Avoiding the simplicity trap and costly post-close surprises with IT due diligence
INSIGHT ARTICLE |
The Simplicity Trap
Picture an acquisition target — a $50 million manufacturing company with 200 employees, QuickBooks accounting software, two in-house servers and unsophisticated business operations. The IT systems seem simple and straightforward. No need for any pre-close IT due diligence, right?
Most private equity firms investing in the lower middlemarket know the value of performing financial, tax and operational due diligence. But when it comes to performing IT due diligence on a company like the one described above, the typical response is, “What’s to assess? They’re on QuickBooks. Why spend the time and money?”
And with that, many firms fall into the simplicity trap — and end up dealing with costly post-close surprises, which, if identified earlier, could have led to a more favorable purchase agreement. “Simple” IT systems often require complex and expensive upgrades to support the desired growth of the business. A buyer might think a company can continue using its entry-level accounting software for the next three years, only to discover post-close that there are already issues in dealing with the current volume of transactions, and that a $100,000 investment will have to be made in the next six months to implement a system that can keep up.
The value of IT due diligence
While every deal is unique, they should all incorporate some level of IT due diligence. For a smaller middle-market company, this doesn’t have to be a drawn-out, expensive process. The assessment should only take one or two days and easily pays for itself by ensuring that any necessary IT expenditure is properly budgeted and planned for, and improvements are made in an organized way that doesn’t distract from the primary goal of driving revenue growth.
Without a pre-close understanding of the systems upgrades that need to be made, a 100-day improvement plan may now take a year because of all the IT issues that have to be dealt with. Moreover, before the right systems are in place, management won’t be able to generate meaningful data and metrics to make informed business decisions to grow revenue — making an efficient and effective IT improvement plan a critical element of success.
Like the manufacturer described above, a majority of deals now involve companies with less than $100 million in sales. QuickBooks or similar entry-level accounting systems may have been perfectly adequate for these businesses’ needs in the past. But if the goal is to grow sales to three times the current volume post-acquisition, the software will need to be replaced — which means overseeing proper implementation, training personnel, making necessary conversions, etc.
IT due diligence identifies the capacity of a company’s current systems and infrastructure to handle growth, and informs buyers of the extent of any necessary investment (both in terms of time and money). Instead of a post-close surprise, private equity firms can plan prudently before signing the letter of agreement, and potentially negotiate a purchase price adjustment if the necessary IT investment has a high enough price tag (which does happen, even with middle-market firms).
Simple systems or red flags?
While it varies by industry, companies with less than $100 million in sales and fewer than 300 employees are most susceptible to the simplicity trap. Their systems generally consist of:
- Small business accounting software (QuickBooks, Peachtree), which often needs to be replaced with an enterprise-wide system to accommodate an increase in transaction volume or the ability to support business process and workflow improvements.
- A couple of in-house servers that are often aging and with limited capacity.
- Standard business software (Microsoft Office, etc.) where licenses may not be current and will need to be purchased.
- Outdated software and networks (e.g., Lotus Office Suite, Novell), which will need to be replaced with industry-standard systems.
Prioritizing what to assess
IT due diligence should evaluate the integrity, fit and viability of business applications, infrastructure and IT organization, strategy and internal controls. Some areas, like the viability of the company’s IT organization, strategy and internal controls, may be fine. Others, like the fit of business applications, may need to be dealt with in the next year or so but aren’t priorities. And some, like the integrity of the infrastructure, may require an immediate investment. By organizing the results of IT due diligence in this way, firms can make the necessary short- and long-term plans and prioritize appropriately.
Don’t underestimate carve-outs
Carve-out situations present another version of the simplicity trap. Rather than having simple systems, the carved-out company may not have any. Here, the trap is assuming that putting in new systems is a relatively simple process.
Private equity firms making their first carve-out acquisition often severely underestimate the cost and effort associated with implementing new accounting software, new networks, new infrastructure and new business applications. What a firm assumes will be a $150,000 IT investment can end up costing nearly 10 times as much. In addition, the implementation process can easily eat up more than half of existing IT resources, which are now focused on building the new systems rather than helping to grow the company.
By performing IT due diligence, firms will be in a position of strength with an understanding of the complexity, cost and timing of the implementation process. They can then use this information to negotiate a better service agreement with the seller so that the carved-out division can continue running on the seller’s systems for an appropriate length of time. IT due diligence will also assess the needs of the carve-out to help ensure that outsourced IT services are handled by the right providers.
A smart pre-close investment
While no two companies’ IT environments are the same, the assessment described above is always relevant and will prevent unpleasant surprises when investing in middle-market firms with simple systems. IT due diligence is a smart pre-close investment that can have a significant impact on how you evaluate the deal and build your post-close action plans.