1157.dl - Mergers, Aquisitions, and Sales PDF

Mergers,
Acquisitions, and
Sales
How Internal Audit Adds Value
and Effectiveness
Carl Pitchford
The Institute of Internal Auditors
Licensed to Customer No. 2098633@iiaext.org. Re-distribution is prohibited.

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ISBN-13: 978-0-89413-880-5
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This book is dedicated to my wife, Chris,
for her continued support and encouragement.

Contents
Foreword. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Acknowledgments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
About the Author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter 1: Greater Than the Sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Chapter 2: Types of Mergers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Chapter 3: Evaluating Mergers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Chapter 4: The Role of Internal Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Chapter 5: Key Risk Areas Associated with MA&S Projects. . . . . . . . . . . . . . . 41
Chapter 6: Corporate Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Chapter 7: Methods for Determining the Value of a Private Company. . . . . 55
Chapter 8: Due Diligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Chapter 9: Two Example Case Studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Chapter 10: Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Appendix A: Sample Due Diligence Checklists. . . . . . . . . . . . . . . . . . . . . . . . . . . 109
Appendix B: Sample Best Practices Document. . . . . . . . . . . . . . . . . . . . . . . . . . . 151

Mergers, Acquisitions, and Sales: How Internal Audit Adds Value and Effectiveness
Glossary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155
Suggested Reading List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
The IIA Research Foundation Sponsor Recognition. . . . . . . . . . . . . . . . . . . . . . . 161
The IIA Research Foundation Board of Trustees. . . . . . . . . . . . . . . . . . . . . . . . . . 165
The IIA Research Foundation Committee of Research and

Education Advisors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
vi

List of Tables
Table 2.1: Impact of EFB Merger on Market Value and Earnings per
Share of MFB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Table 3.1: SFF’s Proposed Acquisition of HI . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Table 3.2: Financial Forecasts After the SFF-HI Merger . . . . . . . . . . . . . . . . . 23
Table 7.1: Earnings Method Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Table 7.2: Earnings Method Factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Table 7.3: Discounted Future Earnings Forecasts. . . . . . . . . . . . . . . . . . . . . . . 66
Table 7.4: Discounted Future Earnings Averaging. . . . . . . . . . . . . . . . . . . . . . 67
Table 7.5: P/E Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
Table 8.1: Calculating Potential IT Due Diligence Returns . . . . . . . . . . . . . . . 86
vii

Foreword
Every day, all over the globe, privately owned and publicly listed organiza-
tions couple and uncouple in the dance known as “strategic transactions.” They
merge. They buy each other out and take each other over. Sales are made, and
businesses are chopped up or sold off. Ultimately, they flourish or die; and on
many occasions, their success or failure is directly related to the strategic trans-
actions that shaped their future.
My intention in writing this book is not to silence the music or stop the
dance of the mergers, acquisitions, and sales (MA&S) process, but to encourage
you, as internal auditors, to think long and hard about the ways you can make
your voices heard, either by championing an advantageous transaction or by
sounding the alarm if a deal does not add up.
Due diligence audits should be carried out by those in the bidding or
acquiring company who have broad, in-depth knowledge, expertise, and
experience regarding the different activity sectors involved and who can
fully comprehend the business of the target company: the internal auditors.
By completing thorough due diligence, internal auditors can impress upon
management important information that signals a red or green light for these
critical business transactions.
The work is complex. Obviously you should be supported in your work by
other departments and by outside experts and consultants, especially if your
internal audit activity does not possess the requisite skills and experience to
complete all aspects of thorough due diligence effectively.
The MA&S process can be long and filled with details, decisions, and diffi-
cult personalities. The larger the target company, the more complicated the
ix

process is likely to be. If your company is purchasing another strictly as a finan-

cial venture, the MA&S process is complicated enough. Difficult personnel
issues, technological concerns, and conflicting strategic objectives can make
the process even more complicated. Buyers and sellers should be clear about
their specific motivations pertaining to the potential purchase or sale. Clearly
defined goals are essential in evaluating the impact of subsequently uncovered
details; and although developing these goals requires advance preparation and
evaluation on the part of both buyers and sellers, it greatly enhances the likeli-
hood of post-acquisition success.
It is also important that buyers and sellers understand the perspectives of
other parties involved in the negotiations. The MA&S process takes place over
an extended period of time, during which the buyers and sellers constantly
learn more about each other. Maintaining an environment of trust helps greatly
in dealing with the numerous complex issues likely to be encountered during
this process. Should the integrity of either party be called into question, the
entire transaction could be placed in jeopardy, even when, on the surface, all
the operational and financial pieces seem to fit.
In the pages of this book, you will find important tips and techniques for
understanding the MA&S process. You will also find sample calculations and
case study examples based on many years of practical experience. It is my
sincere hope that the advice on the following pages helps to bring about effi-
cient and successful MA&S processes at your organization.
Carl Pitchford
Capricorn Consulting

Acknowledgments
I would like to thank all those who have contributed directly to my knowl-
edge of this vast subject—in particular, those internal audit managers, senior
managers, and private equity partners who took the time to explain the intri-
cacies of various transactions. I would also like to thank the owner-managers
from the global furniture industry who gave me the opportunity to be involved
directly in mergers, acquisitions, and sales transactions as a preferred adviser
and due diligence auditor.
I am also grateful to the staff and leadership of The Institute of Internal
Auditors (IIA) and The Institute of Internal Auditors Research Foundation
(IIARF) for their support throughout this project.
xi

About the Author
Carl Pitchford has more than 20 years of experience in the international furni-
ture industry including operations and export management, as well as strategic
and management consulting. In 2003, he created Capricorn Consulting with
the main goal of providing a broad range of strategic services to the global
furniture industry. Although born and raised in the United Kingdom, Carl has
lived and worked in Continental Europe for the past 27 years and speaks fluent
French and Spanish.
He works mainly with privately held companies facing critical issues
including industry consolidation, distribution channel changes, sales and margin
erosion, asset redeployment, global competition, strategic challenges, and
succession concerns. Carl has coordinated more than 350 diagnostic reviews
along with operational and due diligence audits. A major part of his consulting
work also involves providing advisory services in mergers, acquisitions, and
sales (MA&S) transactions within the furniture industry. He is an expert MA&S
adviser with Corporate Finance in Europe.
He holds the French professional qualification in internal auditing (DPAI).
In addition, he is currently completing an Executive Doctorate in Business
Administration thesis with a research focus on the strategic and financial issues
facing the furniture industry.
xiii

Introduction
Many of us have, at some stage in our professional careers, experienced corpo-

rate mergers, acquisitions, or sales. Until 2007, we witnessed a boom in global
merger and acquisition deals. In 2014, as this book is being published, the
opposite may be true.
We live in a world of economic and business cycles. These cycles have a
huge impact on everyday strategic business decisions. It is very difficult in some
industry sectors to know what the future will bring in the short term, let alone
devise a business plan and corporate strategy for the long term. Nevertheless,
businesses and management teams in publicly traded companies all over the
world are pushed to grow, take market share, enter new markets, and create
value for stakeholders. For a private company, it may be either easier or more
difficult to pinpoint the value of these transactions depending on the compa-
ny’s industry sector and its geographical area.
The objective of this book is to examine how internal auditors can add value
to the mergers, acquisitions, and sales (MA&S) process. It highlights the role of
internal audit through various case studies, outlines international best practices,
and provides due diligence checklists. The book also investigates how internal
audit management—in particular, the chief audit executive (CAE)—can be more
effective in terms of strategic decision making regarding proposed MA&S.
Care should be exercised by both buyers and sellers even before moving
into due diligence, as this stage requires extensive disclosure of confiden-
tial information and a substantial time commitment from both parties. A
letter of intent should be signed before moving to the due diligence phase to
ensure that all parties are working toward the same goals with the same set of

assumptions. Auditors should help ensure that both buyers and sellers keep a
close eye on the planning of the post-acquisition environment, so that potential
trouble spots and future areas for enhancement can be discussed before the
transaction is finalized. Performing the steps associated with the purchase of a
company may take several months, but the combined companies must find a
way to coexist and operate as a new organization for many years to come.
This book contains specific action points or bits of essential knowledge
called “Takeaways” at the end of each chapter that you can implement imme-
diately. In keeping with the global scope of internal auditing, this book contains
international case study examples using the U.S. dollar ($), the British pound
sterling (£), and the euro (€).

Chapter 1
Greater Than the Sum
The authors of the book Organizational Behavior wrote in 2008 that synergy
is “the creation of a whole that is greater than the sum of its parts.” This, of
course, is the ultimate goal of all mergers, acquisitions, and sales (MA&S)
activities.
Similarly, Barb Rentenbach, author of the 2009 book Synergy, posited that
“A designed beauty of synergy is that it serves only to add, never subtract.”
We might ask, then, why do some business combinations live up to the
promises of synergy while others fail, and how do we ensure that our MA&S
activities succeed?
Where Has the Synergy Gone?

In looking at the results of any MA&S activity, you should ask yourself, “What
value has been created? At the same time, what value has been destroyed?
How many members of staff have left the recently purchased company or the
newly formed entity? What customers have looked elsewhere because service
slipped while you were busy merging? Are the shareholders abandoning ship as
millions are wiped off their share values?”
This book provides you with tools, techniques, and practical examples to
help your company avoid these nightmare scenarios. Yes, it will be time-
consuming. Yes, it will be challenging. Yes, you will need to do a lot of
convincing. But it will be worth it.
Some of what is written on these pages is basic common sense. No sane
business person should ever enter into a deal that does not feel right, for

example. Often you should do a gut check and continue researching until all
your concerns are addressed; however, as internal auditors, there is only so
much you can do to protect a management team for whom the merger may
provide both a bonus and an ego boost. Only so much can be done with a
determined management team, especially when it is a case of “swallow or be
swallowed.”
You can only go so far: After all, it would be pointless to aggressively ques-
tion and challenge every strategic decision made by your management team;
but you can draw management’s attention to what you seriously believe to be
key risk management issues. Then you will have done your job, regardless of
how management decides to resolve those issues.
Unfortunately, attracting management attention even for the “right reasons”
can sometimes be a major challenge during MA&S activities. For those of you
lucky enough to work in a company that operates in an open culture, sees the
internal auditors as advisers, and embraces a positive perspective regarding the
role of internal audit, then half the battle is already won.
As recently failed MA&S transactions show, relying on audited financials
is only the beginning of a thorough due diligence process. During economic
downturns and volatile trading conditions, for example, an MA&S target compa-
ny’s income projections and pre-sale valuations might prove to be extremely
optimistic. Imagine the benefit a thorough pre-closing audit of these factors
could bring to the negotiation of the transaction.
When a bidding company finally ends up writing off a significant portion of
the price it paid for a target company, it is not surprising if the bidder considers
possible ways for recouping that loss. This could include going to court, which
is usually much more costly than letting the internal audit activity conduct
complete due diligence in the first place.
Think how rewarding it would be to say that you, as an internal auditor,
saved your company from a multiyear journey through the courts to secure
redress for shareholders who witnessed the value of the company’s shares drop
by a significant percentage.
Financial and economic downturns provide buyers with an added incentive
to question the accuracy of financial information, especially when their target
companies are not performing as well as could be expected.
Even when the economy is running well, MA&S activity will involve finan-
cial and operational risks that, if not dealt with appropriately, can lead to enor-
mous erosion in value for the purchaser. When any market slows down, overly

optimistic sales forecasts and projected order books can be exposed. An effec-
tive due diligence audit could uncover some of these discrepancies and put
a quick stop to any deal, however strategic. The audit results may not initially
please those eager management teams, but they can save a lot of your orga-
nization’s time, effort, and money. They may even help maintain shareholder
value when it is in danger of being destroyed.
In a tough economic environment, buyers have become more “streetwise”
and cautious about big-ticket deals.
At an early stage, some management teams decide on an “inorganic”
growth model. In other words, they expand the business by acquiring other
businesses in the same activity sector or businesses providing complimentary
activities, either in the same country or in other areas of the world.
In the past, some of the major global deals were driven by what is
commonly known as the “empire building” theory. With some rhetorical zeal,
the CEOs of merging organizations listed the usual reasons to justify their deci-
sions, such as synergy, scale, scope, operating leverage, and global reach.
The outcome was often very different from expectations: value destruction
for the shareholders of the acquiring organizations. Many of those jumping on
the “merger bandwagon” were inherently unfit because of cultural mismatches
or organizational complexity.
With hindsight, mixing some of these businesses together proved impos-
sible because of five specific constraints:
1. Internal politics
2. Unrealistic expectations (even demands)
3. Excessive hype (from all parties, including the media)
4. “Us versus Them” syndrome
5. Lack of management courage to accomplish the necessary

cleanup
After an acquisition, the new whole must be worth more than the sum of
the parts. (Remember synergy?) When analyzing various deals over the past 10
years, however, this principle appears to be the exception rather than the rule.
Size is an important factor: Costs increased as organizations became “too big

to manage.” Some organizations were even forced to demerge. The odds are
daunting: Since 2005, demergers have been just as common as mergers.
In my experience, successful MA&S deals have five common traits:
1. A sound business case for a merger or acquisition that was

closely monitored by all parties involved in the integration
process
2. Buy-in from key staff in every area of the business
3. An immediate allocation of senior management positions within

days of the merger or acquisition
4. Credible plans to exploit product synergies and cost savings
5. A strong client focus with a merit-based incentive system
These lessons have fundamentally changed thinking among the new gener-
ation of top executives. Their approach to MA&S is far more down-to-earth than
that of their predecessors, who were readily persuaded by the “big is beautiful”
argument. This change will not rule out megamergers completely in the future,
but it does mean that coming deals will be driven less by some sort of gran-
diose design and more by practical issues such as economies of scale.
So if top executives are taking a more practical approach to MA&S, what
about internal auditors? How do they fit into the process?
Based on an informal survey by Capricorn Consulting of 240 internal audit
managers and CAEs from major European companies involved in MA&S activi-
ties, an overwhelming 80 percent of respondents believe that internal auditors
can add value to the MA&S process. Around 20 percent of survey respon-
dents were uncertain or disagreed about the contribution and the added value
of expanding the role of internal audit. One third of responding internal audi-
tors saw their role as “watchdogs” or “internal control experts.” Unfortunately, a
small number of respondents viewed their role merely as “box tickers.”
Internal audit’s low level of involvement in the upstream stages of MA&S
transactions appears to indicate that management would just like to see
the deals go through. Management may believe either that internal audi-
tors are unable to contribute anything substantial to the process, or that the
involvement of the internal auditors will increase the time and cost of the
pre-transaction stage.

Research also leads us to believe that internal auditors want to take on a

more proactive role, moving away from after-the-fact evaluations of the control
and risk aspects of MA&S. Too often, however, the internal auditors are still
continuing to act after the event, rather than proactively helping to steer the
organization toward more successful outcomes in terms of its development
strategy. In fact, internal audit activity contribution to the pre-acquisition stages
of strategic development and due diligence is low to moderate.
Many internal audit managers and CAEs are in a position to provide value-
added services during specialized MA&S projects. However, it appears that
management and audit committees have the perception that internal audit
should continue to act “after the event.”
Reasons for Internal Audit Involvement

Internal audit should always have the right to audit a potential target orga-
nization. The right to audit enables management teams to enhance the fine-
tuning involved in any such transaction, facilitates dealing with issues before
proceeding with any transactions, and helps ensure the bidder organization
“gets its own house in order.” Therefore, we could say that any pre-MA&S trans-
action audit would increase the value of synergies so close to the heart of
management teams at these particularly intensive periods in the organization’s
development.
CAEs are working to expand their roles within their organizations. That
means moving from their traditional focus on compliance and financial auditing
to including a focus on strategic analysis and process improvement. The
survey mentioned previously was intended to discover how internal auditors
are adjusting to the evolving expectations of their roles. Perhaps one of the
biggest challenges for audit executives is the ongoing quest to rebalance tradi-
tional internal audit activities and methods, while becoming more strategic in
mind-set and approach.
When asked to rank a number of risk areas based on their potential to
impact growth, CAEs cited “Execution of Strategy” as the main risk. Many
CAEs believe their departments have the ability to deliver the most value when
they are helping to mitigate risks, identify improvement opportunities, and
strengthen corporate governance. Internal auditors can play a role in sales, for
example, by ensuring that controls remain strong during the financial statement
carve out, when separate financial statements are derived from the consoli-
dated statements of a parent company. Without internal audit involvement, the

acquiring organization cannot know whether the control environment has suffi-
cient rigor, or whether the state of risks and controls are properly taken into
account at the time of valuation by the acquiring organization.
According to the 2011 survey of CAEs, strategic transactions such as MA&S
remain some of the most risk-intensive initiatives that any organization can
undertake. Unfortunately, management teams often underestimate the chal-
lenges associated with the MA&S of a company or a line of business. Without
internal audit evaluation and input, this oversight might lead to opportu-
nity losses or the need for unanticipated additional investments necessary to
address major risk and control issues.
Eight potential ways the internal audit activity can help during strategic
transactions are by taking the following actions:
1. Providing increased visibility and transparency regarding key

risks related to strategic transaction changes
2. Reinforcing the notion that risks and controls are management

responsibilities
3. Identifying gaps in the integration or separation project manage-

ment plan
4. Suggesting opportunities for additional synergies that would

boost the acquisition’s return on investment or cost savings as a
result of the separation
5. Calling out the impact that the acquisition and its integration, or
the sale, may have on other parts of the business
6. Highlighting potential gaps in the internal control structure
7. Supporting management’s prioritization of transition risks and

organizational readiness for effective and efficient resource allo-
cation that addresses the risks
8. Providing increased visibility to process changes impacting

management’s Sarbanes-Oxley Act Section 302 certification
process

CAEs should work closely with their corporate development teams to

ensure the internal auditors are involved during the entire strategic transaction
life cycle. Here are five possibilities:
1. From a strategic standpoint, the internal audit activity can eval-

uate an organization’s readiness for the transaction.
2. During the due diligence phase, internal auditors can alert the
management team to potential risk, control, or regulatory issues
that would cause the organization to overpay or undervalue.
3. Before the closing of the deal, the internal audit activity can help
prevent deal value erosion.
4. After the transaction is finalized, the internal audit team can help
create organizational efficiencies and ascertain proper control
monitoring of new or revised processes.
5. Throughout the strategic transaction life cycle, the internal audit

activity can assess operations to identify potential improvement
opportunities.
Contradictions in Roles
How deeply could and should internal auditors be involved in MA&S transac-
tions? This subject will no doubt stir debate not only among internal auditors
themselves but also among senior management and boards. The intention of
internal audit management to get involved in MA&S projects is a key strategic
aspect, with built-in contradictions.
Internal audit management is cognizant of the myriad benefits of its partici-
pation, early and often, in the process. Sometimes, for political reasons, though,
internal audit management does not want to change board of directors’ and/or
senior management’s perceptions of the MA&S project. Internal audit manage-
ment may also be naturally reluctant to take any responsibility for the possible
failure of an MA&S deal.
Many internal audit groups do not have the available resources or specific
knowledge, expertise, experience, and skills to be involved in an MA&S deal.
Conversely, in some major multinational organizations, MA&S activities

comprise a significant part of strategic development plans. Therefore, the

internal audit activity should adapt its recruitment and retention policies
according to need. Hiring internal auditors who have already participated in an
MA&S audit can provide a wealth of experience. Internal auditors are beneficial
when they have 1) specialized knowledge in accounting for these transactions,
2) knowledge of relevant local and international regulations, and 3) necessary
interpersonal skills to assemble a team of experts. Not only can the team assist
with MA&S projects, it can also deliver workshops on specific techniques and
help in the professional development of colleagues.
Small boutique internal audit organizations do not always have the time or the
budgetary resources to participate actively at this level. In this case, satisfactory
solutions can be found by outsourcing or co-sourcing some of the audit work.
Internal audit management should also build and nurture a strong relation-
ship with the audit committee. (This aspect is particularly important and will be
explored more fully further on.) The audit committee can play a pivotal role, as
it has the authority to approve or disapprove internal audit involvement in the
MA&S process.
Whatever the level of involvement, the internal audit activity should report
directly to the board and the audit committee, if possible. Regardless of the
involvement level or reporting structure, internal auditors must remain objective
when evaluating MA&S processes.
It is in the best interest of the internal audit group to produce a balanced
assessment of all relevant information, given what is at stake in terms of the
outcomes of such projects. If management is reluctant to include the internal
audit group in MA&S activities, the internal auditors should create a case study
portfolio based on the organization’s activity sector. These case studies should
demonstrate where MA&S projects failed to meet expectations because of the
low level of involvement of internal auditors and highlight evidence of added
value where internal auditors had a more proactive role. This portfolio can help
to convince top management of internal audit’s contribution to the successful
outcome of any MA&S process.
As mentioned previously, having internal audit staff that possesses special-
ized knowledge and experience is an enormous advantage. Staff rotation
between the internal audit activity and other administrative or operational func-
tions can also be useful and can enable internal auditors to gain experience
with various processes and procedures in the target organization.
10

It is also essential to have an internal audit toolkit. Examples are risk assess-
ment software and specific audit programs suitable for the various stages of
the MA&S process. Electronic workpapers are also useful in nurturing internal
audit’s proactive role in the MA&S process. The audit work could be saved in a
special database, enabling the internal audit activity to build on, and learn from,
experiences with strategic transactions.
Internal audit activity responsibility in MA&S activities is also a key issue.
Internal audit management can expand the role of its department only if it can
define and communicate an appropriate level of responsibility in the case of
either a positive or a negative MA&S outcome.
Perception is another important issue in organizational culture. Internal
audit must be perceived as a value-added activity. Confidence and trust in
the internal auditor as a valued adviser and consultant is essential. In this
regard, professionalism is vital. Internal audit management must ensure that
the internal audit activity has or develops the necessary knowledge and skills
to effectively audit, monitor, and advise on the target organization’s systems,
processes, and procedures.
Senior management must be convinced that the internal audit activity has
the necessary expertise to assess the control environment and activities of the
target organization. Internal auditors should plan to provide an opinion at the
pre-transaction phase and offer additional information and assistance if the
deal goes through.
During the MA&S project, the internal audit team can join forces with senior
management of both the bidder and target companies to identify functional
and risk areas, prioritize the risks, and create the risk profiles of the target
company and the buyer. These risk profiles can then be used for establishing
audit plans, assessing key risks, identifying key controls, developing findings,
and preparing recommendations. Drawing up such a list of potential acquisi-
tion risks can form the basis for post-acquisition audits of the newly created
company. This is a vital aspect, as it will enhance the level of internal audit
participation in future MA&S projects.
If MA&S activities and subsequent audits of newly acquired processes
are not included in the internal audit activity’s plan of engagements, the CAE
should revise the plan (taking management’s input into consideration) and
present it to the audit committee for approval. This not only keeps the board
informed about essential internal audit activities, it also helps to ensure that the
11

internal audit team has the appropriate capabilities and that MA&S responsibili-
ties do not interfere with other essential audit work.
To provide a smooth transition into the post-acquisition audit, the internal
audit organization needs to function effectively as a member of the new
company. The auditors must understand the control environment, reporting
lines, information systems, and structure of the target company.
Disclaimer: Unfortunately, the above-mentioned prerequisites

cannot guarantee positive results or an expanded role for the
internal audit activity. Nevertheless, they provide useful guide-
lines that can increase the odds of success.
The role of internal auditors is continually evolving. An increasing emphasis on

consulting activities has raised some concerns about independence and objec-
tivity. Internal auditors should rise to the occasion and explore all aspects of their
consulting roles to ensure that they can provide objective feedback and continue
to add value to the organization. Care must be taken to ensure that consulting
activities do not endanger the auditors’ “traditional” role in assurance activi-
ties. Internal audit management, the audit committee, and the board of directors
should periodically assess the role of the internal audit activity in attaining corpo-
rate objectives and in specialized projects such as MA&S activities.
The success or failure of global MA&S transactions and asset disposals can
have a huge impact on the following multiple stakeholder groups:
n Shareholders of the bidder and target companies

n Financial institutions
n Employees
n Suppliers
n Competitors
n Communities
n Economies
The high rates of failure in such business transactions would appear to indi-
cate that most companies underestimate the significance of risk management
in transaction decision making. Internal auditors are well-positioned to improve
the quality of risk management significantly throughout the MA&S process by
carrying out comprehensive due diligence and providing specific expertise and
knowledge of business process integration.
12

It is time for internal auditors to move into action. Each year, strategic trans-
actions receive greater scrutiny from investors, regulators, and the media,
including social media. Internal auditors must be prepared to take on an
expanded role in the risk management process connected with MA&S trans-
actions. A narrow focus on financial statement accuracy is inadequate for risk-
based internal auditing.
Chapter 1 Takeaways
1. Effective due diligence uncovers discrepancies, which can save
time, effort, money, and shareholder value.
2. Be proactive, rather than acting “after the event.”
3. Become strategic in mind-set and approach.
4. Adapt recruitment and retention policies based on need.
5. Consider outsourcing or co-sourcing internal audit project

functions.
6. Build and nurture strong relationships with the audit committee.
7. Develop an effective audit plan, and obtain audit committee

approval.
8. Understand the structure, information systems, control environ-

ment, and reporting lines of target companies.
9. Establish and use an internal audit toolkit—this step is vital.
10. Create a risk profile of target companies, with recommendations

for management.
13

Chapter 2
Types of Mergers
Mergers are often categorized as horizontal, vertical, or conglomerate:
n A horizontal merger is one that happens between two compa-

nies in the same activity sector. The merged companies are
often former competitors. Horizontal mergers may be blocked if
they are considered to be anticompetitive or create a monopoly
situation.
n A vertical merger involves companies that are at different stages

in the production process. For example, a buyer might expand
backward toward the source of raw materials, or forward toward
the final consumer.
n A conglomerate merger involves companies in unrelated busi-

ness sectors. This type of merger has gradually been fading away
since the 1980s.
Sources of Synergy
Internal auditors should plan to make a careful analysis of all proposed syner-
gies, just as they are expected to evaluate other strategies on a regular basis.
For example, one potential motive for a merger is to replace the existing
management team. You would expect that poorly performing companies would
tend to be targets for an acquisition; however, evidence suggests that compa-
nies acquire other companies for reasons that often have nothing to do with
15

inadequate management. Many mergers and acquisitions are motivated by the

potential gains in efficiency from combining operations—again, synergy. This
should indicate that the two companies are worth more together than if they
had remained separate.
No real benchmark or indicator exists that clearly proves why some mergers
succeed and some fail. We must not forget that the value of most businesses
depends on human assets—the management team and other skilled and quali-
fied employees. If the merger does not provide the right environment for these
people, then the best ones will certainly leave.
Various types of synergy can be created through MA&S activities. In
general, the sources of synergy fall into the following categories.
Creating Larger, More Competitive Company (Economies of Scale)

Managers sometimes believe that their companies would be more competi-
tive if they were bigger. Economies of scale enable a company to spread the
amount of fixed costs across a larger volume of output.
Those who favor the economies-of-scale synergies explain that savings
come from sharing central services such as accounting, financial control, and
top-level management, but also from an operational level. In some cases, these
so-called synergies can obviously lead to job cuts. When assessing the value of
these synergies, you should also consider the potential impact of overly opti-
mistic predictions of cost savings, possible employee discontent, and breakup
of certain departments and activities.
Gaining Suppliers or Customers (Vertical Integration)

This synergy often entails mergers with suppliers or customers. At its best,
expanding into areas that are at different points on the same production path
can help reduce costs, for example, by decreasing transportation expenses and
reducing turnaround time.
Due diligence for vertical integrations should take into account differences
in systems and processes that may lead to incompatibility. Vertical integra-
tions have been on the decline in recent years, and many companies are finding
it more efficient to outsource certain activities than to undergo costly and
time-consuming MA&S transactions to bring the activities in-house.
16

Types of Mergers
Combining Complementary Resources

Many small- and medium-sized enterprises (SMEs) are acquired by larger
companies because they can provide the necessary missing ingredients for
the large company’s success. The SME may manufacture a unique product or
provide a niche service but lack the engineering and sales organization neces-
sary to implement mass production and global marketing. The important
element in this particular case is to verify that the complementary resources
really exist.
Recently, a number of acquisitions in the technology sector have later
proved not to be complementary. Because the term resources includes people,
analysis of this type of synergy can help your company save thousands, if not
millions, by not overpaying for complementary resources that could walk out
the door once the merger is completed.
Using Surplus Funds

Suppose you work for a company that is in a mature industry. Instead of distrib-
uting gains to shareholders, your company deploys the surplus cash in an
acquisition. Let’s not forget that companies holding excess cash can often find
themselves a target for a takeover by another company. Using mergers or take-
overs is indeed a form of defense against this latter option: Eat or be eaten.
Dubious Synergies
Other potential synergies described below are more doubtful and should,
therefore, be analyzed in full.
Diversification
The management team of cash-rich companies may prefer to use that cash
for mergers and acquisitions than for shareholder gains; however, diversifica-
tion could be an end in itself. Diversification normally mitigates risk, which is
supposed to be an advantage of a merger. The problem with this argument is
that diversification is easier and cheaper for the individual shareholders than it
is for the company.
What you should ask yourself is, “Why would U.S. Technologies, Inc., buy
U.K. Technologies, PLC, to diversify, when the shareholders of the U.S. organi-
zation can quite easily buy the shares of the U.K. organization to diversify their
17

own portfolios?” It is far easier and cheaper for individual investors to diversify
than it is for companies to combine operations.
The Bootstrap Game

During the 1960s and 1970s, some conglomerates made acquisitions that offered
few or no economic gains. Nevertheless, the conglomerates’ aggressive strategy
produced several years of rising earnings per share. To see how this can happen,
let us take an example of two completely fictitious companies: Multinational
Furniture Brands (MFB) and European Furniture Brands (EFB). MFB intends to
acquire EFB. Both companies are listed and all values are in U.S. dollars ($).
The post-merger situation is illustrated in table 2.1. You will learn here how
to analyze the true value of a particular deal. These techniques can be applied
for mergers of listed companies in all industries.
Table 2.1: Impact of EFB Merger on Market

Value and Earnings per Share of MFB
MFB EFB MFB (after
Item (pre-merger) (pre-merger) acquiring EFB)
1. Earnings per share $2.00 $2.00 $2.67
2. Price per share $40.00 $20.00 $40.00
3. Price/earnings (P/E) ratio 20 10 15
4. Shares outstanding 100,000 100,000 150,000
5. Total earnings $200,000 $200,000 $400,000
6. Total market value $4,000,000 $2,000,000 $6,000,000
7. C urrent earnings per dollar $0.05 $0.10 $0.67
invested in shares
You can see that, because EFB has relatively poor growth prospects, its
shares sell at a lower price/earnings (P/E) ratio than MFB. You can also assume
that the merger produces no economic benefits, so the companies should be
worth exactly the same together as they are separately. The value of MFB after
the merger is thus equal to the total of the separate values of the two companies.
18

Types of Mergers
Because the shares of MFB are trading at double the share price of EFB,
MFB can buy 100,000 shares for 50,000 of its own shares. Therefore, MFB will
have 150,000 outstanding shares after the merger.
MFB’s total earnings double as a result of the acquisition, but the number
of shares increases by only 50 percent. Its earnings per share rise from $2.00
to $2.67. This is what is known as a “bootstrap effect,” because no real gain is
created by the merger and there is no increase in the two companies’ combined
value. Since MFB’s share price is unchanged by the acquisition of EFB, the P/E
ratio falls.
Before the merger, $1.00 invested in MFB bought 5 cents of current earn-
ings and rapid growth prospects. On the other hand, $1.00 invested in EFB
bought 10 cents of current earnings but slower growth prospects. If the total
market value does not change because of the merger, then $1.00 invested in
the merged company gives MFB shareholders 67 cents of immediate earnings,
a bit slower growth than before the merger. EFB shareholders get lower imme-
diate earnings but faster growth.
In fact, neither company wins nor loses, provided that everybody under-
stands the deal. If the investors are taken in by the exuberance of MFB’s CEO
and confuse the 33 percent post-merger increase in earnings per share with
sustainable growth, then the price of MFB’s shares increases and the share-
holders of both companies receive something for nothing in the short term.
You have now seen the types of strategies some financial manipulators
implement and how you can analyze these strategies to provide an opinion on a
proposed merger transaction. This is the sort of added-value service that most
managers will appreciate.
In conclusion, you can now see how the bootstrap game is played. If your
company is enjoying a high P/E ratio because investors anticipate rapid growth
in future earnings, this growth is then achieved not by capital investment,
product innovation or improvement, or increased operating efficiency, but by
purchasing slow-growth companies with low P/E ratios.
The long-term result will be slower growth and a depressed P/E ratio, but
in the short run, earnings per share can increase dramatically. You have to
see through this “strategic game” of fooling investors, because we all know
that expansion does not go on forever. Earnings will eventually decline, and
the house of cards will come tumbling down. In our case, it is probably much
more professional to warn management of the dangers of implementing such
a short-term strategy than to come out with the “I told you so” disclaimers a
couple of years later.
19

Chapter 2 Takeaways
1. Many mergers are motivated by potential gains in efficiency from
combining operations.
2. Be prepared to make a careful analysis of all proposed synergies.
3. If the merger does not provide the right environment, the best
people will leave.
4. Economies of scale enable spreading fixed costs across a larger

volume of output.
5. Savings arise from sharing central services.
6. Beware of overly optimistic predictions of cost savings.
7. Verify that complementary resources exist.
8. Mergers and takeovers are a form of defense against being taken

over for excess cash.
9. Diversification is easier and cheaper for shareholders than for

companies.
10. Look for long-term gains based on capital investment, product

innovation or improvement, or increased operating efficiency,
rather than short-term gains through purchasing slow-growth
companies with low P/E ratios.
20

Chapter 3
Evaluating Mergers
If, in your professional career as an internal auditor, you are responsible for eval-
uating a proposed merger, you should think long and hard about the following
two questions:
1. Is there an overall economic gain to the merger? In other words,

is the merger value enhancing? Are the two companies worth
more together than they would be if they had stayed separate?
2. Do the terms of the merger make the company’s shareholders

and other stakeholders better off? After all, there is no point in
merging if the cost is too high or if all the economic gain goes to
the other company.
The answers to these questions are not so easy. Some economic gains
can be extremely difficult to quantify, and complex cross-border merger
financing can cloud the real terms of a deal. For the purposes of internal audi-
tors, however, the basic principles for evaluating mergers are not terribly
complicated.
Mergers Financed by Cash

Let’s look at another practical example of evaluating a proposed deal.
Your company, which is called Shropshire Fine Foods Ltd (SFF), is consid-
ering the acquisition of a smaller, but very complementary, food company
called Healthy Ingredients Ltd (HI). SFF is proposing to finance the deal by
21

purchasing all of HI’s outstanding shares for £19 per share. The merger would
increase both companies’ combined earnings by £4 million.
The financial information (in British pounds sterling [£]) for the two compa-
nies is provided in table 3.1.
Table 3.1: SFF’s Proposed Acquisition of HI
Item SFF Ltd HI Ltd Combined Companies

Income £150m £20m £172m ( + 2 )
Operating costs £118m £16m £132m ( - 2 )
Earnings £32m £4m £40m ( + 4 )
Cash £55m £2.5m
Other assets’ book value £185m £17m
Total assets £240m £19.5m
Price per share £48 £16
Number of shares 10 million 2.5 million
Market value £480m £40m
Note: The British pounds sterling figures are in millions (m), except for the share prices.
The first question you should ask is, “Why would SFF and HI be worth more
together than apart?”
Let’s assume that the operating costs can be reduced by combining both
companies’ marketing, distribution, and administration processes. Income also
can be increased in HI’s region. The right-hand column (Combined Companies)
in table 3.1 contains projected income, costs, and earnings for both companies,
if the companies were operating together. Annual operating costs post-merger
will be £2 million minus the total of the separate companies’ costs, and income
will be £2 million more. Therefore, projected earnings increase by £4 million.
For simplicity’s sake, let’s assume that the increased earnings are the only
synergy to be generated by the merger.
22

Evaluating Mergers
The economic gain from the merger is the present value (PV) of the extra
earnings. Let’s see now how you can calculate this. If the earnings remain
constant and the cost of capital is 20 percent, then:
Economic Gain = PV (increased earnings) = £4m/.20 = £20m
This additional value is the basic motivation for the merger.

The next questions you should ask are, “What are the terms of the merger?
What are the costs for SFF and its shareholders?”
HI’s management and shareholders will not agree to the merger unless they
receive at least the stand-alone value of their shares. They can be paid in cash
or by new shares issued by SFF. In this case, we are considering a cash offer
of £19 per HI share, which is £3 per share over the prior share price. HI has 2.5
million shares outstanding, so SFF will have to pay out £47.5 million, a premium
of £7.5 million over HI’s prior market value.
Based on these terms, HI’s shareholders will capture £7.5 million out of the
£20 million gain from the merger. That should leave £12.5 million for SFF.
This transaction is confirmed in the Cash Purchase column in table 3.2. Look
first at the bottom of the column, where the total market value of the merged
companies is now £492.50 million.
Table 3.2: Financial Forecasts After the SFF-HI Merger
Item Cash Purchase Exchange of Shares

Earnings £40m £40m
Cash £10m £57.50m
Other assets’ book value £202m £202m
Total assets £212m £259.50m
Price per share £49.25 £49.85
Number of shares 10 million 10.833 million
Market value £492.50m £540m
Note: The British pounds sterling figures are in millions (m), except for the per-share prices.
23

The £492.50 million total market value of the merged companies is calcu-
lated as follows:
The left-hand column (Cash Purchase) assumes a cash price of

£19 per HI share. The right-hand column (Exchange of Shares)
assumes HI’s shareholders receive one new SFF share for every
three HI shares.
To facilitate understanding, the example in table 3.2 ignores taxes and

assumes that both companies are all-equity financed. Also left out, for simplici-
ty’s sake, is the interest income that could be earned by investing the cash used
to finance the merger.
Shropshire Fine Foods Ltd (SFF)

pre-merger market value = £480 million
Healthy Ingredients Ltd (HI)
pre-merger market value = 40 million
Present value of gain to merger = 20 million
Minus cash paid out to HI’s shareholders ( - ) = 47.5 million
Post-merger market value = £492.5 million
SFF’s post-merger share price will be £49.25, which is an increase of £1.25

per share. With 10 million shares outstanding, the total increase in the value of
SFF’s shares is £12.5 million.
To sum up, the merger makes sense for SFF for two reasons:
1. The merger adds £20 million of overall value.
2. The terms of the merger provide only £7.5 million of that £20
million overall gain to HI’s shareholders, leaving £28.4 million for
SFF.
You can, therefore, see that the cost of acquiring HI is £5 million, the differ-
ence between the cash payment and the value of HI as a separate company.
Cost = cash paid out - HI value = £47.5m - £40m = £7.5m
24

Evaluating Mergers
HI shareholders are ahead by £7.5 million, and their gain is your company’s
cost. As we have seen above, SFF shareholders come out £12.5 million ahead.
You can call this SFF’s Net Present Value (NPV) for the merger:
NPV = economic gain - cost = £20m - £7.5m = £12.5m
If you write down the economic gain and cost of a merger in this way, you
separate the motive for the merger (the economic gain or added value) from
the terms of the merger (the division of the gain between the two merging
companies).
Mergers Financed by Shares

For argument’s sake, let’s say that SFF would like to keep its cash for other
investments and, therefore, decides to pay for the HI acquisition with new SFF
shares. The deal calls for HI shareholders to receive one SFF share in exchange
for every three HI shares.
This is the same merger transaction, but with a different financing struc-
ture. By analyzing the right-hand column of table 3.2, you can determine the
outcome.
Like before, start at the bottom of the column. The market value of SFF’s
shares after the merger is £540 million. This amount is £47.5 million higher than
in the cash deal because the cash is kept rather than paid out to HI shareholders.
On the other hand, more shares are outstanding because 833,333 new shares
have to be issued in exchange for the 2.5 million HI shares (a ratio of 1 to 3). The
price per share is, therefore, £540m/£49.85, which is £0.60 pence higher than
in the cash offer.
You may wonder why SFF shareholders do better from the share exchange.
The economic gain from the merger is the same, but the HI shareholders are
unable to capture as much of this gain. They get 833,333 shares at £49.85, or
£41.5 million, a premium of only £1.5 million over HI’s previous market value.
Cost = (value of shares issued) - (HI’s value)

= £41.5m - £40m
= £1.5m
25

The merger’s NPV for SFF’s original shareholders is:
NPV = (economic gain) – (cost)

= £20m - £1.5m
= £18.5m
It is apparent that SFF’s share price has risen by £1.85. The total increase in
value for SFF’s original shareholders, who retain 10 million shares, is £18.5 million.
It is not always easy to evaluate the terms of a merger when it includes an
exchange of shares. HI’s shareholders will retain a stake in the merged compa-
nies; therefore, you have to estimate what the company’s shares will be worth
after the merger is announced and the benefits appreciated by investors.
Notice that we started with the total market value of SFF and HI post-
merger, took into consideration the merger terms (833,333 new shares issued),
and worked back to the post-merger share price. Only then can you calculate
the division of the merger gains between the two companies.
There is an essential distinction between cash and shares regarding
financing terms. If cash is offered, the cost of the merger will not be affected
by the size of the merger gains. If shares are offered, the cost is dependent on
the gains, because the gains show up in the post-merger share price, and these
shares are used to pay for the acquired company.
Share financing also mitigates the effects of over- or under-valuing either
company. Suppose, for example, that SFF had overestimated HI’s value as a
separate entity, maybe because it had overlooked a hidden liability (empha-
sizing the importance of due diligence). Therefore, SFF makes a too-generous
offer. Other things being equal, SFF’s shareholders would have been better off
if it had been a share offer rather than a cash offer. With a share offer, the inevi-
table bad news about HI’s value would have fallen partly on HI’s shareholders.
A Word of Warning
The cost of a merger is the premium the acquirer is willing to pay for the
target company over and above its value as a separate company. If the target
company is a public company, you can measure its separate value by multi-
plying its share price by the number of outstanding shares. However, be careful:
If the investors expect the target to be acquired, its share price may overstate
the company’s separate value. The target company’s share price may already
have risen in anticipation that a premium will be paid by an acquiring company.
26

Evaluating Mergers
Some management teams (and this is where internal audit should be

actively involved) start their merger analyses with a forecast of the target
company’s future cash flows. Any income increases or cost reductions attrib-
utable to the merger are included in the forecasts, which are then discounted
back to the present and compared with the purchase price.
Estimated net gain =

(Discounted cash flow [DCF] valuation of target including
merger benefits) - (cash required for acquisition)
This can be a dangerous exercise. Even the most astute and well-trained
analyst can make huge errors when it comes to valuing a business. The esti-
mated net gain might be positive, not because the potential merger makes
sense, but simply because the analyst’s cash-flow forecasts are overly opti-
mistic. Alternatively, a good merger deal may be lost if the analyst fails to
recognize the target company’s potential as a stand-alone business.
A much better exercise would be to start with the target company’s current
and stand-alone market value, and then concentrate on the changes in cash
flow that would result from the merger.
When evaluating an MA&S transaction, it is a good idea to ask your-
self continually why the two companies should be worth more together than
apart. You have to remember that you add value only if you can generate addi-
tional economic benefits—for example, by taking advantage of some compet-
itive edge that other companies cannot match and that the target company’s
management is unable to achieve by itself.
Thus, it makes sense to keep an eye on the value that investors place on the
gains from merging. If a bidding company’s share price falls when the deal is
announced, investors are sending a very clear message that the merger benefits
are doubtful, or that the bidding company is paying too much for these benefits.
Merger Tactics
In recent years, most mergers have been agreed upon by both parties, but
sometimes an acquirer goes over the heads of the target company’s manage-
ment and makes a direct offer to the shareholders. The management of the
target company may advise shareholders to accept the offer, or it may attempt
to fight the bid in the hope that the acquirer will either raise its offer or with-
draw the bid.
27

Chapter 3 Takeaways
1. When evaluating mergers, ask about the economic gain overall,
and for your organization and its shareholders or stakeholders.
2. Ask why the merging organizations would be worth more

together than apart.
3. Evaluate the terms of the merger in reference to costs.
4. Assess the motive for the merger (economic gain or added

value) in relation to the terms of the merger (the division of the
gain between the two merged entities).
5. Calculate what the organization’s shares will be worth after the

merger is announced and the benefits appreciated by investors.
6. If shares are offered, cost is dependent on gains because gains

influence the post-merger share price, and these shares are used
to pay for the acquired company.
7. Financing mitigates the effects of over- or under-evaluation of

either organization.
8. If investors expect a target to be acquired, the share price may

already have risen in anticipation of a premium to be paid by the
acquiring company.
9. If a bidding company’s share price falls when a deal is

announced, investors are sending a clear message that the
merger benefits are doubtful or too costly.
10. Start with the target company’s current and stand-alone market
value, and then concentrate on the changes in cash flow that
would result from the merger.
28

Chapter 4
The Role of Internal Audit
Strategy Development
Internal auditors can enhance their images as value providers within their orga-
nizations as well as prevent potentially negative consequences throughout the
MA&S process. To do so, it is essential for internal auditors to get involved in
the MA&S process as early as possible.
Most organizations understand the value internal audit can bring once a
deal has closed. What they do not often appreciate is the value internal audit
can provide throughout the transaction process. Initially, internal audit can
determine an organization’s readiness for a merger or acquisition. During due
diligence, internal auditors can alert the organization to potential risks: control,
governance, or regulatory issues that would cause the organization to overpay.
Before closing the deal, internal audit can help prevent deal value erosion.
From a post-acquisition perspective, internal audit involvement in crit-
ical components of the integration can preserve organizational synergies and
ascertain proper control monitoring of new processes or changes in processes.
Throughout the MA&S life cycle, internal audit can evaluate the management of
the program to promote the use of leading practices.
Internal audit provides a critical perspective to MA&S deals that many exec-
utives may not consider. Without that perspective right from the start, the
organization could find out far too late that it paid too much for its acquisi-
tion—or that it must spend a significant amount of money to fix issues that
internal audit could have identified and helped the organization avoid.
29

By ensuring that these four key strategic areas are planned and managed
adequately, the internal audit activity can add value at the strategy develop-
ment stage:
1. Communication. Senior management should ensure an open

and effective communication channel for all nonrecurring events
such as MA&S. The minutes of regular management meet-
ings and even board meetings can help internal auditors take
a more proactive role. Effective communication with the audit
committee can also enhance the auditors’ role, not only in stra-
tegic transactions but in all internal audit work.
2. Risk management. Effective risk management is of utmost

importance during strategic events such as proposed mergers,
acquisitions, sales, or disposal of major assets. A risk-based
approach can help senior management to identify potential risks
and draw up a plan outlining the events or circumstances that
could prevent a company from reaching its objectives and stra-
tegic course. Senior management should be responsible for
establishing the main objectives of any strategic transaction. The
internal auditors should assess the process to fix those strategic
objectives, review the entire ongoing monitoring process, and
evaluate the levels of risk acceptance and mitigation.
3. Control issues. Because the nature of strategic transactions is

confidential and time frames for deal completion are getting
tighter, senior management does not always devote adequate
time to control issues during the planning phase. This is an ideal
occasion for internal audit to shine. Our business is control!
Internal auditors can ensure that control issues or deficiencies
in the target company are addressed during the planning phase.
Internal auditors can add further value for all stakeholders by
reviewing control systems in their own companies and, therefore,
prepare the way for a smoother merger or sale. It is important
for reputations to remain intact after the merger or sale. This is
something senior management can overlook in the heat of the
moment.
30

4. Mergers and acquisitions risk. In any strategic transaction,

target companies can have significant differences in systems and
processes. From my survey of European internal audit organiza-
tions involved in regular mergers, acquisitions, or asset disposal
activities, it would appear that, unfortunately, auditors often
have little or no involvement in MA&S strategy development. In
too many cases, senior management does not inform internal
audit organizations about potential transactions, believing
mistakenly that the role of internal audit should begin only after
the merger or acquisition deal has been done. However, both
research and experience show that if the internal audit organiza-
tions of all parties participate actively during the pre-transaction
phase, then a lot of time and money could often be saved. Some
deals would never even see the light of day, because a nega-
tive opinion issued by internal audit might highlight factors that
spotlight insurmountable obstacles, incompatibilities, or financial
drawbacks.
Pre-transaction documentation and assessment of potential risk events and

related control issues can substantially reduce the cost of integrating these
systems and processes within the combined organization. Let’s not forget that
once an acquisition strategy has been decided, an audit review can add enor-
mous value, especially if the findings are geared toward preparing the company
for change. If a strong control environment and appropriate systems and struc-
tures are in place before the merger or acquisition, then half the battle has been
won before it even begins.
Due Diligence in MA&S Transactions

Due diligence for MA&S transactions is the process of identifying and
confirming the business reasons for the proposed capital transaction. In
appendix A, you will find Due Diligence Checklists used in the course of the
audits carried out for Capricorn Consulting. Let’s take a look now at some best
or preferred practices at this particular stage in the transaction.
31

Best Practice 1
Work in close cooperation with other departments in your organization.
Internal auditors should plan to work closely with departments such as finance
and accounting, human resources, legal, information technology (IT), and
production. You should also ensure you keep open communication channels
within the bidder company because this can be essential for avoiding duplicate
or unnecessary effort.
Best Practice 2
Save time and effort by conducting a thorough review of the target compa-
ny’s internal audit activity. A clear plan to merge or integrate the two internal
audit organizations can provide valuable insights for the entire MA&S project.
A major issue noted in most transactions is the existence of duplicate depart-
ments or processes.
Best Practice 3
Ensure your due diligence includes finance, operations, and compliance.
Evaluation of these areas should be the basis of every due diligence audit.
Ignoring any of these functions could potentially lead to the failure of the MA&S
transaction.
Best Practice 4
Identify and follow up on major issues. You should ensure that weaknesses
unearthed during the due diligence phase are assessed and dealt with before
the deal is finalized.
Best Practice 5
Bring in external consultants and/or outsourced internal audit experts. Internal
auditors possess enormous qualities and skills, but we cannot always be
experts in every area of a particular industry or business. It is common prac-
tice to outsource all or part of the due diligence process to third parties. This
is particularly useful when the internal audit organizations of the compa-
nies involved possess neither the necessary skills nor the experience to carry
out due diligence effectively. Sometimes outside help in areas such as legal
32

aspects, the environment, or trade union relations can prevent sensitive issues
from exploding into full-scale crises. By working closely with experienced third
parties, in-house internal auditors can take advantage of a fantastic opportunity
to upgrade their own skills. To ensure there is no duplication of efforts, open
communication is critically important. Ongoing meetings and feedback are
essential for assuring that audit resources are efficient and effectively deployed.
Best Practice 6
Be aware of regulatory and compliance issues. In most countries, particularly
in Europe, MA&S activities are bound by strict regulatory frameworks in terms
of competitive advantage and monopolies. Many major mergers and acquisi-
tions have failed simply because of noncompliance with these regulatory frame-
works. With specific knowledge of compliance or with the help of outside
consultants, these issues can be avoided.
Best Practice 7
Document the target company’s business processes and control points. The
bidder company’s internal audit organization should have the freedom to
conduct a pre-transaction audit of the target company’s business processes. You
should conduct a complete diagnostic review of the main processes, including
mapping of the principal risk areas and control activities. This review can form
the basis for future audits and save time during the post-acquisition stage.
Too often, senior management has already “sold” the deal before internal
audit organizations—or even outside consultants, for that matter—can have
their say. Because of this “pre-planned” scenario, due diligence may become
more of a fact-finding mission than a critical phase in the transaction deci-
sion process. Senior management may view internal auditors as fact checkers,
and not as a source of important new information. The internal audit activity,
however, can provide management with vital information about the value of the
company being acquired or merged, its financial condition, and any weaknesses
in internal controls.
33

Pre-Merger/Pre-Acquisition Integration
At this stage, the main objective is for both companies to ensure a smooth inte-
gration into a single entity. The integration period is also a time of enormous
uncertainty for staff, especially within the target company.
What Role Can Internal Auditors Play in Reducing the Risk in This
Phase?
1. Play an important advisory role. Internal auditors are in a perfect

position to provide advice to the various departments and func-
tions involved in the integration phase. All companies that merge
or acquire other entities go through a period of change. The new
environment can be distracting for both staff and management.
Internal auditors can play a calming and stabilizing role through
good preparation and communication. It is vitally important, for
the success of any merger or acquisition, to be completely clear
on objectives of the new entity and the roles of all staff. Internal
auditors have expert knowledge of the control environment and,
therefore, can help departments such as human resources, IT,
and finance to overcome possible obstacles during this stage.
Internal auditors can act as important “bridge builders” among
the various functions in both the bidder and target companies.
2. Prepare a checklist. Internal auditors should draw up a checklist

of activities or issues that were identified during the pre-merger
or pre-acquisition stages. This will enable real-time follow-up
and facilitate dealing with issues as they arise. The internal audit
group can play a vital role in minimizing costs and avoiding risks
of failure, but without conscientious use of follow-up systems
and checklists, important details can “fall through the cracks”
during the busy post-merger period.
Post-Merger/Post-Acquisition Audit
The final phase of any MA&S transaction is the post-merger/post-acquisi-
tion audit. Here again, the level of involvement of internal audit is crucial for
34

a smooth transition and potentially, the success of the entire operation. This
involvement often has an impact on the future stages of other transactions.
If the internal audit activity did not get involved in the early stages, then
time-consuming efforts may be necessary to gain an understanding of the
newly formed entity’s key risks and processes. This will ultimately have an
impact on documenting key controls and finalizing the audit plan.
Increased involvement during the initial stages of the post-merger/post-
acquisition audit can provide a much deeper understanding of the newly
merged or acquired company. This means that the audit plan for the coming
year will more effectively address the significant risks facing the combined
organization. Internal auditors can now carry on their work by following these
five steps:
1. Audit the integration process. Here you have the opportunity to

confirm and/or complete the work associated with identifying
and documenting control weaknesses.
2. Report findings. This is the ideal moment for internal audit to

communicate with the business units, the audit committee, and
the board of directors. The audit report should highlight the
target company’s main control weaknesses and provide an over-
view of the internal control environment. It should conclude with
an action plan outlining harmonization and compliance with the
bidder company’s control system.
3. Audit the new entity. This is the opportunity to review the poli-
cies, procedures, and controls in the newly formed entity,
whether a merger or an acquisition. A risk-based approach
should be used. The audit plan will be based on a risk assess-
ment and on the corporate objectives set forth by the new
management team.
4. Assess those objectives. This is another significant aspect of the

post-transaction audit. It will enable the internal audit activity to
evaluate whether the level of compliance with the specific objec-
tives of the MA&S transaction has been met. Obviously, this task
can be carried out more effectively and efficiently if you have
already participated in the pre-merger/pre-acquisition stage.
35

5. Prepare a best practices document. (See appendix B.) Now that

you have reached the end of the project, this is a good occasion
to look back and document the lessons learned. If the internal
audit activity was involved in the project from beginning to end,
they should document the issues that arose and produce a best
practices document that explains how the obstacles were over-
come and sets the tone for future MA&S transactions. This docu-
ment might also include important observations and comments
from the various stages of the merger or acquisition, or a sepa-
rate document could be drawn up to include areas such as:
n Project management, particularly in relation to MA&S

n Audit scoping
n Risk assessment
n Internal control documentation
n Weakness and deficiency evaluations
Internal auditors have a significant opportunity at this stage to help estab-

lish effective post-merger/post-acquisition risk management processes.
Because many processes are likely to be undergoing change, this can be a crit-
ical time for promoting the value of effective internal controls. Auditors should
also take steps to ensure that all employees are highly involved and motivated
to contribute to the MA&S process. This is real teamwork.
You should produce reports for senior management and the board high-
lighting and outlining the following dangers:
n Lack of appropriate and effective due diligence

n Differences in operating styles
n Governance, risk, and compliance issues that may differ
n Differences in strategic perspectives
n Gaps regarding policies and procedures
In conclusion, internal auditors should be well-prepared for the challenge

of participating actively throughout the MA&S process. In some organizations,
however, internal auditors need first to:
1. Overcome negative perceptions from management regarding

their role in certain strategic operations and transactions.
36

2. Ensure that internal audit has the required skills, expertise, and
resources to participate to the extent described above.
Let’s not forget one important point: Part of the role of internal auditors
is to support senior management, and the whole company, as key advisers
during the entire MA&S process. This task can be difficult enough when trying
to support their role in their own country, where they speak the same language
and where business customs are familiar. Imagine this exercise in countries
where internal audit teams do not share the same language and customs. The
degree of difficulty is, under those circumstances, compounded.
The Acquisition Process

A possible framework for a more proactive role for internal auditors should
include the following aspects:
n Develop a specific task force or team. Empower the internal

auditors with full responsibility for specific areas such as
mergers, acquisitions, or asset disposals (including sales of enti-
ties or subsidiaries and spin-off activities).
n Draw up a strategic MA&S plan. This gives the organization a

template for its strategic acquisitions and sales, but is also an
“ideal” profile for a merger partner.
n Identify potential candidates. The next step is to determine the

essential criteria and to be constantly aware of companies that
are for sale and that fit the strategic choices and objectives of
the bidding company.
n Consider valuation and pricing. Deciding on how much to pay

for the target company or how much a new entity (once merged)
is worth is no simple matter. Read on to study some deals where
pricing obviously was not evaluated adequately in the pre-
transaction stage. Here again, internal auditors may be able to
save their company from some embarrassing truths.
37

n Provide thorough due diligence. Remember always to ask

yourself:
¨¨ Does the price add up?
¨¨ Does the target company’s culture fit?
¨¨ Do the financials represent a true picture of what the

bidder company is purchasing?
Chapter 4 Takeaways
1. Internal audit should promote the use of best practices during all
phases of the MA&S process, and should prepare a best practices
document at the conclusion of the project.
2. Open, effective communication with management, the board of

directors, and the audit committee is essential.
3. Internal auditors should develop a risk-based plan to help ensure

the merging organizations meet their objectives.
4. Control issues or deficiencies in the target company should be

addressed during the planning phase.
5. Open communication between the bidder and target company

can be useful in avoiding duplicate or unnecessary effort and
inefficiency.
6. A clear plan to integrate the two internal audit organizations can

provide valuable insights for the entire MA&S project.
7. Internal audit should ensure that significant weaknesses uncov-

ered during the due diligence phase are assessed and dealt with
before the deal is finalized.
8. Third-party outsourcing of due diligence is a common practice,

and a good opportunity for in-house internal auditors to upgrade
their skillsets.
38

9. A complete diagnostic review of significant processes, including

mapping of principal risk areas and control activities, can form
the basis for future audits.
10. Internal auditors can act as important “bridge builders” between

various departments of both the bidder and target companies.
39

Chapter 5
Key Risk Areas Associated with

MA&S Projects
Risks are involved in every major strategic project. Some of the most common
risks associated with MA&S projects are listed in this chapter. The following list
is by no means exhaustive and is not necessarily in order of significance, but it
provides an overview of the key areas internal auditors should evaluate during
MA&S risk assessment. The due diligence process of the MA&S cycle will also
evaluate many of these risks to ensure that they do not pose a serious threat to
either the acquiring or target company; however, the internal audit group also
should perform a comprehensive risk assessment that includes these and other
significant risks.
Business Market
Market Risk
Market risk refers to the possibility that investors may experience losses due
to factors that affect the overall performance of financial markets. Risks such
as recessions, natural disasters, political turmoil, changes in interest rates,
and terrorist attacks can cause a decline in the market that affects compa-
nies across the board. Also called “systematic risk,” market risks can be hedged
against but cannot be totally eliminated through diversification. Sensitivity to
market risk is generally described as the degree to which changes in interest
rates, foreign exchange rates, commodity process, or equity prices can
adversely affect earnings and/or capital.
Analysis of market risk often presents complex variables, but at times it
can be a major factor in decisions regarding MA&S transactions. For example,
41

a company might decide to expand into a new geographic area to diversify

market risk; however, if the new operation is located in an area where war is
imminent, the move might significantly increase overall risk levels.
Marketing Risk
Closely related to market risk, marketing risk refers to risks that lead to
shrinking market share. Marketing risk is affected by factors such as inade-
quate/obsolete product design, unsuccessful marketing campaigns, uncompeti-
tive pricing strategies, or inappropriate distribution methods.
Marketing risk levels often fluctuate in the midst of MA&S activities. For
example, brand loyalty may or may not transfer successfully to an acquiring
organization; or previously successful distribution channels may need to be
changed to fit with the acquiring company’s distribution system. Internal audi-
tors should carefully analyze sales forecasts for possible marketing risk impli-
cations, because sales predictions based on past performance may be heavily
impacted by MA&S activities. Auditors should also be on the lookout for
overly optimistic sales projections that may, consciously or unconsciously, be
designed to present the company in an unjustifiably favorable light during
MA&S negotiations.
Environmental Risk
In the context of MA&S activities, environmental risk refers not just to the risk
of adverse effects on living organisms or the environment from sources such as
emissions, waste, or accidental chemical releases: It refers to all potential events
that could impact the environment, social responsibility, or corporate gover-
nance. Environmental auditing requires a very different skill set from that used
in most other types of auditing. This is an area where it is particularly important
to remember that The IIA’s International Standards for the Professional Practice
of Internal Auditing (Standards) requires the CAE to obtain competent advice
and assistance if the internal auditors lack the knowledge, skills, or other
competencies needed to perform any part of an engagement. If your engage-
ment team does not possess specific knowledge of environmental auditing, it is
advisable to seek advice from an external specialist.
42

Key Risk Areas Associated with MA&S Projects
Information Technology (IT) Risk

IT risk includes all aspects of IT systems and security. In particular, the following
areas should be evaluated carefully during MA&S due diligence: incompatible
and/or obsolete hardware and software systems, data security, protection of
data in different jurisdictions, vulnerability to cyberattacks, the increased use
of social media in professional/private contexts, fallout from bringing different
IT systems together in a proposed merger, and the increased number of third
parties who may have IT access.
Human Resources (HR) Risk

HR risk involves the people aspects of the proposed MA&S deal. At times, HR
risk is overlooked in favor of financial issues, personal motivations, or even
hubris. Cultural awareness is imperative: Cross-border transactions, regional
differences, or even the organizational culture itself, can make or break a deal.
Other important factors include regulations regarding employment contracts
and benefit entitlements, pay scales, industrial relations, recruitment and reten-
tion of employees, key personnel, management team experience, training, and
change management strategies.
Internal Control Risk

Reviewing the internal control risk of an MA&S target can provide valuable
insights into the company’s operational efficiency, financial integrity, and regu-
latory compliance status. Effective due diligence can reveal a lack of or inade-
quate policies, procedures, and controls. This, in turn, can tell us a lot about the
control environment, risk management culture, the “tone at the top,” and the
effectiveness of corporate governance.
Intellectual Property (IP) Risk

In recent years, IP risk has become an important factor in MA&S activities. A
growing percentage of mergers and acquisitions specifically target technolo-
gies, IP, and technical personnel responsible for research and development. IP
rights are usually viewed as valuable assets, especially at companies holding
knowledge-based innovation, high-tech, or specific manufacturing processes.
43

In the past, IP was within the scope of legal due diligence, but audits were
usually limited to the ownership of trademarks, patents, copyrights, and a
review of relevant contract terms. Today, IP issues can be complex, and partic-
ular technologies or software may rapidly become obsolete, which can bring
difficult challenges and uncertainties to the valuation of IP assets. Therefore,
when acquiring a target with major IP assets, it is important to separate
IP matters from other legal relationships and treat them separately in the
valuation.
Information and Communications Risk

This category includes risks related to all areas of internal and external commu-
nication, as well as to the circulation and protection of information. Although
information and communications risks are inherently important in all ongoing
communications, they are especially critical during the MA&S process. Effective
management of these information and communications risks is key to the
successful outcome of the MA&S transaction. Auditors normally should focus
on confidentiality, access to information, public relations (especially in the
case of listed companies), press releases, advertising, sponsorship, corporate
websites, and third-party websites.
Financial Risk
Financial risk includes all areas of valuation of assets, accounting guidelines,
investments, tax issues, and asset and liability management. Internal audit
procedures should include a complete ratio analysis and a thorough examina-
tion of key accounting issues such as pension liabilities, receivables, payables,
profit and loss, cash flow statements, unaudited financials, and incomplete
or unreliable financial data. Auditors should be particularly alert for over-
valued assets and overly optimistic estimates, budgets, and forecasts, because
management estimates are particularly likely to involve “wishful thinking” when
strategic transactions are being considered.
Legal Risk
Legal risk includes risks arising from legal claims or counterclaims, defec-
tive contracts, and lawsuits (for example, as a result of the termination of a
contract). It can also arise from failing to take appropriate measures to protect
44

assets (for example, intellectual property assets described above), or from

uncertainty in the applicability or interpretation of contracts, laws, or regu-
lations. Potential changes in legislation and regulation can also create legal
risks. Depending on specific circumstances, legal risks may include corporate
liability, product liability, contractual agreements, antitrust issues, regulatory
and compliance issues, and contracts with employees, customers, suppliers,
outsourcers, and other risks.
Completed legal actions are not necessarily the most important consid-
eration here. Auditors should be particularly alert for outstanding or pending
lawsuits and legal decisions, keeping in mind that anticipated legal issues may
be a key factor in decisions regarding selling a company or its assets.
Business-Specific or Industry-Specific Risk

Business-specific or industry-specific risk refers to all areas concerning
the competitive environment, business operations, and contingency plan-
ning. Company-specific risks are non-systemic risks specific only to a certain
company. For example, if a wholesaler has only one supplier and the supplier
goes bankrupt, this could greatly impact the wholesaler’s sales, profits, and
other operations. Company-specific risks are difficult to quantify and, thus,
qualitative analysis is needed to determine their nature and likelihood. They
may be reduced by appropriate diversification.
Business-specific risks are as varied as the companies where they take
place; therefore, auditors may need to evaluate business-specific risks or
industry-specific risks ranging from geo-political changes to regulatory
requirements to the financial stability of key suppliers.
Corporate Reputation Risk

Corporate reputation risk involves a threat or danger to the good name or
standing of a business entity. These risks can occur in various ways: directly
as the result of the company’s actions, indirectly due to the actions of an
employee or employees, or tangentially through other peripheral parties such as
joint venture partners or suppliers. Issues are particularly likely to arise during
MA&S activities because of hostile bids or potential job losses, or because the
acquiring or target company is part of a controversial industry sector.
45

Real Estate Risk

Real estate risk includes all areas of facility and property management.
Depending on the specific activities of the target company, all rent and lease
contracts should be thoroughly examined.
Potential risks may surface during reviews of construction permits, reno-
vation work, extensions, continuation of activities (particularly in urban areas),
and environmental regulations. Changes to occupancy and commercial prem-
ises landlord/tenant rights might significantly affect estimated cash flows. If the
combined organization plans to sell duplicate or unneeded facilities, real estate
sales prices can also be an important factor.
Pitfalls
Several significant risks are inherent within MA&S processes. The four most
common risks are described below.
1. Overestimating “synergies.” Though you cannot discuss MA&S

without it, synergy is probably the most overused and over-
abused word in the mergers and acquisitions vocabulary. This
is due in part to the hype that surrounds MA&S transactions,
coupled with the potential creativity of over-zealous manage-
ment teams.
2. Not properly assessing IT systems. This is often caused by a lack

of IT experience. Internal auditors are generally not experts in
IT, and even the most experienced IT auditor may be unfamiliar
with the specific types of systems in use at a target company.
Communication and collaboration with your organization’s IT
department, or with third-party experts who have knowledge of
the types of systems being evaluated, can be vital during due
diligence activities.
3. Inadequately providing due diligence. This pitfall, which can

affect both buyers and sellers, may stem from one or all of the
following:
n Insufficient time to complete the due diligence process
46

n Insufficient information received from the target

company
n Lack of understanding of the target company’s activity
n Not listening to the warning signs noted during the due

diligence process
n Clashing management styles and egos
n Key people leaving the company before, or soon after,

the transaction is completed
n Inability to make realistic forecasts
n Poor post-merger/post-acquisition integration
4. Cancelling MA&S risk. Cancelling MA&S risk is a factor in every

proposed merger, acquisition, or sale. To a certain degree, these
risks are unavoidable, but often they are related to insufficient
preparation, poor MA&S project management, or the potential
aftershocks of project failure. Areas that merit particular atten-
tion are concerns of shareholders and other stakeholders, share
price fluctuations, perceived management inability/incompe-
tence to complete the deal, threat of legal action, and poor
public relations and social media communication strategies.
Chapter 5 Takeaways
1. Various risks must be examined in key areas of focus to diffuse
potential threats to the acquiring and/or target organizations.
2. Key risk areas include Business Market, Environmental, IT,

HR, Internal Control, Intellectual Property, Information and
Communications, Financial, Legal, Business-Specific and
Industry-Specific, Corporate Reputation, Culture, Property, and
Canceled MA&S.
47

3. Lack of IT experience can lead to poor assessment of IT risk, so

expert advice in this area is crucial.
4. Beware of overestimating synergies.
5. Even though myriad causes exist for inadequate due diligence, all
must be avoided.
48

Chapter 6
Corporate Valuation
Valuation is a process used to determine what a business is worth. Determining

a company’s worth and knowing what drives its value are prerequisites for
deciding on an appropriate price in an acquisition, merger transaction, corpo-
rate restructuring, or sale of securities.
There are many acceptable valuation methods, and each will yield a
different result based on the sensitivity of inputs. Certain modifications to
these models are necessary to adjust for public versus private companies. For
example, the cost of capital for private companies is different because they do
not have access to capital by way of equity markets. The key to establishing a
starting point for any company valuation is to determine the type of company
involved, whether it is a private or a publicly traded company, and its appro-
priate industry.
Five questions should be considered when estimating a target company’s
value:
1. What will the acquisition cost?
2. What is the fair market value of the target company?
3. What is the prospective buyer prepared to pay?
4. What is the maximum price the acquirer is prepared to pay and

still obtain the desired rate of return on the investment?
5. What is the probability of achieving the expected return?
49

What Should Be Taken into Account in Target Valuation?

When evaluating a target company’s worth, it is important to consider:
n Availability of financing
n Interest rates
n Economic situation at the time of the valuation, but also for the
future
n Stock price (for public companies)
To gain a clear understanding of the potential acquisition, internal auditors

should focus on the following areas:
n Products and markets

n Operations and organization
n Financials
n Industry and competition
Valuation Techniques
Four valuation methods are commonly used to determine the worth of poten-
tial MA&S transactions:
1. Discounted Cash Flow (DCF)
2. Comparable transactions (i.e., value of similar companies that

have recently been sold or purchased)
3. Comparable companies for benchmarking (i.e., value of similar

companies)
4. Adjusted book value
Let’s look at the first method, DCF, in detail. You should also understand the
concepts of net present value and internal rate of return.
Net present value (NPV) is an indicator of the value or magnitude of an
investment. It gives you the current value of both the incoming and outgoing
cash flow over a future period of time.
50

Corporate Valuation
Internal rate of return (IRR) is a rate quantity, and indicator of the efficiency,
quality, or yield of an investment. An investment is considered acceptable if its
IRR is greater than an established minimum acceptable rate of return or cost of
capital.
Given a time period and cash flow for a project, the IRR follows from the
NPV as a function of the rate of return.
Discounted Cash Flow (DCF) Analysis

The following four steps are used to calculate DCF:
1. Calculate the projected sales and operating profit based on an

assessment of the company’s recent historical income and cost
items, and on certain assumptions regarding the company’s
future prospects.
2. Adjust projected operating profit estimates (after taxes) by

adding back depreciation and deducting net investments in
working capital and capital expenditures.
3. Discount back to the current period the projected free cash

flow from operations and residual value, using an appropriate
discount rate (for the industry sector) to calculate the total value
of the company for the debt holders and shareholders.
4. Deduct the market value of interest-bearing debt, and add the

market value of any excess assets before determining net equity
value.
The underlying assumptions used in the DCF method can significantly alter
the outcome, thereby changing the validity and appropriateness of the valu-
ation numbers. Five components often have the largest impact on decisions
regarding estimated cash flows:
1. Income projections: Are they realistic?
2. Length of the projection period: How many years?
3. Reinvestment opportunities: Is the timing realistic?
51

4. Discount rate: Is it the specific industry rate?
5. Residual value: What value is left after the projection period?
Residual Value
The remaining value of the acquired business, after the projection period, is
referred to as the residual value. The two ways of calculating the residual value
are the perpetuity method and the multiplier approach.
The perpetuity method treats residual value like an annuity, by capital-
izing the final year’s projected cash flow by the discount rate. The multiplier
approach applies a multiple of earnings before interest and taxes (EBIT) to the
final year’s EBIT.
Audit Considerations in Valuation

Development of an appropriate valuation is an essential part of the negotiations
process. Valuation should start during the due diligence process (or sooner)
and should include three key aspects: research, understanding, and judgment.
Just as for any other audit work, internal auditors need to present the
results of their analyses clearly, concisely, and objectively, and to “sell”
their valuation advice and other recommendations to senior management.
Establishing consensus regarding key assumptions and estimates is an essential
step in establishing buy-in for advice, recommendations, and estimates.
Internal auditors should bear in mind the following points:
n “What if” assumptions, such as those used in DCF calculations,

can significantly affect the perceived value of a target organiza-
tion. Auditors should ensure a reasonable basis exists for devel-
oping or changing key assumptions; if not, management may just
be picking an arbitrary number or engaging in wishful thinking,
rather than calculating the true value of the target company.
n Whichever valuation method is used, it should provide a way of

stress-testing factors such as sales growth, expenses, and capital
requirements. It is important not to accept estimates, budgets,
and forecasts at face value. The valuation team should make a
reality check—projections can be awfully wrong sometimes!
52

Corporate Valuation
n The residual value used in the DCF calculations must be under-

stood and tested for overall reasonableness by the internal
auditors.
Chapter 6 Takeaways
1. Many of the same techniques can be used to value public or
private organizations.
2. A starting point for valuation is to evaluate the industry, type of

organization, and whether the organization is public or private.
3. Other considerations for valuation are availability of financing,

interest rates, stock price, and the economy.
4. Factors that influence valuation include size, operational history,

management, operational control, earnings, cash flow, capital
structure, and risk.
5. Each valuation method will yield different results, based on sensi-

tivity of inputs.
6. You should ensure there is a sound basis for key assumptions

and estimates.
7. Proper valuation of a target organization requires research,

understanding, and judgment.
8. Valuation method should provide way of stress-testing factors

such as sales growth, expenses, and capital requirements.
9. Residual values must be understood and tested for overall

reasonableness.
10. Comparable organizations may be reviewed for transactions and

benchmarking.
53

Chapter 7
Methods for Determining the Value

of a Private Company
Valuations can be especially challenging for private companies, regardless

of whether they are small family-owned enterprises, divisions/subsidiaries
of larger private companies, or large corporations. Many of the same tech-
niques used to value public companies can be used to value private compa-
nies; however, finding the true intrinsic value of a private company is a tricky
task. It entails developing calculations and assumptions based on industry-wide
and company-specific statistics. It includes key planning, adjusting of finan-
cial statements, and applying the appropriate business valuation methodology.
Numerous complex factors influence the valuation, including, but not limited to,
the following:
n Size
n Operational history (or lack of operational history)
n Management and operational control issues
n Difficulty in quantifying earnings and cash flow
n Capital structure
n Specific business risks
Following are some useful tips and techniques for determining the value
of a privately owned, unlisted company. Business valuation is part art and part
science. The number and diversity of variables that influence the value of a
privately owned business often make establishing a sale or purchase price
extremely difficult. Factors that can influence values include:
55

n Nature of the business
n Position in the market or industry sector (both nationally and

internationally)
n Outlook for the market or industry sector (both nationally and

internationally)
n Organization’s financial status and stability
n Organization’s earning capacity
n Existence of intangible assets such as patents, trademarks, and

copyrights
n Value of similar companies that have recently been sold or

purchased
n Value of similar companies that are publicly owned
n Specifics such as family dynasty, a well-known founder, and

local/regional presence
n Existence of qualified buyers and sellers interested in such

transactions
Various organizations publish data on the sale and purchase of organi-

zations throughout the world. Perceived values may vary in certain markets
because of industry- or country-specific factors. You may, therefore, find it
useful to research average benchmarks based on the target company’s industry
and location.
Assessing the value of a company’s tangible assets is usually quite straight-
forward, but determining the price of an intangible asset like goodwill, for
example, almost certainly will create a degree of controversy.
Let’s look at both sides: The seller expects the value of goodwill to reflect
the hard work and long hours invested in developing the business. The buyer,
on the other hand, is willing to pay only for those intangible assets that produce
extra income.
56

Methods for Determining the Value of a Private Company
How Can Internal Audit Help Both Sellers and Buyers Reach a Fair Price?
Following are some “golden rules” for establishing the value of a business as
well as ways to help you create your own guiding framework.
Rule 1
There is no single best method for determining the value of a business, because
each business sale is unique. The most practical approach is often to estimate
the value of a company using a mixture of several techniques. The idea is to
review the values you calculate and then decide on the range (according to
market, industry, and country) in which most of the values converge.
Rule 2
To be viable, the deal must be financially feasible for both parties. The seller must
be satisfied with the price received for the business, but the buyer cannot pay an
excessively high price that necessitates an unrealistically high level of borrowing
or that strains cash flows to the point where the transaction has no benefit.
Rule 3
The buyer should have access to all business records. This is called effective
due diligence. Would you buy a house without ever visiting it and its neighbor-
hood, asking the present owner a certain number of questions, and carrying out
a small “investigation”?
Rule 4
Valuations should be based on facts, not feelings or fiction.
Rule 5
The two parties should deal with each other openly, honestly, and in good faith.
As experience shows, this is not always the case and, for that reason, many
business sale transactions simply do not go through or turn into costly and acri-
monious court cases.
The most common reason that buyers purchase existing businesses is to
acquire their future earning potential. The second most common reason is to
57

obtain an established asset base: It is often much easier to buy assets than to
build them. Although some valuation techniques take these objectives into
consideration, many business sellers and buyers simplify the process by relying
on “rules of thumb” to estimate the value of a business.
For example, one rule of thumb for appraising a sporting goods shop is to
use 30 percent of its annual sales, plus inventory, to establish a rough estimate
of its value. Other rules use multiples of a company’s net earnings to value the
business. These multipliers can vary according to the industry sector, with most
small businesses selling for between two and 12 times their earnings before
interest and taxes (EBITs), with an average of between six and seven times EBIT.
Internal auditors should be particularly aware of the following factors,
because any one, or a mixture of factors, could have an impact on due dili-
gence. It doesn’t hurt to study the industry as well.
The five factors that can increase the value of the multiplier are:
1. Proprietary products, services, and patents
2. Strong, diversified customer base
3. Above-average (for the industry) growth rate
4. Strong, balanced management team
5. Dominant market share
The six factors that can decrease the value of the multiplier are:
1. Generic “me too” products and services
2. Dependence on one customer or a small group of customers for

a significant portion of company sales
3. Dependence on a single market or country for a significant

portion of company sales
4. Reliance on the skills of a single manager or key person (e.g.,

company founder or CEO)
5. Declining market share
58

6. Dependence on a single product for generating sales
Specific Techniques
The three techniques most commonly used to verify the value of a business are:
1. The Balance Sheet Method
2. The Earnings Method
3. The Market Method
1. The Balance Sheet Method

By using the balance sheet method, you can calculate the “book value” of
a company’s net worth, or owner’s equity, and use this figure to value the
company. This method starts with the equation:
Assets - Liabilities = Net Worth
First, you should determine which assets are to be included in the sale of
the company. The management teams from both the buying and selling orga-
nizations should draw up a list and come up with a reasonable valuation price.
You should be able to value the assets based on benchmarks and experience.
Remember that the net worth on a financial statement will probably be very
different from the actual net worth in the market.
Let’s take an example, and go through the due diligence and valuation veri-
fications based on the potential sale of MDF Furniture, a small European-based,
flat-pack furniture manufacturer.
MDF Furniture has assets of €1,900,000 and liabilities of €850,000. Thus,
we can calculate the company’s net worth:
€1,900,000 - €850,000 = €1,050,000
Some criticism of this method is that it is regarded as oversimplifying the

valuation process. The issue is that this technique fails to recognize the reality
of the situation: Most small businesses have market values that exceed their
reported book values.
59

Variation: Adjusted Balance Sheet Method

A more realistic method for determining a company’s value is to adjust the
book value to reflect the actual market value. The values reported on a compa-
ny’s books may either overstate or understate the true value of the assets
and liabilities. Typical assets in a business sale include notes and accounts
receivable, inventory, supplies, fixtures, machinery, and equipment. If a buyer
purchases notes and accounts receivable, then internal auditors should esti-
mate the probability of their collection and adjust the value accordingly.
2. The Earnings Method

There are three variations on the earnings method of valuation. Let’s explore all
three.
Variation I: Excess Earnings Method

This method combines both the value of a company’s assets (minus its liabili-
ties) and an estimate of its future earnings potential, to determine the sale price
of the business. One advantage of the excess earnings method is that it offers
an estimate of goodwill.
Goodwill is the difference between an established, successful business and
one that has yet to prove itself. Goodwill is based on the company’s reputation
and its ability to attract customers. This intangible asset often creates prob-
lems in a business sale. A common method of valuing a business is to compute
its tangible net worth and then add an often arbitrary adjustment for goodwill.
Internal audit should help the buyer to clarify the seller’s arbitrary adjustment
for goodwill, because it is possible that it will be inflated.
The excess earnings method provides a reasonable approach for deter-
mining the value of goodwill. It measures goodwill by the amount of profit
the business earns above that of the average business in the same industry. It
also assumes that the business owner is entitled to a reasonable return on the
company’s adjusted tangible net worth.
STEP 1
Using the previous valuation method, calculate the company’s adjusted

tangible net worth. Total tangible assets (adjusted for market value) minus total
60

liabilities gives you the adjusted tangible net worth. In the case of our example,
MDF Furniture, the adjusted tangible net worth is:
€2,000,000 - €850,000 = €1,150,000
STEP 2
Calculate the opportunity cost of investing in the business. The opportunity

cost constitutes the cost of forgoing a choice. In other words, what income
would the potential buyer give up by purchasing MDF Furniture? (If I choose to
purchase this particular business, I cannot invest my capital elsewhere.)
I use three components to set the rate of return to value my business:
1. Basic risk-free return
2. Inflation premium
3. Risk allowance for investing in my particular business
The risk-free return and the inflation premium are reflected in investments
such as U.K. or U.S. government bonds. To determine the appropriate rate of
return for investing/buying a business, the buyer must add to the base rate a
factor that reflects the risk of purchasing the company. The greater the risk
involved, the higher the rate of return should be in the calculation.
An average-risk business typically has a rate of return of 20 to 25 percent;
however, the rate varies greatly between industries. You should, therefore,
research specific benchmarks for the industry and geographic location of the
target company.
I consider MDF Furniture to be a slightly higher-than-average-risk business,
so I will use the 25 percent rate. In this case, for MDF Furniture, the opportunity
cost of the investment/purchase is:
€1,150,000 x 25% = €287,500
The second part of the buyer’s opportunity cost is the salary that the buyer
could have earned by purchasing another business or by making other alterna-
tive investments. Assuming that the buyer forgoes a salary in another business
61

of €60,000 per year, the total opportunity cost for the MDF Furniture transac-
tion would be:
€287,500 + €60,000 = €347,500
STEP 3
Project net earnings. You must be able to estimate the company’s net earn-
ings for the coming year, before deducting the owner’s salary. Averages are
sometimes misleading, especially when analyzing the sale/purchase of small-
and medium-sized businesses. You must also try to analyze the trend of net
earnings and ask what has happened to the earnings over a given period. By
looking at past income statements, you can obtain useful guidelines. Let’s say
that the current owner of MDF Furniture, together with an accountant, have
projected net earnings to be €750,000.
STEP 4
Now let’s calculate the extra earning power. A company’s extra earning power is
the difference between forecasted earnings (STEP 3) and the total opportunity
costs of investing/purchasing the business. The extra earning power of MDF
Furniture is:
(Projected net earnings) – (Total opportunity cost) =

€750,000 - €347,500 = €402,500
STEP 5
Estimate the value of intangibles. You can now use the company’s extra earning
power to estimate the value of its intangibles. If you multiply the extra earning
power by a years-of-profit figure, the result will give you an estimated value of
the intangible assets. The years-of-profit figure for a normal-risk business typi-
cally ranges from three to four. A high-risk business may have a years-of-profit
figure of one, whereas a well-established company might have a figure of seven.
Next, rate the company on a scale of 1 (low) to 7 (high) based on the
following factors. This will enable you and the purchaser of the business to
calculate a reasonable years-of-profit figure to estimate the value of the intan-
gibles. See table 7.1.
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Table 7.1: Earnings Method Risk
Low Risk Average Risk High Risk
Factor 1 2 3 4 5 6 7
1. Risk More risky Less risky
2. Level of competition Intense competition Few competitors
3. Industry attractiveness Fading Attractive
4. Barriers to entry Low High
5. Growth potential Low High
6. Owner’s reason for selling Poor performance Retiring
7. Age of business Young + 10 years old
8. Current owner’s tenure Short + 10 years
9. Profitability Below average Above average
10. Location Problematic Desirable
11. Customer base Limited and shrinking Diverse and growing
12. Image and reputation Poor Strong
To calculate the years-of-profit figure, add the score for each factor and
divide by the number of factors—in this case, 12. For MDF Furniture, the scores
are illustrated in table 7.2.
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Table 7.2: Earnings Method Factors
1. Risk 3
2. Level of competition 2
3. Industry attractiveness 4
4. Barriers to entry 4
5. Growth potential 2
6. Owner’s reason for selling 6
7. Age of business 6
8. Current owner’s tenure 6
9. Profitability 4
10. Location 4
11. Customer base 3
12. Image and reputation 5
Total 49
Therefore, for MDF Furniture, the years-of-profit figure is 49/12, or 4.1, and
the value of intangibles is (€402,500 X 4.1), or €1,650,250.
STEP 6
Determine the value of the business. Now all you have to do to verify that the
price requested by the seller is the right one is to add the adjustable tangible
net worth (STEP 1) and the value of the intangibles (STEP 5). Using this
method, the value of MDF Furniture is:
(Total tangible assets) + (Total intangible assets) =

€1,150,000 + €1,650,250 = €2,800,250
64

Variation II: Capitalized Earnings Approach

Another earnings approach capitalizes expected net earnings to determine
the value of the business. An appraiser takes a weighted average of past years’
sales, with the greatest weights allocated to the most recent years, to estimate
sales for the coming year. Once again, you can estimate the risk of purchasing
the business to determine the appropriate rate of return on the investment.
The capitalized earnings approach divides estimated net earnings (after
deducting the owner’s reasonable salary) by the rate of return that reflects
the risk level. For MDF Furniture, the capitalized value (assuming a reasonable
salary of €60,000) is:
Net Earnings (after deducting owner’s salary) =

€750,000 - €60,000 = €2,760,000
Rate of return 25%
Companies with lower risk factors offer greater certainty and, therefore, are
more valuable.
In our example, a lower rate of return of 10 percent gives us a value of
€6,900,000 compared with companies that have higher risk factors, giving us a
value of €1,380,000.
Variation III: Discounted Future Earnings Approach

This approach assumes that a euro earned in the future is worth less than a
euro earned today. By using the discounted future earnings approach, you
can estimate the company’s net income for several years into the future, and
then discount these future earnings back to their present value. The resulting
present value is an estimate of the company’s worth. For any buyer, this present
value represents the cost of not having the opportunity to earn a reasonable
rate of return, by receiving income in the future instead of today.
The discounted future earnings approach can be calculated in the following
five steps:
STEP 1
Project the earnings for a five-year period into the future. Assume that earnings
will grow by a constant amount over the next five years. Develop three fore-
casts for each year: Pessimistic, Most Likely, and Optimistic.
65

Next, calculate a weighted average for using this formula:
Forecasted (Pessimistic (4 x Most likely (Optimistic

earnings for = earnings for year 1) + earnings for year 1) + earnings for year 1)
year 1 6
The most likely forecast is weighted four times more than the pessimistic
and optimistic forecasts. Thus, the denominator is the total of the weights
(1 + 4 + 1 = 6).
For our example, MDF Furniture, the buyer has forecast the following earn-
ings, illustrated in table 7.3.
Table 7.3: Discounted Future Earnings Forecasts
Year Pessimistic Most Likely Optimistic Weighted Average

2014 €620,000 €750,000 €800,000 €740,000
2015 €650,000 €770,000 €850,000 €760,000
2016 €700,000 €820,000 €920,000 €820,000
2017 €730,000 €910,000 €970,000 €890,000
2018 €760,000 €980,000 €1,300,000 €1,000,000
You should remember that the further into the future the forecasts go,
the less reliable they will be; but you now have a more realistic picture of the
current value of any future earnings.
STEP 2
Discount these future earnings using the appropriate present value factor. If
you are unable to find the appropriate updated present value table, then you
can calculate it yourself by using the following equation:
1/(1 + k)
K = rate of return = 25%
66

The rate you select should reflect the rate that a buyer could earn on an
investment of similar risk. Because MDF Furniture is a normal-risk business, we
can take 25 percent as a maximum value. See table 7.4.
Table 7.4: Discounted Future Earnings Averaging
Forecast Earnings Present Value Factor Net Present Value

Year
(Weighted Average) (at 25%)* (NPV)
2014 €740,000 0.8000 €592,000
2015 €760,000 0.6400 €486,400
2016 €820,000 0.5120 €419,840
2017 €890,000 0.4096 €364,544
2018 €1,000,000 0.3277 €327,700
Total €2,190,484
*To calculate the Present Value Factor, use the following formula:
1/(1 + 25%) = 1/1.25 = 0.8000
Then, keep dividing the Present Value Factor by 1.25 for each year
(0.8000/1.25 = 0.6400) and so on.
STEP 3
Estimate the income stream beyond five years. One technique involves multi-
plying the fifth-year income by 1/(rate of return). For MDF Furniture, the esti-
mate is:
Income beyond year 5 = €1,000,000 x (1/25%) = €4,000,000
STEP 4
Discount the income estimate beyond five years using the present value factor
for the sixth year. For MDF Furniture:
Present value of income beyond year 5: €4,000,000 x 0.2621 = €1,048,400
67

STEP 5
Now you can calculate the total value of the business.
Total value: €2,190,484 + €1,048,400 = €3,238,884
The main advantage of this technique is that you can evaluate any type
of business solely on the basis of its future earnings potential. Its reliability,
however, depends on making accurate forecasts of future earnings and on
selecting a realistic present value factor.
3. The Market Method

The market or price/earnings approach uses the price/earnings (P/E) ratios of
similar businesses to establish the value of a company.
This technique is especially useful for appraising the value of listed compa-
nies and then drawing up a comparative table of values for similar compet-
itor companies. The technique is not only for listed companies: It can also be
used to make comparisons with privately owned companies, but obviously the
comparisons will be somewhat skewed.
A company’s P/E ratio is the price of one share of its common stock on the
market, divided by its earnings per share (after deducting preferred stock or
dividends). To obtain a representative P/E ratio, you should average the P/E
ratios of as many similar businesses as possible.
You should multiply the average P/E ratio by the private company’s esti-
mated earnings to calculate a company’s value. For example, suppose you find
four companies that are similar to MDF Furniture but whose shares are publicly
traded. Their P/E ratios are illustrated in table 7.5.
Table 7.5: P/E Ratios
Company 1 3.3
Company 2 3.8
Company 3 4.3
Company 4 4.1
Average 3.875
68

This average P/E ratio produces a value of €2,906,250.
Value = (Average P/E ratio) X (Estimated net earnings)

= 3.875 X €750,000 = €2,906,250
The advantage is that this technique is quite simple; however, the market
approach method has four specific disadvantages:
1. You are comparing publicly traded and privately owned compa-

nies. Any P/E ratios, therefore, will be subjective and, of course,
lower than those of publicly held companies.
2. You may make unrepresentative earnings estimates. The private

company’s net earnings may not realistically reflect its true earn-
ings potential.
3. You may have difficulty finding similar companies for

comparison.
4. Remember to use the after-tax earnings of a private company to

determine its value, if you use an after-tax P/E ratio from a public
company.
Which Method is the Best?

No one best method exists. The techniques outlined provide a range of values,
and when advising your management during the price/value analysis phase,
you should look for values that are close before deciding on an offer or bid
price. Ultimately, all these techniques can be used to evaluate both a sale price
and a purchase price. They work both ways. Where you can really add value is
by making a complete analysis using all methods, and using your results to help
and guide management in the decision-making process.
69

Chapter 7 Takeaways
1. The number and complexity of variables that influence the value
of a privately owned business make establishing a price difficult.
2. Some influencing factors are the nature of the business, market

position, market outlook, financial status, earning capacity, and
ownership of intangible assets.
3. Another factor is the values of similar companies that are

publicly owned, or recently purchased or sold.
4. Goodwill is sometimes created by a well-known founder, a family

dynasty, or market presence.
5. Sellers expect the value of goodwill to reflect their hard work

and long hours.
6. Buyers only want to pay for goodwill if it produces extra income.
7. A practical approach to business evaluation is to use a mixture of

several techniques.
8. Buyers purchase an existing business to obtain its future earning

potential and its established asset base.
9. Three basic techniques to verify the value of a business are the

balance sheet, excess earnings, and market methods.
10. You can add value by making a complete analysis using all
methods and using the results to guide management in the
decision-making process.
70

Chapter 8
Due Diligence
In this chapter, we will examine some of the major areas that should be
reviewed during the due diligence process. It is important to remember that
due diligence frameworks and checklists must be adapted to suit the target
company’s industry sector, the objectives of the acquisition, and the final
outcome. Even when they operate in similar activity sectors and locations,
companies often vary greatly in many other respects. It is impossible, therefore,
to create a standard “one size fits all” set of due diligence guidelines that are
appropriate for all companies and situations. Appendix A presents an example
of the due diligence checklists that I use as a starting point in such evaluations.
It is essential to evaluate how well the acquisition will meet the acquiring
company’s objectives. The seven primary areas for consideration are:
1. Motives for the acquisition
2. Consequences of any external factors
3. Potential advantages of the acquisition
4. Motives for the sale of the company
5. Length of time the company has been for sale
6. Existence of other potential buyers/bidders
7. Any other offers that have already failed
71

General Data on the Transaction

In general, when you undertake an audit of the MA&S process, the necessary
information should already be available; but companies are extremely reluc-
tant to provide such information up front. The following documents are vital if
internal auditors are to conduct thorough due diligence:
n Terms of the acquisition (are there any hidden agendas?)
n Financing arrangements (i.e., the basics of the deal)
n Accounting treatment (e.g., International Financial Reporting

Standards [IFRS] and generally accepted accounting principles)
n Tax treatment (e.g., jurisdictions and tax shields)
n Arrangements and contracts with external consultants and experts
Collect All the Relevant Information on the Target Company

Important areas of relevant information include:
n Background/history of the target company, including how the

company developed, previous and existing subsidiaries, changes
in the capital structure, initial public offerings (IPOs), market
capitalizations, or insolvency proceedings
n Complete sales overview, including the product range, domestic

and export markets, main customers, quality issues, delivery
deadlines, and payment collection periods
n Company structure, including business units, subsidiaries,

regional offices, and production sites
n Organizational chart, including any recent changes
n Boards and management committees, including a complete

list of past and present directors, non-executive directors, and
managers—including a breakdown of their activities, mandates,
and tenures
72

Due Diligence
n Headcount, including the number of full-time and part-time

employees, temporary staff, employment contracts, human
resources (HR) policies and procedures, recruitment, reten-
tion, recent dismissals, potential redundancies, past and pending
employee court cases, and compensation rewards
n Market capitalization and shareholder distribution, including the

number of shareholders, details concerning the principal share-
holders, and shareholder rights and agreements
n Professional advisers, including contract details for accountants/

auditors, lawyers, main bankers, investment bankers, consultants,
and experts
n Share listings, including all stock market listings, filings, and a

breakdown of ordinary and preferred shareholders
n Copies of all contracts and policies, including employment

contracts, agency, dealer and loyalty agreements, employee
profit-sharing schemes, pension plans, leases, sales, and purchase
agreements, bonus plans, stock-option plans, insurance poli-
cies, patents, trademarks, copyright agreements, and intellectual
property
Company and Industry Sector Characteristics

You should evaluate the target organization in relation to other organizations in
the same industry by considering the following:
n The company’s position and reputation. How well is the

company known at home and abroad? What is its image in
relation to the products and services it supplies compared to
industry leaders and benchmarks, both national and interna-
tional? Is it a member of relevant trade associations?
n The reputation of the people involved. This could include the

current owners, family ownership, directors and non-executive
directors, management, and professional advisers.
73

n Competitive advantage. This includes innovation, patents,

trademarks, technological and technical know-how or exper-
tise, product research and development (R&D), cyclical factors
affecting the industry, and product “pipeline.”
Organization and Management

The nature of a company’s management is of utmost importance when
reviewing a target company. The buyer’s due diligence team should determine:
n Key people (e.g., founders, owners, and family “dynasties”)

n Number of years of service of key people
n Reasons for wanting to sell (why now?)
n Relationships with the principal shareholders
Key People
You can enhance your role in the acquisition process by providing a thorough
overview of the “people aspects” of the transaction, which are increasingly
important and can have a significant impact on the success or failure of any
transaction.
A target company that has a well-rounded management team and that has
identified a good secondary backup for the CEO is obviously worth more than
a comparable company that is basically a one-person operation. If a compe-
tent management team is in place that can replace the owner/founder, and if
key staff is in place in other areas of the business, it is likely that the buyer’s
investment is safer. From the target company’s point of view, the company
will benefit from a higher market value if it has taken the time to develop its
management team.
Why Does the Owner Want to Sell?

It is important to understand the motives behind the sale, especially if the seller
is a key member of management. Will this person’s services be needed, and will
this person be prepared to stay around after the merger or sale to help manage
the transition? It is essential that you communicate this information to your
management.
74

Due Diligence
Often the target company owners want to sell because they have invested
most of their personal net worth in their company and would like to diversify
their risk. In many cases, the target company’s management would like to be
able to get away from the day-to-day pressures of running a business, while still
remaining active in the business. Understanding the owner’s motivation places
you in a better position to advise your company’s management regarding struc-
turing the transaction.
Relationships between Key People and Shareholders

Evaluating the relationships between principal parties in the transaction is
important because the motives for the sale may vary between the different
“owners” of the company, especially if that ownership includes both family and
non-family members. You should also investigate whether any of the owners
or key employees have been involved in criminal proceedings, regulatory viola-
tions, or court cases.
Relationships between the New Owners (Your Company) and

Customers
This area is of vital importance to the outcome of the purchase/sale transac-
tion. Many management teams and external consultants have ignored or greatly
underestimated the importance of customer retention. There is no guarantee
whatsoever that after you acquire a company the customers will stay around,
especially if they do not appreciate your “new way of doing things.” You need to
determine what changes will take place and the consequences these changes
will have on the customer base, for both domestic and international markets.
You need to understand significant competitive advantages and disadvan-
tages. This may include technology, patents, copyrights, product-design spec-
ifications, service provision, technical production aspects, capital investments,
marketing, and sales networks.
You should ensure that the internal audit team conducts a Strengths,
Weaknesses, Opportunities, and Threats (SWOT) analysis of the key success
factors of the target company, benchmarking them with both your company
and the competition. What aspects make the target company more attractive
than similar companies in the same industry? There should be substantiated
evidence before the acquisition that the target company is likely to maintain its
competitive advantages. You should also identify potential developments that
75

could cause the target company to lose those advantages and assess the prob-
ability of that happening.
Products and Services

Your review of a target company’s product range and service provision could
take up an enormous amount of time in the due diligence process. You and
your team will, therefore, need to draw up an effective plan very early in this
stage. If the products and services represent only a small part of the target
company’s activities, however, consider rearranging the review schedule so that
team efforts are concentrated first on more important aspects of due diligence.
This will ensure that you are not wasting valuable resources.
The main areas to examine regarding products and services are:
n Main products and services from the sales income point of view,
in both national and international markets
n Product and service contribution margin, and contribution to

overhead expenses and revenue
n Product ranges of particular interest (e.g., cash cows, trademarks,

brand names, patents, and end-of-life or obsolete products)
n Financial aspects such as consistent gross margins, exces-

sive trade discounts or financing, thin margins on cash cows,
continual supplier contracts and agreements, own brand label
products, and product warranties and liabilities
n Proprietary products and own-brand labels can be particu-

larly attractive for an acquiring company because the process of
developing and marketing brand identification, both in national
and international markets, is expensive and time-consuming
n Demand fluctuation, delivery deadlines, and accounts receivables
It is also important to evaluate product profitability and contribution

margin. Product life cycle is important in relation to the speed of change in
technology and/or customer demand.
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Due Diligence
Customer Base
You should examine the customer profile and determine the risks. The customer
base may include:
n Individual customers (i.e., business to consumer)

n Business customers (i.e., business to business)
n Public sector customers
n E-commerce
n Domestic customers
n Export customers
n Contracts and agreements
n Sales channels (e.g., direct sales, agents, wholesalers, and online)
n Pricing policy
Sales Administration Policy

You should review sales performance over a given time period, usually for at
least the past five years. This will enable you to identify trends that could affect
future sales and be helpful in estimating future cash flows. You can even go
further and draw up a forecast of the target company’s sales expectations and
estimated market share. This data can then be compared and benchmarked
against industry-wide projections in both national and international markets.
For example, it is vital to understand how the distribution channels work, and
how much the target company depends on repeat sales.
Other significant points to review are:
n The logistics chain, including the means of transport for both

national and international markets, shipping from the production
units, outsourcers, international subsidiaries, or wholly owned or
third-party warehouses
n The specific terms and conditions for the transport
n International market particularities
n Sales team, agent, and distributor remuneration policies (e.g.,

fixed salaries, commission rates, and end-of-year bonuses)
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n The advertising and sales promotion practices and campaign

documents
n The advertising media, results, and returns
n A complete analysis of distribution and sales costs over the

past five years, for use in identifying possible shifts in profitable
customers and products
n A complete analysis by country/geographic area of marketing

plans and campaigns, paying particular attention to market fore-
cast comparisons, order cancellations, product returns and
reasons for returns, departmental costs in relation to the overall
budget, sales and expenses breakdown for each sales team
member, after-sales-service costs, changes in product mix prof-
itability, order processing costs, customer complaints, and the
number of lost customers in relation to the number of new
customers
Research and Development (R&D)

Examine the target company’s relative successes and failures in R&D, including:
n R&D budget for the past five years
n Product origination stemming from organic R&D activities versus

product originations resulting from the purchase of rights from
other companies
n Number of patents and/or trademarks registered
n List of new products introduced and in what markets. This can be

reviewed over a five-year period, and such an analysis can reveal
pressures that are placed on manufacturers because of techno-
logical/technical advances.
Finally, you should determine whether the target company has been
spending enough on R&D activities in relation to its planned budget, the
particular industry sector, and the competition. This is vital for understanding
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Due Diligence
whether the target company has reached its full potential earnings power, or if
there is room for improvement.
Industry Conditions and Competition

Industry conditions and competition are critical aspects of the due diligence
process. Areas to be examined should normally include the following:
n Number of companies operating in the industry sector at both

national and international level. Has the number been increasing
or decreasing over the past five years?
n Number of mergers, acquisitions, and sales that have taken place

in the past year
n Terms and conditions of these deals; in particular, the prices and

multiples that were paid
n Current state of the industry, for example, plant or store closures

or openings and the rate of business failures in the target compa-
ny’s market
n Number of international companies in the market and the

number that are expected to enter the market in the near future
n Number of market leaders (national and international) that are

core industry players or part of larger multinational groups
n Reasons why these companies are market leaders at national and

international levels
n Relationships between the market leaders and key players,

and the degree of competiveness in the market. Are the power
wielders the suppliers or are they the buyers?
n Latest reports from industry trade organizations, consulting firms,

and national bodies concerning the outlook for the industry
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n Latest analyses from investment bankers, financial analysts, or

leading auditing firms
n Possible changes in the local regulatory environment. Analyze

the potential impact of pending legislation and/or lawsuits on
your target company’s activity and industry.
n Potential environmental issues and pending legislation that

might have an impact on the target company’s products and
export markets
n Political, economic, and social situations that could impact

industry activity. Examples include supply interruption, imposi-
tion of trade restrictions or sanctions, and expropriation of land
and buildings by foreign governments.
n Vulnerability of the industry sector to other external forces
Purchasing, Outsourcing, and Suppliers

You should thoroughly investigate the target company’s purchasing processes
and supplier, and/or outsourcer base. Some of the areas to be reviewed include:
n Reports on purchasing quantities, prices, and contracts (previous

and current years) to identify significant trends
n Results of supplier and outsourcer audits (previous and current

years). Ideally, this will include audits of all main suppliers
and outsourcers, including a quality assessment of the prod-
ucts, spare parts, and fittings. If these audits have not been
conducted, risk assessments should be performed to determine
which audits should be completed before the sale is finalized.
n Relationship between raw material costs and sales over the last
three to five years
n Reports on identification of main raw materials, sub-products,

and semi-finished or finished product requirements:
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Due Diligence
¨¨ Determine price trends, market conditions, and raw

material supply for global markets and, in particular, for
competitors.
¨¨ Determine the inventory policy, together with minimum

and maximum inventory levels, in each significant location.
¨¨ Determine whether preferred practices are complied

with; for example, purchase order requisitions and
economic order quantities.
¨¨ Determine whether competitive bidding processes are

in place and operating effectively.
n Examine the existence of standardized procedures throughout

the organization.
n Evaluate delivery deadlines established by the production

department and suppliers to determine the extent to which
operating staff consider these deadlines in requisitioning mate-
rials. You should also look carefully at the number of “rush” or
“urgent” deliveries and orders. If this number is high or getting
higher, it can be important to understand why.
n Review operating information regarding cash discounts, oper-

ating costs compared to budget, waste scrap, salvage disposals,
and rejections of incoming materials and products.
Production Plants and Facilities

You should obtain as much information as possible concerning the target
company’s production plants and facilities. This should involve selected site
visits, depending on the resources available and the proximity of the site. The
most important areas are:
n Description and exact location of the facilities (e.g., purchase,

sale, and lease contracts)
n Deeds of property and insurance policies
n Real estate taxes
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Financial Information
There will be numerous sources for up-to-date financial information, especially
if your target is a listed company. However, evaluation of the following docu-
ments can improve your role in fulfilling management’s expectations. In general,
you should examine:
n Previous audited financial statements/annual financial reports

(over a three-year period)
n Internal and external auditors’ reports and management letters
n Banking contracts and agreements, and statements from the

current and previous years
n Previous financial deal structuring for MA&S transactions
n Operating budgets and cash flow projections
n Comparatives and industry benchmarks over the past three years
n Cost of goods sold, sales, and administrative expenses. You should

review these for major trends, especially in controllable costs such
as advertising, travel, and maintenance and repair costs.
n All extraordinary expenses and significant nonrecurring expenses

for the past three years
Make a financial ratio comparison of the past three years’ financial informa-
tion, and also include industry benchmarks. The following ratio comparisons will
provide important insights into the financial management of the target company:
n Current assets to current debt
n Net profits to net sales, tangible net worth, and net working
capital
n Net sales to tangible net worth, net working capital, and

inventory
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Due Diligence
n Average collection and payment periods
n Fixed assets, current debt, and total debt to tangible net worth
n Inventory to net working capital
Balance Sheet
You should review the following in order of priority:
n Bank statements, together with current and projected cash

positions
n Cash management techniques
n Marketable securities
n Financial risk management and derivative contracts
n Accounts receivable and accounts payable ledgers
n Breakdown of customer and product turnover, together with

credit policies and customer files
n Ratio of returns and discounts to sales for each month, inventory

turnover rates, and gross profit for the past year. Compare these
with industry standards/benchmarks.
n Inventory summary for each product line for the current and
prior year, including the latest physical inventory. Physically
observe the general condition and quality of inventory in the
various warehouses.
n Look for trends, obsolete products, and unusual movements.
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Internal Audit and Financial Management

In general, you should concentrate on the following areas, depending on the
industry sector:
n Start with reviewing the target company’s internal audit organi-

zation. Review a copy of the internal audit activity’s most recent
enterprise-wide risk assessment, its plan of engagements, the
results of its most recent periodic quality assessment review, and
a sample of reports in areas of interest, based on an initial risk
assessment.
n Assess the adequacy of internal controls, with special emphasis

on accounting and financial aspects.
n Review documentation concerning policies, procedures, and

internal controls.
n Assess the target company’s attitude to the control environ-

ment, governance, corporate social responsibility, and risk
management.
n Review any previous cases of fraud and/or suspected fraud.
n Look for instances of “creative” accounting practices or

“managed” earnings.
n Look for any strategies employed by the target company to

make the company appear more attractive for the acquisition/
sale (including less conservative accounting policies, cutbacks
in discretionary expenses, cutbacks in maintenance, or obsolete
inventories).
n Assess the overall strength of financial management policies and

procedures.
n Review segregation-of-duties policies.
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Due Diligence
Human Resources (HR)

You should review the following areas regarding HR:
n Total number of employees on all sites, including trends over the

past three years
n Recent layoffs, industrial relations, and union memberships
n Projected early retirements of key personnel in the current year

and coming years
n Salaries, wages, and bonuses—both trends over the past three

years and comparisons to industry averages
n Target company’s history in relation to industrial relations, strike

history, overtime, and production incentives
n Employee morale (particularly during any merger or acquisition),

working conditions, history of industrial accidents, staff turnover,
sick leave history, absenteeism, and safety inspection records
n Recruitment and retention policies, including professional

and personal development, training, talent, and knowledge
management
n Health insurance coverage and other benefits
n Pension plans and current liabilities
Information Technology (IT)

Many MA&S deals have failed because of a lack of thorough due diligence
in the information technology area. It is vitally important for you to look at
the compatibility of IT systems to ensure a smooth transition. It is extremely
important to have experienced IT auditors participate in the due diligence team,
especially because IT constitutes a growing percentage of corporate spending.
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Identify the Hidden IT Risks and Costs… Before the Deal Closes
According to informal research studies conducted by my company, Capricorn
Consulting, about half of all MA&S events end up destroying value, and another
two in 10 events fail to create meaningful value for stakeholders. It is your job to
help beat these odds and to ensure the deal builds business value. But in many
cases, IT problems and related unforeseen costs, issues, and complexities can
trip up an otherwise well-thought-out merger or acquisition strategy. Again, our
research reveals that IT issues contribute up to 25 percent of all financial risks in
strategic transactions. All too often, no one has evaluated the enormous poten-
tial impact that IT risks pose.
Here is how you can ensure that IT contributes positively to the transaction:
n Expertly investigate IT operations, searching beyond the obvious.
n Uncover hidden IT costs, risks, and synergies.
n Quantify the effects on the financial impact model.
n Make sound decisions by weighing drawbacks against expected

benefits.
n Create a transition or integration plan that addresses IT infra-

structure, applications, processes, and people.
Table 8.1 illustrates an example of how to calculate the potential return on

an IT due diligence investment.
Table 8.1: Calculating Potential IT Due Diligence Returns
Sample Acquisition
A Acquiring company’s IT budget $12,500,000
B Target company’s IT budget $5,500,000
C Total combined IT budget (A + B) $18,000,000
D Average one-time charge (12%) ($2,160,000)
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Due Diligence
Table 8.1: Calculating Potential IT Due Diligence Returns (continued)
Risk-Based Risk-Based Risk-Based

Adjustments to the Adjustment Your Risk Adjustment
One-Time Charge Example Risk Level (Risk % x D) Level (Risk % x D)
E Thoroughness of IT due 25% ($540,000)
diligence
F IT department’s 50% ($1,080,000)
experience with
integrations
G IT department’s overall 0% $0
ability to execute
H Risk adjustment to one- ($1,620,000)
time charge
I Risk-adjusted to one-time ($3,780,000)
charge (D + H)
In addition to the IT aspect, you should look for undervalued and over-
valued assets. The due diligence phase can be quite long in duration, time-
consuming, and a drain of already limited resources. Unfortunately, there is no
magic formula that can be applied to all businesses.
It provides, however, a perfect opportunity for you to conduct an assess-
ment of the business processes (not only of the target company but also of
your own (acquiring) company). When this phase is complete, your work is still
not done because internal audit can also contribute to the post-merger imple-
mentation and integration phases.
The success of any MA&S transaction relies greatly on three key areas:
n Processes
n People
n Technology
Your efforts should be concentrated on these factors, without forgetting

the financial aspects, current market environment, and the outlook for your
industry sector.
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You should also remember that an effective communication strategy is vital

during these critical transition periods for all companies involved in any form
of a strategic MA&S transaction. For example, the communication strategy
must take into account the unique cultures of the organizations involved. These
cultural aspects are particularly important when dealing with cross-border
MA&S transactions.
Customer and Supplier Involvement and Integration

With so much at stake, the last thing you want is for your new customers and
suppliers to leave. Internal audit should be alert to the risks if critical customer
and supplier relationships are not actively being nurtured and prepared for
a new start—both for newly acquired customers and suppliers, and for the
acquiring company’s existing customers and suppliers.
Sell-Side Due Diligence

When acquisitions do not work out, due diligence on a subsidiary before
offering it for sale should be considered. This is especially important if the
subsidiary received minimal pre-acquisition or post-acquisition due diligence.
When a company is not completely familiar with a subsidiary, “surprises”
may still exist. Potential buyers who discover these surprises during their
pre-acquisition due diligence may walk away from the deal or demand a
substantial price reduction.
Once the marketplace becomes aware of these aborted deals, it may be
more difficult to sell the subsidiary at a reasonable price. In extreme cases, a
company’s reputation for impeccable business ethics may be tarnished.
Sell-side due diligence is similar to pre-acquisition due diligence. In general,
a buy-side due diligence mind-set is needed. Sell-side due diligence should
result in two primary deliverables to management:
1. A due diligence report that identifies issues and exposures that

could substantially affect the sales process and final sales price
2. Recommendations to help mitigate the above exposures
Internal auditors can assist their companies in ensuring a strong due dili-
gence process is maintained in all its forms: pre-acquisition, post-acquisition,
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Due Diligence
and sell-side. A strong due diligence process is critical to ensure the acquirer
is fully aware of all aspects of the deal and provides access to vital intelligence
that is used to negotiate the final price and integrate the new subsidiary more
effectively.
In conclusion, based on my experience and knowledge of MA&S successes
and failures, I believe strongly that if internal audit can take on a more proactive
role and be involved from the start of the strategic process, continue throughout
the due diligence process, and review the post-merger/post-acquisition integra-
tion, then companies are more likely to avoid costly mistakes. This will also help
generate strategic business combinations that create stakeholder value.
Chapter 8 Takeaways
1. Establish an experienced and qualified MA&S team.
2. Implement a pre-merger and acquisition strategy plan.
3. Define potential target criteria.
4. Determine the integration plan.
5. Set the valuation methodology and transaction price.
6. Conduct thorough due diligence.
7. Renegotiate the terms of the deal after the due diligence results.
8. Ensure a smooth transition for all parties involved.
9. Perform an ongoing review of the post-transaction integration.
10. Build on the successful outcome and take advantage of the

lessons learned.
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Chapter 9
Two Example Case Studies
Disclaimer: Both of the example case studies are fictitious. Any

resemblance to real life situations, companies, or organizations is
purely coincidental.
Example Case Study I

Fraud or Price/Earnings (P/E) Envy?
P&H Systems, Inc., is based in the United States and manufactures technology
hardware. In 2012, it acquired Soft Cell, a U.K.-based producer of sophisticated
software products. Two months ago, P&H Systems made a statement regarding
the unusual amount of write-downs caused by its recent acquisition.
Since then, attention has focused on allegations of fraud against the U.K.
software company’s previous management. The U.S. technology group holds
Soft Cell’s prior management responsible for much of the nearly $9 million of
value destruction it has suffered on the $12 million deal.
Was it really a case of fraud, or was it a result of mismanagement? Could
the problem have been P&H Systems’ credulity, or was it possibly a result of
poor due diligence? The essential lesson to be learned here is to examine what
can be done to prevent such a case from happening again in the future. The
most important point is not whether fraud was committed or by whom, but
how the value was lost.
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The most fundamental question we should ask is why the U.S. group paid so
much for this type of company. There was no particularly sound business reason
for P&H Systems to buy Soft Cell. Where was the much-acclaimed “synergy”?
P&H Systems’ management comments were relatively vague regarding its
strategic plan and what it was going to accomplish with the purchase. The CEO
of P&H Systems spoke about grandiose projections for “ongoing cooperation”
and “reinventing the world as we know it.” There was never even a clear inten-
tion of how the new acquisition would be integrated into the U.S. group.
Upon later, more in-depth analysis, it appeared that P&H Systems’ real
motives had less to do with commercial logic than with managing the stock
market. A more convincing explanation for the acquisition is that the CEO
wanted to rearrange the technology group to enhance its attractiveness to
the growth-focused fund managers who had traditionally been purchasers of
P&H Systems’ shares. P&H Systems was in a maturing market, and this factor
weighed heavily on its stock market valuation. Those fund managers who had
originally supported P&H Systems were looking elsewhere for their returns.
The hope was that Soft Cell’s much higher market valuation would
somehow rub off on P&H Systems’ share price. This was one more example of a
deal simply driven by what could be described as “Price/Earnings (P/E) envy.”
For all intents and purposes, the CEO of P&H Systems had become just
another fund manager. He was, in fact, shuffling a portfolio of companies rather
like a fund manager shuffles a portfolio of shares. Chasing the stock market
might have been the primary reason behind this strategic acquisition.
We have witnessed this misconception many times before (obviously, few
lessons have been learned from previous debacles), as CEOs across the globe
take on the role of elated fund managers. During the MA&S bull market, many
companies allowed their strategies to be dictated by stock market valuations.
The role of CEOs is not to mirror fund managers but to run a business that
adds value, primarily through the provision of goods and services to customers.
If senior management succeeds at this, they will generate long-term returns for
their investors. What is troublesome is that some companies make a habit of
systematically “getting it wrong,” with acquisition after acquisition, or merger
after merger, wiping millions, if not billions, of value off companies’ net worth.
The long MA&S bull market that ended in 2007 may have convinced
investors that companies could somehow increase in value without actually
becoming better managed. Today, however, the global business environment is
much tougher. CEOs need to think much more about staff and customers, and
less about the stock market.
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One of the lessons learned from this case study is the importance of
possible accounting irregularities and fraud during strategic transactions. When
internal audit is involved in the due diligence process from the very begin-
ning, they can alert stakeholders that vague answers regarding why a target
company is an attractive acquisition may be an indication that sound business
practice and honest synergy are not the underlying motivations.
What Should the Internal Audit Response Be?
1. Intensify the entire due diligence process. It may be necessary to

assign additional audit resources to the project.
2. Audit the strategy and objectives of the MA&S process.
Example Case Study II

Merging Two Internal Audit Organizations
This fictitious case study is based on the merger of two internal audit organi-
zations during the proposed merger of two European insurance companies. It
demonstrates how successful a merger can be when international best prac-
tices are followed and, particularly, when you start by merging two internal
audit organizations.
Background of the Deal
Company I: FR ASSURANCE (FR-A)

Revenues: €72 billion
Assets under management: €1,000 billion
Number of clients: 51.5 million
Number of staff: 90,000
Number of internal auditors: 300
Public company listed in Paris and New York
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Company II: DE VERSICHERUNG (DE-V)

Revenues: €18 billion
Assets under management: €100 billion
Number of clients: 13 million
Number of staff: 19,000
Number of internal auditors: 60
Subsidiary of DE Bank listed in Zurich and New York
FR Assurance (FR-A) acquired DE Versicherung (DE-V) on January 4, 2012.

The terms of the deal were €7.9 billion plus €1 billion of debt refinancing. The
objectives of the deal were to reinforce FR-A’s leading position in Europe, and
to increase its presence in the high-growth markets of Central Europe and Asia.
Overall Approach to the Merger Process

It was a joint approach, shaped and driven by FR-A’s Strategic Implementation
Committee, which steered the process. Work streams for each professional area
and local business were standardized, with weekly reporting and an issue esca-
lation process. The goal was to complete as much as legally possible before the
merger was closed.
Key Objectives for the Merger of the Two Internal Audit Organizations
1. To identify the key strengths (people, methodology, and tools)

from each organization and retain them.
2. To achieve a good level of resources. Both companies decided on

3.5 auditors for each 1,000 employees as a benchmark for each
country.
3. To ensure that the merged internal audit team would be fully

operational and staffed by July 2012.
4. To draw up a risk-based 2013 audit plan for the combined entity

by July 2012.
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Some General Points Concerning the Merged Organizations
n The deal was announced on January 4, 2012.
n The joint FR-A and DE-V internal audit work team first met in
February 2012.
n It was imperative to move quickly and decisively. Speed was

essential for removing uncertainty among the internal audit staff
and for maintaining productivity.
n The global organization plan was approved by the Strategic

Implementation Committee in April 2012.
n The internal audit sub-work teams were established in May 2012.
n The internal audit leaders for each country were appraised and
selected in May and confirmed in June 2012.
n The acquisition was completed and the merged internal audit

activity was operational as of July 2012.
The FR-A’s CAE had the following comments concerning the merger of the
two internal audit organizations:
Be pragmatic in everything you do. Concentrate on getting the

job done. Focus on implementation, not perfection, and don’t
integrate things that don’t need integrating!
DE-V’s internal audit process, standardization, and tools were generally

superior to that of FR-A. A single globally recognized automated workpaper
tool was adopted globally, and other processes, such as standardized recom-
mendation tracking, were scheduled to be reviewed during 2013.
The risk assessment systems were different, and integration was deferred
until summer of 2013, in time to be ready for third-quarter and fourth-quarter
planning.
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Merging Departments—Key Steps

The audit management team decided the following steps were essential for
ensuring a smooth integration of the internal audit activities.
1. Get organized.
2. Set up a joint integration team to identify concerns, coordinate

work, make decisions, and escalate issues.
3. The internal audit global work team would consist of a core four-
member team, with two executives from each company.
4. The team would meet every two weeks, in Paris and Köln.
5. All joint decisions would be approved by the Strategic

Implementation Committee.
More advice from the FR-A CAE follows:
Get people at all levels together quickly. Start a dialogue as early

as possible, with presentations on the approach to audit, tools,
and governance framework, among other topics.
FR-A’s approach to internal audit was presented to the DE-V team in Köln
and then to teams around the world, explaining the decentralized versus
centralized approach:
n No central reporting for recommendations versus centralized

reporting
n Local methodologies versus standardized methodology
n Multiple tools versus one tool
n Elements of autonomy versus conformity
This was followed by question-and-answer sessions with all the staff.

Orientation sessions for senior internal audit staff were held in Paris, with
conference calls every two weeks, during which the internal audit leaders
for each country shared issues. The audit management team from DE-V also
attended FR-A’s internal audit country-head, work-group sessions.
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The FR-A CAE then added the following comments:
During the initial stages, it is vital to determine the organizational

structure and the resources needed: Which audit teams will be
responsible for what, the staff numbers, and skill mix that are
required by each entity.
Issues to be considered for the newly merged internal audit organization:
n Number of budgeted FR-A internal audit staff
n Number of budgeted DE-V internal audit staff
n Total number of internal audit staff for the merged company
n Number of staff required from the redeployment pool
n New organizational structure to be completed and staff nomi-

nated by mid-May
n Identification of Eastern European countries to be audited from

Germany (pending confirmation that it is acceptable to manage-
ment that internal audit in Eastern Europe would be provided
from Germany)
Implement a Staff Assessment and Selection Process

The staff assessment process was designed centrally, to be followed by all loca-
tions. A decision was made to retain all existing internal audit staff because
there was little duplication of resources. In most locations, the internal audit
group had significant existing vacancies, exacerbated by the decision to freeze
all post-merger hiring. In eight countries, an internal audit country leader had to
be selected and, in three of these, someone from the DE-V staff was chosen.
The FR-A CAE said, “Cross-fertilize teams early in the process. Mix respon-
sibilities as soon as possible to foster integration, to exchange information and
best practices, but also to broaden the experience base.”
Initial efforts to integrate the teams quickly and efficiently were compli-
cated because, although FR-A and DE-V operated in the same countries, none
of their offices were located in the same cities. For example, offices in Spain
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were located in Madrid and Barcelona; and offices in Germany were located
in Köln and Frankfurt. “Joint teams” were established to foster the integra-
tion and ensure staff would gain experience across all aspects of the merged
organization.
The FR-A CAE comments on merging internal audit organizations and the
actions that could have been done better follow:
Regarding staff retention: We managed to retain 80 percent

of the original DE-V internal audit team; but some good
people were lost, particularly in Asia. Why did this happen?
Unfortunately, the engagement of the internal audit group’s
and the local FR-A’s management teams was poor, and deci-
sion-making was too slow.
Second, there was the weakness of matrix reporting. When the

focus is on synergies and cost reduction, it is difficult to focus
simultaneously on filling vacancies and planning recruitment.
We had planned to fill 50 pre-merger vacancies by redeploying
displaced staff from operations to internal audit. This reasoning
failed because of timing issues and a poor value proposition in
some countries. The pools of displaced staff had not yet been
identified, and there was insufficient appeal among some staff
to join internal audit, as many had received offers for other posi-
tions outside the company.
Finally, some legal aspects of the merger had been completed,

but the merger finalization was delayed because of ongoing
work-related negotiations with employees in some countries.
Adherence to Professional Standards

Both FR-A and DE-V had adhered closely to The IIA’s Standards. This was obvi-
ously a key contributing factor to the internal audit group’s success in meeting
each of the integration milestones ahead of other functional areas. There was
so much in common: language and approach, risk assessments, audit plans,
and recommendations. Internal auditors possessed the necessary technical
skills, including appropriate professional qualifications/certifications and a real
commitment to professional standards.
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The Internal Audit Organization Was the First to Integrate

In the FR-A/DE-V merger, internal audit was the first function to integrate,
with the aim of being operational as one function by July 2012, which was the
closing date of the acquisition. This was achieved because:
1. There was a clear plan.
2. A strong governance structure existed.
3. The plan was carried out efficiently and pragmatically.
4. Significant effort was made to build personal relationships across

the companies.
5. Speed of execution was a top priority.
6. All the processes and procedures were underpinned by The

IIA’s Standards and other guidance contained within The IIA’s
International Professional Practices Framework.
Chapter 9 Takeaways
1. When internal audit was the first team to integrate and become
an operationally effective transversal function, it facilitated
internal audit’s strategic reviews of merging business operations.
2. A pragmatic “quick and dirty” approach consistent with overall

objectives helps get things done.
3. Establishing a joint team and meeting face-to-face immediately

after the acquisition announcement were good foundations for
mutual trust and openness.
4. Early exposure to the “other side” helps to reassure staff that

approaches to internal audit are similar and that quick integra-
tion is credible.
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5. Early agreement with senior management regarding staffing

levels means effort can be better focused on key issues such as
staff retention and selection of CAEs.
6. If a “best-of-the-best” selection process is implemented, it must

be perceived as fair and objective.
7. In previous acquisitions, staff was left to “specialize” on the

historic business of pre-merged companies, which hindered inte-
gration, knowledge sharing, and, ultimately, retention.
100

Chapter 10
Conclusion
Causes Leading to the Failure of Mergers

To review: One cause of merger failure is the lack of adequate due diligence,
including detailed analysis of finances, management, and assets at both the
company being acquired and the one doing the acquiring. The team performing
the due diligence should, at the very least, include accountants to review finan-
cial statements, lawyers to investigate exposure to various liabilities, and tax
experts, each of whom should have a strong understanding of the target
company’s industry. It is important to note that these teams of accountants,
lawyers, and tax experts must be independent to avoid conflict of interest.
The failure of mergers is determined by a number of factors, including:
n Lack of experience in merger processes
n Failure in analysis of due diligence
n Strategy management incompatibility between the companies

involved in the merger
n Inadequate integration of corporate cultures
n Unverified financial positions
n Lack of communication between managers and employees
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The risk of failure can be minimized if you examine the manufacturing

processes, characteristics, product design, product refusal/return rates, busi-
ness advertising, marketing, number of customers, and employee profiles. The
decision to buy a company should not be influenced by factors like headquar-
ters being located in a luxurious beachfront building.
Cultural differences can create major problems. If one company is conser-
vative and the other company is transparent and open, conflicts or misunder-
standings are likely. An example is the merger of Daimler and Chrysler. Often,
buyers neglect organizational culture in favor of a more detailed analysis of
systems and business processes; but this neglect can result in a lack of accep-
tance and resistance to change.
Managers must be sensitive to cultural differences between organizations.
By doing so, they can minimize conflicts by using frequent communication with
employees, customers, and other stakeholders interested in post-merger inte-
gration success. It is the duty of those who lead the integration process to seek
ways to make the organizations’ cultures compatible.
During a merger or acquisition, lack of adequate communication can create
uncertainty and foster insecurity among employees, leading to employee reten-
tion problems. Employees worry and complain about conflicting rumors. They
ask the questions, “Will we be restructuring? Will I be moved to another depart-
ment? What will happen to my boss?”
In the majority of restructuring initiatives, the message to employees is that
everything is fine, and there is no need to worry. Instead, the message should
be, “No, the integration will not be easy, but it should be viewed as a great
opportunity, not as a problem.”
Another potential problem is that very few companies have managers
already in place who have the ability to control companies in different indus-
tries. To achieve a successful conglomerate merger, managers should evaluate
this issue and receive advice from specialists.
Immediately after a merger, most business functions will be duplicated,
and the integration team should decide and communicate the responsibility
for actions during the transition and after, if they want to support productivity
and employee morale. Roles, responsibilities, incentives, and structures must be
clearly defined. Acceptance occurs if employees can imagine themselves and
their futures in the new combined entity. Even more than on other occasions, they
need a clear understanding of what is required of them, opportunities for personal
development, and details about their career, compensation, and benefits.
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Conclusion
Internal Audit Can Help Ensure a Successful Merger Process

The internal audit profession faces many challenges in the new millennium.
Driven by the need to minimize costs and increase profits, or at least main-
tain both at reasonable levels, internal audit activities are seeking ways to
add value to an organization and prove they can still “do business” for their
employers. Internal audit’s role has changed over the years to a proactive,
role-based business consultancy. Unfortunately, even if the role of internal
audit has been extended in the case of mergers, internal audit often does not
contribute significantly past the due diligence phase. Perhaps one reason for
this is that managers believe that internal auditors do not have the necessary
skills to be actively involved in all stages of business. There is a great need for
further study regarding the role of audit in mergers and acquisitions because
the internal auditors can significantly improve the quality of management
throughout the entire merger process.
Managers often do not understand the importance of internal audit in
all stages of a merger. Internal auditors can contribute significant value by
ensuring that a vibrant due diligence process is in place and operating as
intended. A rigorous audit of the MA&S due diligence process can help compa-
nies take advantage of legitimate new business opportunities, while at the same
time helping to minimize the risks.
Making the case for auditing the due diligence process can be awkward for
an internal audit group that has not previously done so. In such situations, it is
often advisable to consider outsourcing or co-sourcing parts of the project to
an experienced third-party service provider. Bringing in outside expertise can
help assure the completeness of your work and help the internal audit staff
develop the requisite skills to perform these reviews.
Strong relationships with the audit committee and management are key
factors in making the case for audit involvement in due diligence, as is the repu-
tation of the internal audit organization itself. If these items are lacking, it will
be difficult to obtain buy-in for auditing the due diligence process, or any other
new area for that matter.
Ensuring Internal Audit Effectiveness

In an ideal world, MA&S transactions might take place only after the internal
audit team issues an unqualified report. In all likelihood, however, you will
unearth a variety of important issues that should be brought to management’s
103

attention. Time is of the essence here: If the auditor’s opinion is with reserva-
tions, there may be reason to reject the proposed merger, so it is essential to
keep management informed as quickly as possible when you become aware of
potential issues. Timely communication about potential risks and issues can also
enable management to address problems even before your report is issued.
Unfortunately, your work will be in vain if appropriate action is not taken
on your recommendations, and in the midst of MA&S activities, an enthusi-
astic management team may be very tempted to accept risks they otherwise
would consider unacceptable. The IIA’s Standards require that, when the CAE
concludes that management has accepted a level of risk that may be unaccept-
able to the organization, he or she must discuss the matter with senior manage-
ment, and if the matter is not resolved, it must be communicated to the board
of directors.
Even if management enthusiastically embraces all of your recommenda-
tions, there is a danger that reported issues may not be addressed appropri-
ately. Action plans must be developed for each reported risk or control issue,
clearly indicating those items that must be completed before the strategic
transaction is finalized. Rigorous follow-up is essential: Keep in mind that in the
midst of frenzied MA&S activities, it is very common for management to let
details “fall through the cracks” or for them to postpone addressing important
control issues in favor of other activities that are more likely to impress the new
senior management team.
Pre-Acquisition Due Diligence

The audit of the MA&S due diligence process should begin with determining
whether or not a senior management champion has been explicitly identi-
fied. This individual should assist with management buy-in for the MA&S due
diligence process and facilitate communication of key issues across all func-
tional areas potentially affected by a new acquisition, such as business process
owners, legal counsel, the board and its committees, and outside consultants.
Internal audit also should ensure that robust accounting and internal control
due diligence checklists are used and that they have been tailored to address
unique risks associated with a prospective subsidiary or other acquisition.
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Conclusion
Post-Acquisition Due Diligence

Pre-acquisition due diligence may miss important issues, especially when it
is conducted in a competitive environment in which the acquiring company
has only a few days to access financial records and key personnel. It is always
possible for a buyer to overlook fraudulent financial reporting and material
weaknesses in internal control. An audit of the post-acquisition due diligence
process can help compensate for such risks by providing early identification of
unmet initial business plan goals, which may enable the acquiring company to
take corrective action before substantial losses are incurred.
Critical components of effective post-acquisition due diligence include:
n Appointment of a transition manager

n Participation by business process and control experts
n Completion of an initial comprehensive business process control
review
n Completion of an annual financial audit
Each new subsidiary should be assigned a transition manager who joins

the subsidiary on a full-time basis for several months. The transition manager
should be a financial expert who works closely with the subsidiary’s chief finan-
cial officer to provide direct assistance with onsite integration, including imple-
menting the acquiring company’s culture and acting as a liaison with senior
management during the integration. Transition managers should not be directly
involved in running the business, so they are better able to maintain objectivity
with respect to the integration. They also should receive formal training on
change management/transition management that includes understanding the
corporate culture and how all the elements of the transaction fit together.
Business process and control experts should have the primary responsibility
for integrating the various infrastructure processes such as accounting, finance,
information technology, procurement, and contract management. One or more
business process and control experts should be assigned to each new subsid-
iary, depending on the specific infrastructures that must be integrated.
Ideally, newly acquired operations might be subject to a comprehensive
business process and control review before the completion of a strategic trans-
action. In reality, however, comprehensive reviews of business processes and
controls are not likely to be completed before the strategic transaction is final-
ized. Risk assessments often indicate that, within the first 30 to 60 days after
105

a merger or acquisition, newly acquired operations should undergo a compre-

hensive business process and control review. The intent of this review is to give
management a road map of the controls and process changes that must be
implemented to bring the company into alignment with the parent company’s
controls, culture, and reporting requirements.
Throughout the first few months after acquisition, the business process and
control experts and transition manager should employ a supportive, consulta-
tive approach toward the new subsidiary, with a focus toward implementing
the items detailed in the road map. Before the end of the fiscal year, the new
subsidiary should undergo its first rated audit. A rating of satisfactory or unsat-
isfactory should be given, based on whether the road map’s recommendations
have been implemented.
An unsatisfactory rating should be examined closely. If serious process and
control deficiencies were identified from prior review(s) that need an extended
time period to fully remediate (i.e., a new accounting system), then this should
be taken into account. If control deficiencies have been left to languish, then
this could result in the loss of jobs within the subsidiary’s senior management.
Internal auditors are not traditionally MA&S strategists, but they excel at risk
assessment and risk management. Internal audit can play a critical, proactive,
and consultative role in a successful merger or acquisition throughout every
phase of the sales life cycle.
A continuing theme of this book has been that internal auditors should try
to be involved as early as possible in the merger process. It is important that
they receive information about potential mergers, even if the likelihood of the
merger has not been established. Their advice on systems and processes for
the merger could reduce the risks.
The target company in a merger may have very different systems and
processes. Effective documentation and analysis can reduce the costs of inte-
grating those systems and processes within the newly formed company.
Unfortunately, internal audit organizations usually have little or no involve-
ment when the strategy of merger is elaborated. Too often, company manage-
ment believes that the role of internal audit begins after the merger; but in
reality, early involvement is indispensable. Internal auditors should consult with
specialists in various fields such as finance, HR, and legal departments. Working
with external consultants (experts like external auditors or a consulting firm)
may increase the chance of successful fusion. Internal audit can provide vital
information to management about the value of the acquired company, its finan-
cial situation, and any deficiencies.
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Conclusion
A merger that is “respected” is one preceded by a process of due diligence

in which the company examines the candidate’s business health, ensuring that
there is no unpredictable or unnecessary exposure to risk. A coherent and
consistent information and communications plan may lead to the success of the
merger, or at least result in employees who are not dissatisfied, and hence will
not decline in productivity.
In conclusion, I would like to point out that the involvement of internal audi-
tors in both the pre-acquisition and post-acquisition due diligence processes
is no guarantee of the success of any deal. The internal audit activity can play
a significant role in the MA&S process; however, it is not an easy role to play.
The first step is to help ensure management support for the important role that
internal auditors can play throughout the MA&S process.
Chapter 10 Takeaways
1. Internal auditors can contribute significant value by ensuring
a robust due diligence process is in place and operating as
intended.
2. The team performing due diligence should include accountants,

lawyers, and tax experts.
3. Due diligence should happen pre-acquisition, post-acquisition,

and on the sell-side.
4. In proper due diligence, a target’s business health is examined

to ensure no unpredictable or unnecessary exposure to risk is
present.
5. If the auditor’s opinion is given with reservations, there may be

reason to reject the proposed merger. Therefore, it is essential
to keep management informed as quickly as possible when the
auditors become aware of potential issues.
6. Roles, responsibilities, incentives, and structures must be clearly

defined.
107

7. It is the duty of those who lead the integration process to make

conflicting cultures more compatible.
8. Adequate communication that describes the merger as an

opportunity, rather than a problem, leads to employees who can
imagine their roles in the new entity.
9. A coherent and consistent information and communications plan

may lead to a successful merger and avoid a potential decline in
productivity.
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Appendix A
Sample Due Diligence Checklists
Depending on the type of mergers, acquisitions, and sales (MA&S) activity,

different due diligence processes may be appropriate. The following are three
sample due diligence checklists from which internal auditors might choose.
Sample Due Diligence Checklist 1
A. Organization and Good Standing
1. Company’s Articles of Incorporation and all amendments thereto
2. Company’s Bylaws and all amendments thereto
3. Company’s minute book, including all (a) minutes and (b) reso-
lutions of the shareholders and directors, executive committees,
and other governing groups
4. Company’s organizational chart
5. Company’s list of shareholders, and number of shares held by

each one
6. Copies of agreements relating to options, voting trusts, warrants,

puts, calls, subscriptions, and convertible securities
7. List of all countries where the company is authorized to do busi-

ness, and annual reports for the last three years
109

8. List of all countries where the company owns or leases property,

maintains employees, or conducts business
9. List of the company’s assumed names and copies of registrations

thereof
B. Financial Information
1. Audited financial statements for three years, together with audi-

tors’ reports
2. Most recent un-audited statements, with comparable statements

for the prior year
3. Auditors’ letters and replies for the past five years
4. Company’s credit report, if available
5. Any projections, capital budgets, and strategic plans
6. Analyst reports, if available
7. Schedule of all indebtedness and contingent liabilities
8. Schedule of inventory
9. Schedule of accounts receivable
10. Schedule of accounts payable
11. Description of depreciation and amortization methods and

changes in accounting methods over the past five years
12. Any analysis of fixed and variable expenses
13. Any analysis of gross margins
14. Company’s general ledger
15. Description of the company’s internal control procedures
C. Physical Assets
1. Schedule of fixed assets and the locations thereof
2. All leases of equipment
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3. Schedule of sales and purchases of major capital equipment

during the last three years
D. Real Estate
1. Schedule of the company’s business locations
2. Copies of all real estate leases, deeds, mortgages, title policies,
surveys, zone approvals, variances, and use permits
E. Intellectual Property
1. Schedule of domestic and foreign patents and patent
applications
2. Schedule of trademark and trade names
3. Schedule of copyrights
4. Description of important technical know-how
5. Description of methods used to protect trade secrets and

know-how
6. Any “work for hire” agreements
7. Schedule and copies of all consulting agreements, agreements

regarding inventions, and licenses or assignments of intellectual
property to or from the company
8. Patent clearance documents
9. Schedule and summary of any claims or threatened claims by or

against the company regarding intellectual property
F. Employees and Employee Benefits

1. List of employees including positions, current salaries, salaries,
bonuses paid during last three years, and years of service
2. All employment, consulting, nondisclosure, and non-solicitation

or non-competition agreements between the company and any
of its employees
3. Curriculum vitae of key employees
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4. Company’s personnel handbook, a schedule of all employee

benefits, and employee holiday and sick leave policies
5. Summary plan descriptions of qualified and nonqualified retire-

ment plans
6. Copies of collective bargaining agreements, if any
7. Description of all employee problems within the last three years,

including alleged wrongful termination, harassment, and discrim-
ination complaints and lawsuits
8. Description of any labor disputes, requests for arbitration, and

grievance procedures currently pending or settled within the last
three years
9. List and description of employee benefits, including all

employee health and welfare insurance policies and self-funded
arrangements
10. Description of workers’ compensation claims history
11. Description of unemployment insurance claims history
12. Copies of all stock option and stock purchase plans and a
schedule of grants
G. Licenses and Permits
1. Copies of any governmental licenses, permits, or consents
2. Any correspondence or documents relating to any proceedings

of any regulatory agency
H. Environmental Issues
1. Environmental audits, if any, for each property leased by the

company
2. Listing of hazardous substances used in the company’s

operations
3. Description of the company’s disposal methods
4. List of environmental permits and licenses
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5. Copies of all correspondence, notices, and files related to

national and local regulatory agencies
6. List identifying and describing any environmental litigation or

investigations
7. List identifying and describing any known superfund exposure

8. List identifying and describing any contingent environmental
liabilities or continuing indemnification obligations
I. Taxes
1. National, local, and foreign income tax returns for the last three
years
2. Value-added tax (VAT) returns for the last three years
3. Any audit and revenue agency reports
4. Any tax settlement documents for the last three years
5. Employment tax filings for three years
6. Excise tax filings for three years
7. Any tax liens
J. Material Contracts
1. Schedule of all subsidiary, partnership, or joint venture relation-

ships and obligations, with copies of all related agreements
2. Copies of all contracts between the company and any officers,

directors, 5-percent shareholders, or affiliates
3. All loan agreements, bank financing arrangements, lines of credit,
or promissory notes to which the company is a party
4. All security agreements, mortgages, indentures, collateral

pledges, and similar agreements
5. All guaranties to which the company is a party

6. Any installment sale agreements
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7. Distribution agreements, sales representative agreements,

marketing agreements, and supply agreements
8. Letters of intent, contracts, and closing transcripts from any

MA&S transactions within the last five years
9. Options and stock purchase agreements involving interests in

other companies
10. Company’s standard quote, purchase order, invoice, and warranty

forms
11. All nondisclosure or non-competition agreements to which the

company is a party
12. All other material contracts
K. Product or Service Lines
1. Lists of all current products or services, and of products or

services under development
2. Copies of all correspondence and reports related to regulatory

approvals or disapprovals of any company’s products or services
3. Summary of all complaints or warranty claims
4. Summary of results of all tests, evaluations, studies, surveys, and

other data regarding existing products or services and products
or services under development
L. Customer Information
1. Schedule of the company’s 12 largest customers in terms of sales

thereto and a description of sales thereto over a period of two
years
2. Any supply or service agreements
3. Description or copy of the company’s purchasing policies
4. Description or copy of the company’s credit policy
5. Schedule of unfilled orders
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6. List and explanation for any major customers lost over the last
two years
7. All surveys and market research reports relevant to the company

or its products or services
8. Company’s current advertising programs, marketing plans and

budgets, and printed marketing materials
9. Description of the company’s major competitors
M. Lawsuits
1. Schedule of all pending litigation
2. Description of any threatened litigation
3. Copies of insurance policies possibly providing coverage as to

pending or threatened litigation
4. Documents relating to any injunctions, consent decrees, or

settlements to which the company is a party
5. List of unsatisfied judgments
N. Insurance Coverage
1. Schedule and copies of the company’s general liability, personal

and real property, product liability, errors and omissions, key man
and/or directors, officers, worker’s compensation, and others
insurance
2. Schedule of the company’s insurance claims history for the past

three years
O. Professionals
1. Schedule of all law firms, accounting firms, consulting firms, and

similar professionals engaged by the company during the past
five years
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P. Articles and Publicity
1. Copies of all company articles and press releases within the past
three years
2. Sample Due Diligence Checklist 2

I. Financial Information
A. Annual and Quarterly Financial Information for the Past Three Years
1. Income statements, balance sheets, cash flows, and footnotes
2. Planned versus actual results
3. Management financial reports
4. Breakdown of sales and gross profits by:
a) Product type
b) Channel
c) Geography
5. Current backlog by customer, if any
6. Accounts receivable aging schedule
B. Financial Projections
1. Quarterly financial projections for the next three fiscal years
2. Revenue by product type, customers, and channel:
a) Full income statements, balance sheets, and cash
b) Major growth drivers and prospects
3. Predictability of business
4. Risks related to foreign operations (e.g., exchange rate fluctua-

tion and/or government instability)
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5. Industry and company pricing policies

6. Economic assumptions underlying projections (i.e., different
scenarios based on price and market fluctuations)
7. Explanation of projected capital expenditures, depreciation, and

working capital arrangements
8. External financing arrangement assumption
C. Capital Structure
1. Current shares outstanding
2. List of all stockholders with shareholdings, options, warrants, or
notes
3. Schedule of all options, warrants, rights, and any other poten-

tially dilutive securities with exercise prices and vesting
provisions
4. Summary of all debt instruments/bank lines with key terms and

conditions
5. Off-balance sheet liabilities
D. Other Financial Information
1. Summary of current national and international tax positions,

including net operating loss carry forwards
2. Discuss general accounting policies (i.e., revenue recognition)

3. Schedule of financing history for equity, warrants, and debt (e.g.,
date, investors, dollar investment, percentage ownership, implied
valuation, and current basis for each round)
II. Products
A. Description of Each Product
1. Major customers and applications
2. Historical and projected growth rates
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3. Market share
4. Speed and nature of technological change
5. Timing of new products, product enhancements
6. Cost structure and profitability
III. Customer Information

A. List of Top 15 Customers for the Past Two Fiscal Years and Current Year-
to-Date by Application, Including:
1. Contact details
2. Product(s) owned
3. Timing of purchase(s)
B. List of Strategic Relationships, Including:
1. Contact details
2. Revenue contribution
3. Marketing agreements
C. Revenue by Customer, Including:
1. Name
2. Contact name
3. Phone number for any accounting for 5 percent or more of

revenue
D. Brief Description of Any Significant Relationships Severed within the

Last Two Years, Including:
1. Contact details
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E. List of Top 10 Suppliers for the Past Two Fiscal Years and Current Year-
to-date with Contact Information, Including:
1. Contact details
2. Purchase amounts
3. Supplier agreements
IV. Competition
A. Description of the Competitive Landscape within Each Market Segment,
Including:
1. Market position and related strengths and weaknesses as

perceived in the marketplace
2. Basis of competition (e.g., price, service, technology, and

distribution)
V. Marketing, Sales, and Distribution

A. Strategy and Implementation
1. Discussion of domestic and international distribution channels
2. Positioning of the company and its products
3. Marketing opportunities/marketing risks
4. Description of marketing programs and examples of recent

marketing/product/public relations/media information on the
company
B. Major Customers
1. Status and trends of relationships
2. Prospects for future growth and development
3. Pipeline analysis
C. Principal Avenues for Generating New Business
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D. Salesforce Productivity Model
1. Compensation
2. Quota average
3. Sales cycle
4. Plan for new hires
E. Ability to Implement Marketing Plan with Current and Projected Budgets
VI. Research and Development (R&D)

A. Description of R&D Organization
1. Strategy
2. Key personnel
3. Major activities
B. New Product Pipeline
1. Status and timing
2. Cost of development
3. Critical technology necessary for implementation
4. Risks
VII. Management and Personnel

A. Organizational Chart
B. Historical and Projected Headcount by Function and Location
C. Summary Biographies of Senior Management, Including:
1. Employment history
2. Age
120

3. Service with the company

4. Years in current position
D. Compensation Arrangements
1. Copies of key employment agreements
2. Benefit plans
E. Discussion of Incentive Stock Options Plans
F. Significant Employee Relations Problems, Past or Present
G. Personnel Turnover
1. Data for the last two years
2. Benefit plans
VIII. Legal and Related Matters

A. Pending Lawsuits Against the Company, Including Details On:
1. Claimant
2. Claimed damages
3. Brief history
4. Status
5. Anticipated outcome
6. Name of the company’s legal adviser
B. Pending Lawsuits Initiated by Company, Including Details On:
1. Defendant
2. Claimed damages
3. Brief history
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4. Status
5. Anticipated outcome
6. Name of company’s counsel
C. Description of Environmental and Employee Safety Issues and Liabilities
1. Safety precautions
2. New or pending regulations and their consequences
D. List of Material Patents, Copyrights, Licenses, and Trademarks, Including:
1. Issued
2. Pending
E. Summary of Insurance Coverage and Any Material Exposures
F. Summary of Material Contacts
G. History of U.S. Securities and Exchange Commission (SEC) or Other

Regulatory Agency Problems, If Any
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Item Description Why? What to Look For
Section I. Organization and Corporate Records

I.1 Initial Documents related to organization of Ensure you have Look for any
Organization the company before incorporation. the latest official changes in
version. shareholders and
key personnel.
I.2 Documents related to acquisitions, Ensure you Transparency and
Organizational restructurings, reorganizations, have the “real openness.
Changes bankruptcies, dispositions, picture.” There
repurchases, and changes of form should be no Good corporate
(i.e., from a partnership to an LLC). surprises. governance.
I.3 Articles Articles of incorporation and all
amendments thereto.
I.4 Bylaws Corporate bylaws and all
amendments thereto.
I.5 Minutes Minutes of the board of directors, Again, ensure Look for
including shareholder resolutions, you get the “real modifications
written consents, and the minutes picture.” made afterwards.
of any director or executive
committees. Some documents
could be missing.
Find out why.

I.6 Shareholder All communications with
Communications shareholders, including annual
reports, letters, solicitations, and
proxy statements.
I.7 Stock Ledger The stock ledger for the company
and each subsidiary.
I.8 Share Records A list of all shares authorized,
issued, and outstanding.
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I.9 Securities Agreements relating to options, This may take Look for
Agreements option plans, voting trusts, some time, shareholder
warrants, agreements to issue but these movements,
securities, calls, agreements documents can activism, and
to purchase securities, puts, reveal effective changes to suit
subscriptions, Employee Stock corporate management
Purchase Plans (ESPPs), stock strategies. rather than the
bonus plans, and convertible company.
securities.
I.10 Equity All equity compensation agreements,
Compensation including a list of all participants,
the number of shares they own, the
restrictions on those shares, and
their exercise price.
I.11 Shareholder All agreements with shareholders
Agreements relating to voting, acquisition,
redemption, or disposition of
securities.
I.12 Change of All documents relating to anti- These documents Management
Control Plans takeover measures or any will reveal egos.
agreement, plan, or document any previous
that contains change of control MA&S activity. Extra bonuses or
provisions. And, not only incentives based
success stories, on transaction
but also failed success.
transactions and
the reasons why.
I.13 Organizational charts showing
Organizational ownership and operational structure,
Charts including information related
to subsidiaries, divisions, joint
ventures, and affiliates.
I.14 Certificates Certificate of Good Standing
from the secretary of state of
incorporation and any other.
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I.15 List of List of all states, provinces, or
Jurisdictions countries where the company
owns or leases property, maintains
employees, or is otherwise
authorized to do business.
Section II. Financial Information

II.1 Financial All annual and quarterly financial
Statements statements for the past five
years for the company and all its
subsidiaries.
II.2 Interim The latest available interim financial
Financial information (e.g., unaudited monthly
Statements financial statements).
II.3 Auditor All communications with auditors, You can Look for any
Communications including auditors’ letters and sometimes learn challenging
replies, Provided by Client (PBC) more about the situations or
lists, and other correspondence for financial health U-turns made by
the past five years. of a target the auditors.
company than
the financial
statements
themselves.
II.4 Budgets All available company-wide and
departmental budgets for the last
five years.
II.5 Projections The latest financial projections and These documents A complete
estimates for the company and its are essential to understanding
subsidiaries, including a discussion understanding of the strategy
of assumptions made. the target and potential
activity. The real synergies will
business case for help you discover
MA&S. the reality behind
the transaction.
125


II.6 Capital The latest available capital budget,
Budgets including a discussion of essential,
nonessential, and strategic
investments.
II.7 Cash A detailed schedule of all
cash holdings and short-term
investments.
II.8 Inventory A detailed schedule of inventory by
product and geography.
II.9 Accounts A detailed aged schedule of
Receivable accounts receivable by customer
and geography.
II.10 Long-Term A detailed schedule of long-
Investments term investments, including
shareholding, bonds, and debt
instruments.
II.11 Property, A detailed schedule of all property,
Plant, and plant, and equipment, including
Equipment acquisition cost, accumulated
depreciation, and depreciable life.
II.12 Accounts A detailed schedule of all accounts
Payable payable by vendor.
II.13 Debt A detailed schedule of all
outstanding notes payable, bonds,
mortgages, and other long-term
debts.
II.14 Orders A detailed schedule by customer of
Booked orders booked for the past five years.
II.15 Revenues A detailed schedule of revenues
and Cost of Sales and cost of sales broken down by
customer, geography, and product
for the past five years.
126


II.16 Selling, A detailed schedule of selling,
General, and general and administrative expenses
Administrative by division, subsidiary, and
(SG&A) Expenses geography for the past five years.
II.17 Contingent A detailed schedule of all contingent This is to avoid A contingent
Liabilities liabilities. the surprises. liability is
A potential recorded in
obligation that the books of
may be incurred accounts only if
depending on the contingency
the outcome of a is probable and
future event. the amount of
the liability can
be estimated.
Examples could
be lawsuits
for patent
infringement or
environmental
damage.
II.18 Off- A detailed schedule of all off-
Balance-Sheet balance-sheet transactions,
Items including lease liabilities and credit
derivatives.
II.19 Capital A detailed schedule of all capital Is the target Look for window
Expenditures expenditures for the past five years, spending for ego dressing, which
including descriptions of each major or for investing? may make the
expenditure. target price look
more appealing.
II.20 A detailed schedule of any
Restructurings restructurings, reorganizations,
or major operational changes
undertaken in the past five years.
127


II.21 Accounting A schedule of any changes in Particularly Look for the
Changes accounting policies, principles, or important for reason why
procedures in the past five years, cross-border depreciation
including an explanation of why MA&S with charges changed.
such changes were made. different
accounting
systems.
However, also
essential in
understanding
the target’s
accounting
system.
II.22 Controls A detailed description of the
company’s internal controls.
II.23 Reserves Details of any reserves held (i.e.,
reserve for obsolete inventory).
II.24 Details of all transactions between
Intercompany the company and its subsidiaries,
Transactions parents, or other related parties.
II.25 Details and descriptions of any
Extraordinary extraordinary or nonrecurring
Items items appearing in the financial
statements during the past five
years.
II.26 Deferred A detailed schedule of all deferred
Income income items for the past five years.
II.27 Accounting A detailed description of all
Policies accounting policies, including
depreciation methods.
II.28 Breakeven An analysis of the company’s
Cash Flow monthly breakeven cash flow, broken
Analysis down by fixed and variable cash
inflows and outflows.
128


II.29 Financial Description of services provided by
Services accountants, auditors, financial
advisers, actuaries, brokers, and
other financial professionals for the
past five years.
Section III. Legal, Regulatory, and Compliance

III.1 Litigation A detailed schedule of all ongoing,
pending and threatened issues,
including any action, arbitration,
audit, examination, investigation,
hearings, litigation, claim, suit,
administrative proceeding,
governmental investigation, or
governmental inquiry affecting the
company, its assets, or operations.
III.2 Regulators Copies of all correspondence,
Correspondence reports to and filings with all
regulators, including but not limited
to the U.S. Securities and Exchange
Commission (SEC), state securities
authorities, foreign securities
authorities, the Department
of Justice, the Environmental
Protection Agency, and the
Department of Commerce.
III.3 Court Orders A detailed schedule of all
court orders, writs, judgments,
injunctions, decrees, and
settlements to which the company
is a party.
129


III.4 Notices Copies of all notices of legal
or regulatory violations and
infringements, including
correspondence, reports, notices,
and filings related to any dispute,
alleged violation, or infringement
by the company, its agents, or
employees of any local, state,
federal, or foreign law, regulation,
order, or permit relating to
employment violations, unfair
labor practices, equal opportunity,
bribery, corruption, occupational
safety and health, antitrust
matters, intellectual property, and
environmental matters.
III.5 Permits All local, state, federal, and
foreign approvals, authorizations,
certifications, clearances, licenses,
permits, registrations, and
waivers related to the company, its
operations, or assets.
III.6 Breaches A detailed schedule of all breaches
and Defaults or defaults that have occurred under
agreements to which the company
is a party, including all agreements
that would be affected by the
contemplated transaction (e.g.,
change of control provisions).
Section IV. Taxes

IV.1 Returns All local, state, federal, and foreign
tax returns and filings (including
sales tax returns) made by the
company for the past five years.
130


IV.2 Tax Authority All correspondence with local, state,
Correspondence federal, and foreign tax authorities
including audits, revenue agents’
reports, and notices of proposed or
final adjustments to the company’s
tax liabilities for the past five years.
IV.3 Any determination letters from the
Determination Internal Revenue Service (IRS) or
Letters other tax authority received in the
past five years.
IV.4 Settlements All agreements, consents, elections,
requests, rulings, settlements, and
waivers made with any local, state,
federal, or foreign tax authority in
the past five years.
IV.5 Compliance All documents related to the
company’s compliance with tax laws
and regulations for the past five
years.
IV.6 Opinions All tax opinions received from
attorneys, accountants, or other
specialists for the past five years.
IV.7 Open Years A detailed schedule of all open years
for local, state, federal, and foreign
taxes.
IV.8 Jurisdictions A detailed schedule of all tax
jurisdictions (including sales tax
jurisdictions) where the company
operates, maintains a physical
presence of any kind, or has
employees or agents.
IV.9 Tax A detailed schedule of all tax
Liabilities liabilities.
131


IV.10 Tax Basis A detailed schedule of the tax basis
of all assets, its accumulated
depreciation, and the depreciation
method used.
IV.11 Carry- A detailed schedule of all tax carry-
Forwards and forwards and carry-backs, including
Carry-Backs the source (e.g., net operating loss
or foreign tax credit), the expiration
dates, and any limitations on its
use.
IV.12 Tax-Free A detailed schedule of all tax-free
Transactions transactions not listed on the
company’s tax returns.
IV.13 Transfer A description of transfer pricing
Pricing methodologies.
IV.14 Tax Liens A detailed schedule of all tax liens
against the company’s assets.
Section V. Intellectual Property (IP)

V.1 Intellectual A detailed schedule of all patents, This is a key Any internal
Property (IP) patent applications, trademarks, area because or external
Portfolio trademark applications, trade of the difficulty document that
names, trade name applications, in valuating will clarify
copyrights, copyright applications, intangible assets. ownership and/or
service marks and service mark rights.
applications owned, held, or used by
the company, including ownership, Any previous
adverse claims made, involvement lawsuits (see
in litigation (if any), jurisdiction of Contingent
registration, and registration status. Liabilities,
Section II.17 of
this table).
132


V.2 Trade Secrets A description of trade secrets
and other unpatented proprietary
information.
V.3 Know How A description of significant technical
know-how used by the company.
V.4 License A detailed schedule of all license
Agreements agreements to which the company
is party.
V.5 Royalty A detailed schedule of all royalty
Agreements agreements to which the company
is party.
V.6 Technology A detailed schedule of all
Sharing technology-sharing agreements to
which the company is party.
V.7 Other IP A detailed schedule of all
Agreements agreements related to IP, including
use of technology or information,
disclosure of information, and
confidentiality.
V.8 Domain A schedule of all Internet websites
Names and domain names owned or used
by the company.
V.9 Software A detailed schedule of all software
assets owned or licensed by the
company.
V.10 A detailed schedule of all potential
Infringement or current matters relating to
infringement, interference, or unfair
competition.
133

Section VI. Employee Matters

VI.1 Officers and A list of all officers and directors of
Directors the company.
VI.2 Organizational charts describing the
Organizational company’s management structure
Charts and lines of reporting.
VI.3 Key A list of all key employees, their Most This is time-
Employees function, their salary, their résumés, organizations consuming;
and their importance to the do not update however, you
business. employee need to know the
résumés, work current status of
contracts, all key employees.
changes in
status, or Desk reviews
even new and interviews
qualifications on with supporting
a regular basis. documents
should provide
the necessary
information.
VI.4 Employee A list of all employees, including
List position, salary, and location.
VI.5 Consultants A list of all consultants and
and Contractors contractors working for the company.
VI.6 Employment All employment, consulting, change
Agreements of control, nondisclosure, non-
solicitation, or noncompetitive
agreements between the company
and any of its employees,
contractors, or consultants.
134


VI.7 Bonus Plans Documents describing any bonus,
incentive, or profit-sharing plans,
including funding requirements and
schedules of amounts paid under
the plan for the past five years.
VI.8 Pension Documents describing any
Plans retirement or pension plans
including funding requirements;
actuarial reports; financial reports
or financial summaries; IRS Form
5500, 5310, or 5330; annual reports,
reportable event notices, notices
of intent to terminate a plan filed
with the Pension Benefit Guaranty
Corporation; any applications for
determination filed with the IRS; and
VI.9 Insurance Documents describing any group life
Plans insurance, death benefit, disability,
accident, cafeteria, health,
major medical, medical expense
reimbursement, dependent care
or sick leave policies or programs,
including funding requirements;
actuarial reports; financial reports
or financial summaries; IRS Form
5500, 5310, or 5330; annual reports,
135


VI.10 Vacation Documents describing any holiday,
Plans vacation, leave-of-absence, or
sabbatical plans, including funding
requirements; actuarial reports;
financial reports or financial
summaries; IRS Form 5500,
5310, or 5330; annual reports,
VI.11 Stock Plans Documents describing any stock
option, stock purchase, stock
appreciation right, stock bonus,
employee stock option and employee
stock ownership plans, including
funding requirements; actuarial
reports; financial reports or financial
136


VI.12 Savings Documents describing any
Plans and Other savings, deferred compensation,
Employee Benefit supplemental unemployment
Plans benefit, welfare, salary continuation,
severance pay, termination
pay, change of control, worker’s
compensation or other employee
benefit plan, including funding
requirements; actuarial reports;
financial reports or financial
VI.13 Employee Documents describing any plan that
Retirement qualifies as an “employee pension
Income Security benefit plan” or “employee welfare
Act (ERISA) Plans benefit plan” as defined by Section 3
of the Employee Retirement Income
Security Act of 1974.
VI.14 Collective Copies of any collective bargaining
Bargaining agreements related to any labor
Agreements unions or other employee groups.
VI.15 Details of any reductions in force
Reductions-in- made by the company within the
Force past 12 months, including lists of
employees made redundant and the
costs of such reductions in force.
137


VI.16 Employee A detailed schedule of any
Disputes allegations of wrongful termination,
harassment, discrimination or other
employee disputes for the past five
years.
VI.17 Litigation A detailed schedule of all employee
or labor-related litigation and
investigations, whether settled,
ongoing, or pending, over the past
five years.
VI.18 Labor A detailed schedule of any labor
Relations disputes, requests for arbitration, or
Disputes grievances filed or pending within
the past five years.
VI.19 Code of Copies of codes of ethics or conduct
Ethics used by the company.
Section VII. Contracts

VII.1 Contracts A detailed schedule of all Who audits the Links and
with Other subsidiaries, partnerships, joint supplier of the relationships in
Organizations ventures, and strategic alliances supplier of the the supply chain
along with copies of all related supplier? It is network.
agreements. essential to find
out if there are Analyze financial
any weak links in statements
the supply chain. wherever possible
to check for
This is key financial stability.
to business
success.
VII.2 Contracts Copies of all contracts between the
with Related company and its officers, directors,
Parties shareholders, and affiliates.
138


VII.3 Contracts Copies of all loan agreements,
with Creditors bank financing agreements, lines
of credit, promissory notes, security
agreements, mortgages, indentures,
collateral pledges, or other contracts
with creditors.
VII.4 Guaranties Copies of all agreements that
And Indemnity obligate the company to indemnify a
Agreements third party, or that otherwise commit
the company to provide a guaranty
of any kind.
VII.5 Sales Copies of all contracts related
Agreements to sales, agency, franchise,
dealer, marketing, or distribution
agreements or arrangements.
VII.6 Supply Copies of all contracts related to
Agreements supplier or vendor agreements.
VII.7 Customer Copies of all customer agreements
Contracts with a value of $______ or greater.
VII.8 Licensing, Copies of all licensing agreements,
Franchise, and franchise agreements, and
Conditional Sales conditional sales agreements to
which the company is party.
VII.9 Quotes Copies of all outstanding bids,
quotations, or tenders with a
potential value of $____ or greater.
VII.10 Purchase Copies of the company’s standard
Orders quote, purchase order, and invoice
forms, including standard terms and
conditions.
139


VII.11 Mergers, Copies of any memoranda
Acquisitions, and of understanding, letters of
Sales (MA&S) intent, contracts, agreements,
or closing documents related to
any acquisition or disposition of
corporate shares, companies,
divisions, businesses, or other
significant assets by the company.
VII.12 Copies of any agreements that
Noncompetitive prohibit, limit, or restrain the
Agreements company from engaging in any
business activity or otherwise
competing with another entity.
VII.13 Copies of any nondisclosure
Nondisclosure agreements to which the company
Agreements is a party.
VII.14 Other Copies of all agreements with a
Material value of $_____ or greater, or
Agreements that have a material impact on the
operation of the business, and are
not requested elsewhere in this
checklist.
Section VIII. Real and Personal Property

VIII.1 Business A detailed schedule of all locations
Locations where company business is
transacted, including offices,
warehouses, stores, and factories.
VIII.2 Owned Real A detailed schedule of all real estate
Estate owned by the company.
140


VIII.3 Titles and A copy of the deed or title to any real
Rights to Owned estate owned by the company and
Real Estate a description of all rights attached
to the property (e.g., air or mineral
rights).
VIII.4 Debts and A detailed schedule of all debts,
Encumbrances liens, or other encumbrances on real
on Owned Real estate owned by the company.
Estate
VIII.5 Other A copy of all surveys, zoning
Documents approvals, variances, use permits,
Related to Owned or appraisals related to real estate
Real Estate owned by the company.
VIII.6 Leased A detailed schedule of all real estate
Real Estate rented or leased by the company.
This schedule should contain a
brief description of the lease terms,
including amount and frequency of
rent and the remaining term of the
lease or rent agreement.
VIII.7 Owned A detailed schedule of all personal
Personal Property property owned by the company
with a value of $______ or greater.
This schedule should include a
description of the property, its
location, its book value, and any
debt or encumbrances on the
property. This schedule also should
include all inventories, machinery
and equipment, tools, furniture,
office equipment, computer
hardware and software, supplies,
materials, vehicles, and fixtures.
141


VIII.8 Leased A detailed schedule of all personal
Personal Property property rented or leased by the
company with a value of $______
or greater. This schedule should
include a description of the property,
its location, its book value, the
amount and frequency of rent, and
the remaining term of the lease
or rent agreement. This schedule
also should include all inventories,
machinery and equipment, tools,
furniture, office equipment,
computer hardware and software,
supplies, materials, vehicles, and
fixtures.
VIII.9 Lien Search The results of any lien searches.
VIII.10 Uniform A schedule of all UCC filings on the
Commercial Code assets of the company.
(UCC) Filings
VIII.11 Capital A detailed schedule of all capital
Equipment equipment purchases and
Purchases and dispositions made during the past
Disposals five years.
142

Section IX. Credit Facilities

IX.1 Long-Term A detailed schedule of all long-term
Debt Facilities debt facilities, including capitalized
leases, guaranties, and other
contingent obligations, along with
copies of all related documents.
IX.2 Short-Term A detailed schedule of all short-term
Debt Facilities debt facilities, including capitalized
leases, guaranties, and other
contingent obligations, along with
copies of all related documents.
IX.3 Copies of all correspondence with
Correspondence lenders, including consents, notices,
waivers of default, and compliance
certificates.
Section X. Environmental Matters

X.1 Permits A detailed schedule of all
permits, licenses, registrations,
notices, approvals, certifications,
contingency plans, and any
other authorization related to
environmental, health, or safety
matters.
X.2 Audits Environmental audits for each
property owned or leased by the
company.
143


X.3 Hazardous A detailed schedule of all hazardous
Materials substances (including dangerous,
toxic, radioactive, or infectious
substances, materials, pollutants,
contaminants, or waste) that the
company has or may have used,
stored, generated, treated, handled,
released, or disposed of.
X.4 Disposal A description of the company’s
Methods methods of handling, treating,
storing, securing, transporting,
recycling, reclaiming, and disposing
of hazardous materials. This
should include a detailed schedule
describing all wells, above-ground
storage tanks, below-ground storage
tanks, surface impoundments, and
any other waste disposal facility
owned, operated, or used by the
company to store or dispose of
hazardous materials.
X.5 Internal Copies of all internal reports
Reports (whether created by company
personnel or a third party) relating
to environmental, health, or safety
matters. Such reports should include
emissions monitoring results,
sample testing results, laboratory
analyses, and monitoring logs.
X.6 Regulators Copies of all statements, reports,
and correspondence involving the
Environmental Protection Agency or
any other environmental, health, or
safety regulatory group, agency, or
body.
144


X.7 A detailed schedule of all
Environmental-, environmental-, health-, or safety-
Health-, or related litigation and investigations,
Safety-Related whether settled, ongoing, or
Litigation pending, over the past five years.
Section XI. Related Parties

XI.1 Contracts Copies of any contracts or
agreements between the company
and any current or former director,
officer, shareholder, or affiliate of
the company.
XI.2 Receivables A detailed schedule of any amounts
and Payables owed by the company to any
current or former director, officer,
shareholder, or affiliate of the
company, and any amount owed to
the company by a current or former
director, officer, shareholder, or
affiliate of the company.
XI.3 Other Copies of documents relating to
Transactions any other transaction between the
company and any current or former
director, officer, shareholder, or
affiliate of the company.
XI.4 Conflicts of Describe any interests of any
Interest current or former director, officer,
shareholder, or affiliate of the
company in any business that
competes with, conducts any
business similar to, or has any
arrangement or agreement with the
company.
145

Section XII. Securities & Investments

XII.1 Equity A detailed schedule of companies in
Investments which the company holds an interest
of 5 percent or more.
XII.2 Offering Copies of all offering circulars,
Documents private placement memoranda,
syndication documents, or other
securities placement documents,
prepared or used by the company
over the past five years.
XII.3 Engagement Copies of contracts, agreements, or
Letters engagement letters with investment
bankers, finders, business brokers,
or other financial advisers pursuant
to any contemplated financial
transaction over the past five years.
Section XIII. Imports and Exports

XIII.1 Imports A description of the company’s major
imports, the import process, and
dealings with U.S. Customs and
Border Protection.
XIII.2 Exports A description of the company’s major
exports and the export process.
Include a detailed schedule of the
company’s exports (both products
and services), along with the annual
amount of revenue derived from
each export and the country to which
the product or service was exported.
146


XIII.3 Foreign A description of the company’s
Corrupt Practices procedures and controls for
Act (FCPA) complying with the Foreign
Corrupt Practices Act. Include
a detailed schedule of all sales
representatives, commission agents,
dealers, and consultants dealing
with foreign companies or agencies
on the company’s behalf.
Section XIV. Products and Services

XIV.1 Product A detailed schedule of all existing
and Service Lines products and services offered by the
company.
XIV.2 Complaints A detailed schedule of any
complaints, warranty claims, or
litigation related to products or
services offered by the company.
XIV.3 Internal Copies of any tests, evaluations,
Reports studies, surveys, and other internal
reports related to existing or
contemplated products and services.
147

Section XV. Customer Information

XV.1 Customer A detailed schedule of the Ensure that the Check customer
List company’s customers, along with target sells its listings, sales
annual sales to each customer over products and records, and valid
the past five years. services to bona value-added tax
fide customers. (VAT) numbers.
This is
particularly
important for
organizations
involved in export
activities.
XV.2 Terms and A description of the company’s
Conditions standard sales terms and
conditions.
XV.3 Market Description of all marketing
Activities research, campaigns, plans,
programs, budget, and materials.
XV.4 Competitors A list of the company’s 10 most
significant competitors.
Section XVI. Other

XVI.1 A detailed schedule of all law firms,
Professionals accounting firms, consulting firms,
and other professionals engaged
by the company over the past five
years.
XVI.2 Licenses Copies of all licenses, permits, or
and Permits consents held by the company.
148


XVI.3 Press Copies of all press releases issued
Releases by the company over the past five
years.
XVI.4 Insurance Copies of all insurance policies,
Policies whether by third parties or self-
insured.
XVI.5 Claims A detailed schedule of the
company’s insurance claims history
over the past five years.
XVI.6 Other Any other document or information
Significant that may be significant to the
Matters company or its operations.
149

Appendix B
Sample Best Practices Document
Following is an overview of international best practices based on various

international assignments involving mergers, acquisitions, and sales (MA&S)
transactions.
Organizations often underestimate the challenges associated with the inte-
gration of a newly acquired company. Internal audit can help assure adequate
consideration is given to the following key issues:
n Potential finance, information technology (IT), human resources

(HR), or operational risks
n Gaps in the integration project management plan
n Opportunities for additional synergies that would boost the

merger’s and acquisition’s return on investment
n The impact the mergers and acquisitions and integration may be

having on other parts of the business
n Potential gaps in the combined internal control structure
Without internal audit’s insight, costs could include a loss of opportunity,

additional investments to fix the overlooked risk and control issues, and more.
During key leverage points in the MA&S life cycle, internal audit should act
as a trusted adviser to the program management team so that it can assess
151

and monitor program management activities, review controls, and provide key
insights, while maintaining independence and objectivity.
Internal audit can play a crucial role in the MA&S life cycle in six key areas:
1. Strategy. An organization may have a target in its sights, but

before it makes a move, internal audit should assess the corpo-
rate strategy process, the risks to the organization, and the busi-
ness case process. This will help the organization determine,
from the beginning, whether the mergers and acquisitions target
aligns with the organization’s corporate growth strategy.
2. Due diligence. During the due diligence process, internal audit

can assess the valuation process, the risks and internal control
environment, corporate governance, and the synergy valida-
tion process. These assessments will enable the organization to
determine whether the price is right, to provide early insights
on any risk or control issues that may be lurking beneath the
financial statements, and to uncover what kind of synergies the
mergers and acquisitions target offers to improve the buyer’s
return on investment.
3. Deal approval and close. Before the organization signs on the

dotted line, internal audit can review the deal approval process
to confirm that short- and long-term goals are defined before the
deal closes. Internal audit can also evaluate and monitor the valu-
ation process leading up to the close to determine the possible
impact of any changes in the risk and control environment,
changes in anticipated synergies, or changes in key personnel.
4. Integration. Internal audit should be part of the integration team

and promote the use of leading practices throughout the integra-
tion. Internal audit should assess the integration design and plan-
ning processes, integration project management, and integration
execution to help mitigate transaction risk and value leakage
through the integration life cycle.
152

Sample Best Practices Document
5. Transaction value assessment. As an independent party, internal

audit should lead a company’s effort to conduct a look-back
review of each significant merger and acquisition. Internal audit
should conduct these reviews 12 to 18 months after integration,
and focus on realized value and the associated root causes that
resulted in exceeding or falling short of transaction expectations.
6. MA&S program management. Throughout the MA&S process,

internal audit should form a part of the program management
team so it can assess and monitor program management activ-
ities and provide key insights. Internal audit can also audit
program management activities to highlight process gaps and
areas of future improvements.
153

Glossary
Acquisition—Takeover of a company by purchasing that company’s shares or

assets.
Leveraged Buy-Out (LBO)—Acquisition of the company by a private group

using substantial borrowed funds.
Management Buy-Out (MBO)—Acquisition of the company by its own manage-

ment in a leveraged buyout.
Merger—Combination of two companies into one, with the acquirer assuming

the assets and liabilities of the target firm.
Proxy contest/fight—Takeover attempt in which outsiders compete with

management for shareholders’ votes.
Tender offer—Takeover attempt in which outsiders directly offer to buy the

stock of the company’s shareholders.
155

Suggested Reading List
Antila, E. and A. Kakkonen. 2008. “Factors affecting the role of HR managers in

international mergers and acquisitions: A multiple case study.” Personnel
Review 37.3: 280–299.
Balle, N. 2008. “Hearts at stake: A theoretical and practical look at commu-

nication in connection with mergers and acquisitions.” Corporate
Communications: An International Journal 13.1: 56–67.
Bou-Raad, G. 2000. “Internal auditors and a value-added approach: the new

business regime.” Managerial Auditing Journal 15.4: 182–186.
Brody, G. R. and D. J. Lowe. 2000.“The new role of the internal auditor.

Implications for Internal Auditor Objectivity.” International Journal of
Auditing 4.2: 169–176.
Cai, C. 1997. “On the functions and objectives of internal audit and their under-
lying conditions.” Managerial Auditing Journal 12.4/5: 247–250.
Candreva, P. J. 2006. “Controlling Internal Controls.” Public Administration

Review 66.10: 463–465.
Carmichael, D.R., J. J. Willingham, and C.A. Schaller. 1996. Auditing Concepts

and Methods. A Guide to Current Theory and Practice, 6th Ed. McGraw-Hill
Education.
Cigota, M. and P. Modesti. 2008. “A note on mergers and acquisitions.”

Managerial Finance 34.4: 221–238.
157

Cook, R. 1993a. “Auditing Acquisitions: Part 1–Implementing Acquisitions

Strategies.” Managerial Auditing Journal 8.1: 28–32.
———. 1993b. “Auditing Acquisitions: Part 2–Post Acquisition Review.”

Managerial Auditing Journal 8.2: 25–31.
Dittenhofer, M. 2001. “Internal auditing effectiveness: an expansion of present

methods.” Managerial Auditing Journal 16.8: 443–450.
Dounis, N. 2006. “Internal Auditing’s Role in M&As.” Internal Auditor 63.4:

109–112.
Fadzil, F. H., H. Haron, and M. Jantan. 2005. “Internal auditing practices and
internal control system.” Managerial Auditing Journal 20.8: 844–866.
Karagiorgos, T., G. Drogalas, and A. Dimou. 2008. “Effectiveness of internal

control system in the Greek Bank Sector.” The Southeuropean Review of
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and management information systems.” The Southeuropean Review of
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Kumar, S. and L. Bansal. 2008. “The impact of mergers and acquisitions on

corporate performance in India.” Management Decision 46.10: 1531–1543.
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Response.” Applied Psychological Measurement 32.1: 248–260.
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Auditing Journal 17.4: 6–11.
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strategy: Evidence from U.S. banking firms.” International Journal of
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Auditing 4.1: 101–109.
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related to mergers and takeovers.” Managerial Finance 15.4: 1–11.
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Suggested Reading List
Myers, P. M. and A. A. Gramling. 1997. “The perceived benefits of certified

internal auditor designation.” Managerial Auditing Journal 12.2: 70–79.
Nogeste, K. 2010. “Understanding mergers and acquisitions (M&As) from a

program management perspective.” International Journal of Managing
Projects in Business 3.1: 111–138.
Nunnally, J. C. 1978. Psychometric Theory, 2nd Ed. New York: McGraw-Hill.
Ramakrishnan, K. 2010. “Mergers in Indian industry: performance and impacting

factors.” Business Strategy Series 11.4: 261–268.
Savcuk, O. 2007. “Internal Audit Efficiency Evaluation Principles.” Journal of

Business Economics and Management 6.4: 275–284.
Sawyer, L. B. 2003. Sawyer’s Internal Auditing: The Practice of Modern Internal

Auditing, 5th Ed. Altamonte Springs, FL: The Institute of Internal Auditors.
Schraeder, M. and D. Self. 2003. “Enhancing the success of mergers and acqui-
sitions: an organizational culture perspective.” Management Decision 41.5:
511–522.
Schweiger, D. M. and P. Goulet. 2000. “Integrating acquisitions: an international

research review” in Cooper, C. and A. Gregory Eds. Advances in Mergers
and Acquisitions, Vol. 1. Greenwich: JAI/Elsevier Press: 61–91.
Soubeniotis, D. and Th. Fotiadis. 2005. “Conceptual Framework of Internal

Auditing: Theoretical Approach and Case Study Analysis.” Enimerosi,
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Taylor, D. H. and W. G. Glezen. 1991. Auditing: Integrated Concepts and

Procedures, 5th Ed. United States: John Wiley & Sons Inc.
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Professional Practice of Internal Auditing. Altamonte Springs, FL: Institute
of Internal Auditors.
Walker, P. L., W. G. Shenkir, and T. L. Barton. 2003. “ERM in practice.” Internal

Auditor 60.4: 51–55.
Wolf, R. 2003. “Integration: key to M&A success.” Financial Executive 19.6:

62–64.
Wood, G. 2005. “The relevance to international mergers of the ethical perspec-

tives of participants.” Corporate Governance 5.5.
159

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Mergers,

The Institute of Internal Auditors

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Published by The Institute of Internal Auditors Research Foundation

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The Institute of Internal Auditors’ (IIA’s) International Professional Practices

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About the Author. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii

Chapter 1: Greater Than the Sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Chapter 2: Types of Mergers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Chapter 3: Evaluating Mergers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

Chapter 4: The Role of Internal Audit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

Chapter 5: Key Risk Areas Associated with MA&S Projects. . . . . . . . . . . . . . . 41

Chapter 6: Corporate Valuation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

Chapter 7: Methods for Determining the Value of a Private Company. . . . . 55

Chapter 8: Due Diligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71

Chapter 9: Two Example Case Studies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91

Chapter 10: Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101

Appendix A: Sample Due Diligence Checklists. . . . . . . . . . . . . . . . . . . . . . . . . . . 109

Appendix B: Sample Best Practices Document. . . . . . . . . . . . . . . . . . . . . . . . . . . 151

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Suggested Reading List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157

The IIA Research Foundation Sponsor Recognition. . . . . . . . . . . . . . . . . . . . . . . 161

The IIA Research Foundation Board of Trustees. . . . . . . . . . . . . . . . . . . . . . . . . . 165

The IIA Research Foundation Committee of Research and

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Table 3.1: SFF’s Proposed Acquisition of HI . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

Table 3.2: Financial Forecasts After the SFF-HI Merger . . . . . . . . . . . . . . . . . 23

Table 7.1: Earnings Method Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63

Table 7.2: Earnings Method Factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

Table 7.3: Discounted Future Earnings Forecasts. . . . . . . . . . . . . . . . . . . . . . . 66

Table 7.4: Discounted Future Earnings Averaging. . . . . . . . . . . . . . . . . . . . . . 67

Table 7.5: P/E Ratios. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Table 8.1: Calculating Potential IT Due Diligence Returns . . . . . . . . . . . . . . . 86

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process is likely to be. If your company is purchasing another strictly as a finan-

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Many of us have, at some stage in our professional careers, experienced corpo-

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Greater Than the Sum

Where Has the Synergy Gone?

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2. Unrealistic expectations (even demands)

3. Excessive hype (from all parties, including the media)

4. “Us versus Them” syndrome

5. Lack of management courage to accomplish the necessary

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1. A sound business case for a merger or acquisition that was

2. Buy-in from key staff in every area of the business

3. An immediate allocation of senior management positions within

4. Credible plans to exploit product synergies and cost savings

5. A strong client focus with a merit-based incentive system

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Research also leads us to believe that internal auditors want to take on a

Reasons for Internal Audit Involvement

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1. Providing increased visibility and transparency regarding key