So you are contemplating the acquisition of a small company with an exciting product and technology that seems to complement your own. The few early adopters seem relatively pleased, your marketing team is quite excited about the market potential, and the financial model (based on the proverbial “hockey stick” sales forecast) seems to work out. Your legal team gives you the green light as well.
Two weeks before the closing, you send your due diligence team on location. Based on the initial conversations with the target, you already have a very good feel about this. Looks and sounds like a done deal, right?
Well, studies show that more than 85% of such acquisitions fail to deliver against initial expectations, and most by a wide margin. A post-mortem analysis study on small company acquisitions by large corporations that ended in a significant (80% and greater) capital loss to the acquirer point to discounted issues already found in due diligence as the main drivers of the ultimate financial non-performance.
Let’s examine the 7 top reasons why, and how you could save millions just by avoiding these pitfalls.
1. The underlying technology is a solution looking for a problem. Many “groundbreaking innovations” have failed spectacularly even if there were a few early adopters and technology enthusiasts. The “hockey stick” never materializes. Perhaps the product was developed as a custom solution for a few people and then packaged and sold to you as the “next revolution”?
2. Ignoring manufacturability sourcing, quality, and yield issues. The “dream product” works well as a prototype and perhaps even in small batch manufacturing, yet you are planning to ramp up significantly and the design is not mature and robust enough for that. The risk is identified; however it is discounted as a “manageable issue”. Even when it’s clearly not.
3. The product design is “almost done”. The product development team is ironing out a few last details, and the product will launch in a few short months. Be very circumspect in such situations. It is very likely that the remaining issues are not trivial, and they will not be “ironed out” without a significant additional investment, time, or both. The stability and market acceptance of a product can only be proven within six months or more after launch. It is almost always best to wait until “almost done” becomes “verifiably done”.
4. Ignoring quality systems and regulatory compliance scaling. The level of regulatory scrutiny correlates with the size of the company. The post-acquisition cost of bringing the state of compliance up to the acquirer’s standards is often misunderstood and minimized in due diligence, yet it becomes abundantly clear at the very next regulatory agency audit. In some extreme cases, the cost of the resultant remedial action can negate the entire financial upside – and then some.
5. Most of the key patents are either provisional or pending. The trap here is that there might be prior art and / or potential infringement issues in the space which might block your acquired product’s commercialization – or make it extremely expensive. There is usually not enough time to conduct a comprehensive claim analysis and prior art search in due diligence, so this is usually chalked up to the “risk bin” -- with no corresponding financial model impact as well.
6. Treating the earned-out agreement as a proxy for risk control. Yes, this will cover some of the risk as you will not incur some (or most of the) acquisition cost when sales do not materialize. However, this will not cover your opportunity costs and the additional personnel and operational resources you will have to provide for the post-acquisition integration and the subsequent manufacturing, marketing, and sales ramp-up.
7. Treating technical and regulatory due diligence as confirmatory. Good engineers are an introverted bunch, with a great deal of respect for authority. If the task is to confirm a decision already made, they know that they will encounter a great deal of resistance from their boss if they come up with hard reasons to stop the deal. So they will list the showstopper issues as “potential risks” and side with the team in recommending a “conditional go”. The “risks” are soon forgotten, until (most often than not) they end up materializing several years later at a great cost to you to either continue with the venture or to divest and write it off.
To get assistance in identifying and quantifying these “hidden” areas of risk in due diligence, based on your specific timing and situation, please visit www.priusmedical.com for more information.
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