Sherlock Holmes: The Invisible Asset in Corporate Finance Deals

Detective work used to be restricted to eccentrics based in Baker Street or to the local CID. Today, a forensic investigation approach is increasingly used when businesses change hands, not because companies are typically out to defraud, but because the process itself is complex and the scope for misunderstandings significant. What information should sellers provide in order to market the company effectively? How should buyers structure the due diligence process in order to find the information they need to negotiate successfully? New forensic accounting techniques such as data mining, background research and computer forensics, working alongside traditional corporate finance services, can provide peace of mind for all concerned and greatly improve the quality of decision-making. When deals are negotiated, problems are most likely to occur with the data, people or the deal process itself.

Data is rarely in short supply when it comes to buying or selling a business. Indeed it is common practice to establish a ‘data room’ to facilitate the due diligence process. Much of this data has been created by management and is unaudited, leaving the onus very much on the purchaser to test and probe further. When carrying out an investigation before the deal, assuming data can be obtained electronically, data mining techniques can assist with the due diligence process. Trends and transaction patterns can be easily identified: this includes patterns that are unusual or suspicious and require further investigation. These techniques can help to identify abuse of core controls, such as authorisation limits. Data mining can also help to identify future opportunities for the business by pinpointing geographical hotspots, potential duplicate payments (which could be recovered by the purchaser), and key products and accounts. Other forensic techniques adopted include the use of experienced interviewers to elicit detailed, relevant information not provided in the data. In a recent deal, a key member of the target company’s management team was being particularly cagey in his response to questions relating to particular contracts.

Using forensic interview techniques, within an hour of discussions it transpired that he was planning, in collusion with another employee, to set up a rival business and steal the company’s most profitable clients. Needless to say, the deal did not complete. Where disputes often arise, after a deal, is in agreeing what data was disclosed. Computer forensic techniques can overcome this – electronic images can be made of the relevant data at the time of the deal and given to both sides as a record. This removes any doubt as to what was and was not disclosed from the outset.

Ideally, when investigating an issue on a warranty claim post-deal, email traffic, past and present, should be reviewed especially where there are suspicions of non-disclosure of key information. More often than not, when conducting forensic investigations, electronic evidence is retrieved which sheds a different light on what we have been told by directors. Emails stating: ‘Whatever you do, don’t tell them about that contract we lost!’ or ‘Which creditors listings shall we show them?’ are more common than you might think. At the end of the transaction process, it is essential to handle the mass of sensitive and confidential data collected in a proper manner. Computer forensic techniques can be adopted to ensure this data is destroyed or stored in a secure way.

People are fundamental to the continuing success of the organisation to be sold. For vendors, the concern must be to sell for the right price to bona fide purchasers, especially in a market where international money laundering rules have tightened. The European Union also continues to expand apace, yet this has encouraged more interest from central European countries where standards of corporate governance are not traditionally as high. For purchasers, the key task is to ascertain whether the people running the business are up to the job. Thorough background vetting of employment history, academic records or performance on the job can be extremely revealing.

The most common issue arising at this stage in the process is the identification of undisclosed relationships or events that, if revealed, might give rise to a different course of action such as a reshaping of the deal. Often, parties will claim that disclosure of such information was not required because the event or relationship was not relevant. It almost always is. Recent incidents also include the discovery of bogus academic qualifications and work credentials. Research by MORI* has shown that references are not followed up in 30 per cent of instances and work histories are either fabricated or exaggerated almost 50 per cent of the time. Having ascertained that the right people are in place, the next issue is ensuring that they stay there and continue to perform effectively for the new owners. Earn out structures usually involve payments that maybe made to key individuals who have stayed on after the sale for a required term and have met agreed performance targets, typically related to the delivery of projects, or to increases in turnover or profitability to which they have contributed. It is important that they are structured so that vendor and purchaser understand how and when performance will be measured and by whom. The measurement criteria need to be immune from manipulation for advantage by either side. They can often be rendered meaningless by an opportune reorganisation or unforeseen developments. To deal with this, agreements need to include a flexing procedure that will ensure the mechanism continues to work as intended. The forensic accountant’s experience can quickly highlight potential shortcomings and solutions.

The deal process itself is often fraught with difficulties. In many cases warranties are provided which are unrealistic, for example being too broad or relating to future performance which the vendor is not in a position to control. Disputes can also arise when the completion accounts result in assets valued at a lower level than was agreed when the deal was closed. We have often worked on behalf of buyers to challenge successfully the completion accounts prepared by the vendors, on the basis that these were inconsistent with the vendors’ previous accounting methods and policies. At the time that the sale and purchase agreement is drafted, our forensic accountants as a matter of course will vet the accounting warranties, accounting definitions and the specific clauses that relate to how the completion accounts are prepared. In the preparation of completion accounts, consideration should be given, for example, to whether UK GAAP (Generally Accepted Accounting Practice) takes priority over the usual policies, practices and procedures of the target company if differences occur.

Caution is thus essential at every stage in the deal process, from pre-planning through to completion accounting and the warranties. A ‘forensic’ eye reviewing information, weighing possibilities and using bespoke techniques to avoid problems is an asset which won’t appear on any balance sheet, but undoubtedly adds real value to the process.

A prospective purchaser was extremely excited about acquiring a company from our client, the vendor. One of the conditions set by the vendor was that the new owner would actively seek to maximise the benefit to the local community of what was the largest employer in a small market town in the Home Counties. Background research focusing on associated directorships and shareholdings, revealed that despite his promises, this purchaser had a track record of acquiring in-town businesses, closing them down and re-developing the land for residential purposes. In this instance, we were able to find our client a more suitable purchaser elsewhere. Case study details are changed in order to maintain confidentiality.

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