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The Board of Directors and M&A due diligence

Media reports of merger and acquisition negotiations often refer to due diligence being a condition for making a bid or closing a deal. This means that before the intending acquiror will commit finally to the deal, it wants to do due diligence on the target, the company being acquired or merged with.

Due diligence means a close examination of the target, closer than the acquiror is able to do with publicly available information. How much due diligence is needed varies, depending on whether the target is a public company or a private company. The outcome will be a decision by the acquiror on whether to do the takeover or merger, and if so, at what price.

In a private company takeover, the acquiror may have some modest amount of information on the target. The target's financial statements, the results of observation from physical inspection of its premises and inventory, the outcome of discussions with its executives, other information on its reputation gleaned from its customers and suppliers and from credit rating agencies.

For a public company takeover, there will be detailed financial statements and other public data filings. There may also be equity analysts' reports, and media stories that spread light on the target's situation. And the acquiror will have all of the usual information sources that can be accessed for a private company.

Why the need for due diligence?

For a public company acquisition, the acquiror will have a wide range of information about the target, most of it reliable and trustworthy. For a private company takeover, information may be more sparse, triggering the need for a search for more and better quality intelligence about the target. In both cases, the acquiror may feel it needs to know more.

Due diligence is done for two reasons.

First, to probe for target problems that may not be apparent in public information, or may not have been disclosed by target management.

Second, to search for better and more detailed information about the target that will help confirm whether the acquiror's confidential plans for the target are workable.

In the probe for target problems, the acquiror looks for contracts with suppliers and customers that may have unknown and unexpected terms, financing arrangements that might change in the event of control of the target changing, property rights that may be coming to an end, and key personnel who may soon be leaving.

The search for confirmation to confirm future plans for the target may concern integration of the target into the acquiror's business, downsizing the target by divesting divisions or other assets, cutting target costs by reducing personnel, or diverting target asset to more productive uses. The information needed for this evaluation will often not be in the public domain, thus the need for due diligence. And because the acquiror will not wish to disclose its future plans to target management and shareholders, it cannot ask the target directly for the data it needs and must get it by way of the due diligence process.

Where does the Board of Directors fit in?

Neither the acquiror's Board nor the target's Board is likely to be closely involved in due diligence. The process involves the target making a boardroom available to the acquiror, and offering to produce any documentation the acquiror might wish to see. The acquiror asks for target correspondence, supplier and customer contracts, banking records, employment agreements and asset registers. Target personnel are made available for interview by the acquiror. The process is carried out by specialists and professionals mandated by the acquiror.

The target's Board of Directors is keen to ensure that due diligence passes without glitches. Its worst case scenario is the uncovering of problems that it knows nothing about, and for which it may be accountable. It can only wait and see.

The acquiror's Board will be presented by its executive management with a due diligence report. It will base its decision to approve the acquisition, or not approve it, in part on this report. If it approves the acquisition, the acquiror moves to final negotiations with the target on price and execution of the takeover.

Corporate strategy in the Boardroom

A company is the product of a vision, usually the founder's. He starts the company with a mind picture of how the business should turn out. Strategy is the method that the founder or his successors implement to achieve the vision.

In most companies the CEO and the executive team formulate strategy. They develop it in long-term discussions or at brainstorming sessions. Or they hire outside consultants to advise on strategy. From this process they assemble a strategic plan. The CEO presents this plan to the Board of Directors once a year at a Board meeting. The CEO represents that the plan is his own, and he recommends that the Board should support it. The Directors discuss the plan, make minor changes, and the Board adopts it by voting for it. The Board usually has little time to debate the plan, and no information about alternative strategies. The Board's input is negligible.

This process seems to work for most companies. A CEO with a clear understanding of the company's vision and a strong belief about the right course of action is likely to propose a credible strategy that will be accepted by the company's staff and customers, and therefore implemented .

Shareholders are unaware of the company's internal strategy process, but they know that the Board of Directors approved the strategy. Shareholders may hold the Board responsible for the company's strategy, particularly when things are not working out well. The Directors voted for the strategy, didn't they?

Regulators and stakeholders also want to hold the Board accountable for strategy. UK accounting regulations require Boards to publish a Strategic Report for this purpose.

Pointers for Directors on strategy:

Who controls the Boardroom?

Control of a company means the right to take decisions about how corporate resources are managed. In practice, this means the right to appoint the CEO, because the CEO has operational decision-making authority with respect to the company's resources.

The Board in control

The Board of Directors asserts control of the company in the Boardroom. The Board has the authority to appoint and dismiss the CEO, and if control means the right to appoint the CEO, then the Board has control.

But going beyond this meaning of control, the issue of who has control is more subtle and complex.

Shareholder control

To take matters up one level, although the Board asserts control in the Boardroom, the Board itself is controlled by the shareholders, who collectively have the right to appoint Directors by voting at shareholders' meetings. On this meaning of control, the shareholders have ultimate control.

On the other hand, the shareholders find it hard to exercise control, collectively or individually. There may be many of them, so it is impractical for them to come together very often to take decisions jointly, and many are apathetic. The best they can manage is an annual meeting, which is poorly attended and has low proxy voting participation.

With this lack of clarity about where real control lies, investors with less than all the shares may find that taking control or a degree of control, is within their grasp.

Owning 100 percent of a company's shares means controlling 100 percent of the company's shareholder votes, and implies control of the Board of Directors. This is clearly full control of the company. This is the situation where a holding company has a wholly-owned subsidiary.

A public company usually has many shareholders and they are dispersed. Still, some public companies have a single shareholder with majority control, which means the holding of 50 percent plus one of the company's shares and therefore of its shareholders' votes. This majority shareholder can singlehandedly carry a majority vote at a shareholders' meeting.

Even a minority shareholder can have control. A shareholder who holds a block of shares smaller than 50 percent can exercise effective minority control of a public company. For example, holding 30 percent or even 20 percent of the shares may enable the shareholder to exercise control of the company, if that shareholder is the biggest blockholder and all other shareholders have small shareholdings and are dispersed and cannot coordinate opposition to the blockholder's initiatives.

Control with zero shareholding

And then there is influence - the ability to affect the company's projects and strategic decisions by engagement, persuasion or other negotiating leverage over the Board of Directors, without holding any shares.

Who has this influence? Outsiders sometimes, if they have personal contracts with Directors and are able to influence their decisions. In a public company dominated by one family, family members may have sway over the Board's decisions even if they are not themselves shareholders. Major suppliers or customers may indicate that they will shut down commercial relationships if their plans are not implemented by the Board. Creditors are able to influence Board decisions based on their contractual rights against the company.

Activist investors are also in this spotlight. They sometimes use investments in private derivative contracts to exert influence or control over public companies. The strategy is to make public disclosure of holdings of derivative contracts, deemed under shareholder interest disclosure laws to be equivalent to equity interests. These disclosures enable the investors to threaten to use their derivative contracts to acquire shares in the future, and so to lean on the Board of Directors to accede to their demands.

So the answer to the question who controls the Boardroom may not always be as clear as it seems.

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