subjects, the lack of privacy compliance policies could impede any subsequent disclosure of the data by the Target Company to the Acquiring Company and any further processing by the Acquiring Company of the data. This can potentially render the data assets as useless.

If you are thinking that compliance is just one of a dozen issues and things can be sorted out, consider the size of fines being promulgated for non-compliance for privacy matters under the EU GDPR or even that of the EU AI Act. These are fines pegged to a percentage of global turnover. Even business friendly Singapore, fines can be pegged to annual Singapore turnover for data protection issues.

When regulators benchmark their fines to global or regional turnover, the cost calculation and impact on valuation makes it obvious: pre-acquisition due diligence in legal and regulatory compliance becomes a matter of existential importance. It is no longer an affordable ‘rap on the wrist’.

WAIT. DAVID LOOKS SHORTER THAN HE SEEMED AT FIRST.

Any experienced business operator knows that not all pipeline dollars or revenue is the same. Contracts heavily favouring the opposite side are more costly than they appear. Margins may be lower, or even the same, yes, but this is not all.

The true cost of servicing or living with an unfavourable contract has hidden financial cost and legal exposure. A David who hungrily signed every one-side contract it was foisted with will carry a longer tail of liability and risk exposure than a David who was more judicious. This is a “hidden cost to serve” that could reduce projected value in the long term.

How easy it is to forget when one looks only at spreadsheets and margins.

So, another area of focus is the contracts that are entered into. As the Target Company may not have sufficient resources to support contracting, the contracts entered into may be standard contract templates that do not fully reflect the needs of the Target Company or may simply be third party contract templates that are on terms that are less favourable to the Target Company.

Given the limited resources, there may also be limited monitoring of those contracts to ensure compliance with the terms contained therein resulting in potential breaches that have yet to surface to the Target Company and may remain a blackhole unless these are picked up during the due diligence process.

Unfortunately, this risk may not be limited to commercial contracts as even for employment contracts, unknown to the Acquiring Company, there can be clauses that are tied to certain commercial targets which can include sale of certain assets that result in the Target Company having to pay off employees additional value for such assets or make it a condition to any sale the pay off of such compensations to employees.

Again, this would otherwise have not been picked up if insufficient due diligence is not conducted to review such agreements and pick up these clauses.

DAVID IS STARVING – ITS NOT JUST IN THE CASH FLOW

We preach the gospel of cash flow discipline. And many startups, and small companies might be hand to mouth. But it’s not just that.

A symptom of cash starved companies, is the palpable problem of the Target Company using limited resources to execute operational tasks using individuals and resources stretched beyond their limits.

Consider employees acting in multiple roles and functions including application and maintenance of software / IP licences for the operations of the businesses and/or the assets. This could be a recipe for insufficient software / IP licences were maintained by the Target Company, exposing it to claims for infringement or a shakedown for pricier software remedial licensing fees.

Such gaps can only be surfaced by conducting regulatory specific due diligence where independent experts familiar with the regulatory framework can advise on the licensing requirements, the consequences in not maintaining the same as well as proposed remedial measures to be taken should the Acquiring Company decide to proceed with the acquisition of the relevant assets of the Target Company.

WELL, WHAT SHOULD GOLIATH DO?

Firstly, RECOGNISE that conducting legal and regulatory due diligence on the Target Company is NOT a matter of “going through the motions”.

It is even more important for companies of Goliath’s size to ensure that it is not buying a David that has a closetful of hidden issues – liability time bombs, and value-vapourising regulatory entanglements.

Secondly, the manner in which the due diligence is conducted may have to differ from the regular due diligence. Perhaps start with a preliminary due diligence prior to signing.

Thirdly, as part of the pre-completion undertaking for the Target Company, ask for the data room to carry more details so that due diligence can be carried out pre-completion but post-signing. Inevitably this can have an impact on the deal timelines so this is something that the Acquiring Company may have to factor in.

Fourthly, the due diligence scope should be more targeted at certain key risk areas that the Acquiring Company is of the view will have a material adverse effect on the assets to be acquired.

This is only possible if the due diligence process is conducted with support from independent experts that have a deep in-house knowledge of the industry and the assets that the Acquiring Company is interested in.

Fifth, with the dual due diligence approach, this would also mean that under the agreement, the Acquiring Company should retain the right to make adjustments to the assets post-signing but pre-completion following the outcome of the detailed due diligence process.

The pricing adjustment mechanism will then depend on the Acquiring Company’s internal evaluation of the risks and price reasonable for the risks to be taken.

Finally, at the risk of sounding less than objective, be realistic about the transaction and due diligence costs. The subtle irony is that smaller deals might merit more scrutiny and effort to get right IF you want to get a realistic return.

The next buyer or the next stage of growth might not be inclined to keep one eye closed.

Conclusion

All in all, it will be futile and highly cost ineffective to try to conduct due diligence in the same way on a Target Company that is not as established as the Acquiring Company itself as this will mean more frustration and misplaced concerns around the Target Company.

In-house expert knowledge of the industry will be key to ensure that the due diligence is conducted in a manner that is laser focused on the key issues the Acquiring Company will need to protect itself from.

The real Goliath underestimated David and was brought down by a sling. Today’s Goliaths need to tread carefully. David is a riskier counterpart than he looks.

Do not be fooled by his small size.

Authors: Jeffrey Lim and Frederick Tay

Footnotes

[1] Refer to my earlier article “Taking the driving seat on pharma and life science investments” for a possible explanation for this phenomena in the pharmaceutical and life science industry.

[2] Please note that nothing in our series is intended to re-write the biblical story or intends to illustrate the concept that in such transactions, David and Goliath are on opposing ends. In most cases, the common interests should be the motivation behind the transactions.