the ama of due diligency

THE AMA HANDBOOK OFDUE DILIGENCEREVISED AND UPDATED EDITION

WILLIAM M. CRILLY and ANDREW J. SHERMAN

American Management AssociationNew York • Atlanta • Brussels • Chicago • Mexico City • San Francisco

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This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal,accounting, or other professional service. If legal advice or other expert assistance is required, the servicesof a competent professional person should be sought.

Library of Congress Cataloging-in-Publication Data

Crilly, William M.The AMA handbook of due diligence / William M. Crilly and Andrew J. Sherman. — Rev. and updated ed.

p. cm.Rev. ed of: Due diligence handbook. 1998-Includes bibliographical references and index.ISBN 978-0-8144-1382-11. Auditing—Law and legislation—United States. 2. Disclosure of information—Law and legislation—United States. 3. Valuation—Law and legislation—United States. I. Sherman, Andrew J. II. Crilly, William.M. Due diligence handbook. III. American Management Association. IV. Title. KF1357.C753 2010346.73’063—dc22

2009050209

© 2010 by William M. Crilly and Andrew J. ShermanAll rights reserved.Printed in the United States of America.

The previous edition of this book was published as the Due Diligence Handbook, Volumes 1 and 2 byWilliam M. Crilly.

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DUE DILIGENCE HANDBOOK iii

CONTENTS

See Individual Sections For Detailed ContentsSECTION PAGE

List of Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

1. Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2. How To Use The Due Diligence Handbook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3. Overview Of Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

4. Compatibility With Investment / Acquisition Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

5. Capitalization And Ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

6. Organization And Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67

7. Relationships With Outside Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89

8. Description Of Products And/Or Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105

9. Revenues And Market Share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

10. Marketing Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

11. Customer Service. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

12. Inventory Control And Purchasing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

13. Production . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311

14. Physical Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

15. Computer, Communications And Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389

16. Financial Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419

17. Legal Affairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 469

18. Security And Safety. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495

19. Human Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 505

20. Land And Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

21. Introduction To Financial Analyses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 559

22. Balance Sheet Analysis - Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565

23. Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587

24. Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593

25. Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 613

26. Net Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 621

27. Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627

28. Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633

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29. Financial Ratio Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

30. Income Statement Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 657

31. Balance Sheet Projections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 679

32. Cash Flow Projections. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699

33. Due Diligence Checklists . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 707

34. Transaction - Specific Due Diligence Checklists For Acquisitions Or Investments On Specific Dealings In Selected Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 727

35. Sample Forms Related To Effective Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 737

36. Due Diligence Checklists For Special Situations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 769

Appendix A: Bibliography And Recommended Further Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 791

Appendix B: A Selection Of Blank Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793

Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799

About the Authors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 827

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LIST OF FORMS, CHECKLISTS, AND OTHER DOCUMENTS

*Note: all forms in this book are available as customizable Word documents. They are on the CD providedat the back of the book.

Section 3: Overview of Entity3-01. Background Information On Entity3-02. Financial Summary

Section 4: Compatibility With Investment/Acquisition Objectives4-01. Compatibility With Investment/Acquisition Objectives4-02. Compatibility With Investment/Acquisition Criteria4-03. Potential Impact Of External Factors4-04. Potential Benefits From Acquisition4-05. Potential Impact Of Locational Factors On A Prospective Investment4-06. Characteristics You May Wish To Avoid4-07. Why Is The Entity Available?4-08. Comparison With Other Potential Investment/Acquisition Candidates

Section 5: Capitalization And Ownership5-01. Summary Of Capitalization5-02. Capitalization—Common Stock5-03. Common Stock—Miscellaneous Information5-04. Common Stock—Dividend Record5-05. Common Stock—Price And Trading Volume5-06. Common Stock—Holders Of More Than Four Percent Of Shares5-07. Capitalization—Preferred Stock5-08. Preferred Stock Dividend Record5-09. Capitalization—Bonds5-10. Bond Yields And Major Bond Holders

Section 6: Organization And Management6-01. Board Of Directors6-02. Board Of Directors—Other Affiliations And Compensation6-03. Board Of Directors—Current And Prospective Security Holdings6-04. Corporate Organization6-05. Corporate Management Resumes6-06. Recent Compensation History Of Corporate Management Personnel6-07. Company Security Holdings Of Corporate Management Personnel6-08. Organization And Management Information Requests6-09. Board Of Directors Opinions Of Management6-10. Board Members Apparent Position Regarding Potential Acquisition6-11. Overall Management Assessment6-12. Assessment Of Individual Management Personnel

Section 7: Relationships With Outside Organizations7-01. Relationships With Accounting Firms7-02. Relationships With Law Firms7-03. Relationships With Commercial Banks7-04. Relationships With Investment Banks7-05. Relationships With Venture Capital Firms7-06. Relationships With Private Investors And/Or Investment Groups7-07. Relationships With Consulting Firms7-08. Relationships With Trade Associations

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7-09. Relationships With Other Professional Organizations7-10. Outside Organization Information Request

Section 8: Description of Products And/Or Services8-01. Summary Of Product Lines/Services8-02. Individual Product Line/Service Overview8-03. Competitive Product/Service Analysis8-04. Product Line Positioning8-05. Identified Product And Service Improvement Projects8-06. Potential Future Product And Service Improvement Opportunities8-07. Recently Discontinued Products And/Or Services; Products And/Or Services Potentially Subject To

Early Termination8-08. New Product And/Or New Service Development Projects8-09. New Product Development—Summary Of Current Projects 8-10. Schedule Of Expenditures For Approved Development Projects8-11. Performance On Past Development Projects8-12. Distribution Of Company Development Funds8-13. Source Of Total Development Funds8-14. Trend In Development Expenditures, Salaries And Staffing Levels; Comparison Of Budget Versus

Actual Expenditures8-15. Comparison Of Development Expenditures With Other Companies8-16. Current Development Budget Considerations8-17. Future Development Requirements8-18. Accounting For Development Expenditures8-19. Development Organization8-20. Development Organization—Resumes Of Key Personnel8-21. Compensation Of Key Development Personnel8-22. Development Staffing Levels8-23. Trend In Development Staffing8-24. Internal Development Procedures8-25. Current Product/Service Information Request8-26. New Product/Service Development Information Request8-27. Summary Of Major Development Strengths And Weaknesses 8-28. Potential Impact Of An Acquisition On The Development Organizations

Section 9: Revenues And Market Share9-01. Trend In Total Revenues—All Products And/Or Services9-02. Trend in Revenues By Product Line Or Service9-03. Trend In Market Share By Individual Product Line Or Service9-04. Revenues By Major Customer9-05. Trend In Revenues By Customer9-06. Revenues By Channel Of Distribution9-07. Revenues By Distribution Channel—Direct Sales To Customers, Retailers9-08. Revenues By Distribution Channel—Direct Sales To Industry, Government9-09. Revenues By Distribution Channel—Sales Through Wholesale Offices, Distributors9-10. Revenues By Distribution Channel—Through Sales Representatives, Other Channels9-11. Revenues By Geographic Region9-12. Trend In Revenues By Geographic Region9-13. Trend In Revenues By Month9-14. Seasonal Variation In Revenues9-15. Trend In Revenues From Commercial Negotiated Contracts9-16. Commercial Negotiated Contracts9-17. Commercial Negotiated Contracts—Renegotiation Experience; Status Of Current Renegotiations9-18. Trend In Revenues From Government Contracts9-19. Government Contracts

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9-20. Government Contracts—Renegotiation Experience; Status of Current Negotiations9-21. Trend In Revenues Generated Through Independent Distributors; Ten Largest Independent Distributors9-22. Trend In Revenues Generated By Independent Sales Representatives; Ten Largest Independent

Sales Representatives9-23. Summary of Factors Impacting Market Share9-24. Backlog By Product Line Or Service9-25. Book-To-Ship Ratio9-26. Schedule of Deliverable Backlog9-27. Lost Sales; Current or Potential Problem Customers9-28. Revenue Information Request9-29. Potential Revenue Improvement Opportunities9-30. Potential Impact Of An Acquisition On The Combined Revenues

Section 10. Marketing Operations10-01. Marketing Organization10-02. Marketing Organization—Resumes Of Key Marketing Personnel10-03. Compensation Of Key Marketing Staff Personnel10-04. Qualification, Recruiting And Training Of Direct Sales Personnel10-05. Compensation Of Direct Sales Personnel10-06. Marketing Organization—Expense Accounts10-07. Marketing Locations And Facilities—Domestic10-08. Marketing Locations And Facilities—Foreign10-09. Marketing Channels10-10. Distribution Channels—Characteristics Of Present System10-11. Distribution Channels—Miscellaneous Questions10-12. Market Planning And Research—Organization And Activities10-13. Market Planning And Research—Methodology And Expenditures10-14. Advertising Organization And Activities10-15. Advertising—Media And Expenditures10-16. Comparison Of Advertising Programs With Major Competitors10-17. Sales Promotion Organization And Activities10-18. Trade Show Participation10-19. Sales Promotion Expense10-20. Comparison Of Sales Promotion Programs With Major Competitors10-21. Foreign Marketing Considerations10-22. Summary Of Franchise Operations—Entity As Franchiser10-23. Summary Of Franchise Operations—Entity As Franchisee10-24. Factors Impacting Marketing Activities10-25. Pricing—Organization10-26. Internal Pricing Policies10-27. Special Pricing Solutions10-28. Price Trends10-29. Current Pricing Environment10-30. Terms Of Sale And Credit Policies10-31. Terms Of Sale—Product Warranty And Return Policies10-32. Terms Of Sale—Competitive Environment10-33. Product Leasing Programs10-34. Other Marketing Programs10-35. Marketing Financial Performance10-36. Marketing Performance Versus Budget10-37. Marketing Information Request10-38. Summary Of Observations Regarding Marketing Activities10-39. Third Party Comments Regarding Marketing Activities10-40. Summary Of Major Marketing Strengths And Weaknesses

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10-41. Potential Impact Of An Acquisition On Marketing Organizations10-42. Potential Impact Of An Acquisition On Outside Marketing Firms

Section 11: Customer Service11-01: Customer Service Organization11-02. Resumes Of Key Customer Service Personnel11-03. Compensation Of Key Customer Service Personnel11-04. Customer Service Locations11-05. Trend In Customer Service Staffing; Customer Service Financial Performance11-06. Customer Service Activities11-07. Quality Of Customer Service11-08. Profitability Of Service And Repair Operations

Section 12: Inventory Control And Purchasing12-01. Inventory Control Organization12-02. Resumes Of Key Inventory Control Personnel12-03. Compensation Of Key Inventory Control Personnel12-04. Inventory Control Activities12-05. Trend In Inventory Control Staffing; Inventory Control Financial Performance12-06. Purchasing Organization12-07. Resumes Of Key Purchasing Personnel12-08. Compensation Of Key Purchasing Personnel12-09. Purchasing Activities12-10. Availability Of Materials And Supplies12-11. Identification Of Critical Materials And Supplies12-12. Price Trends For Purchased Materials And Supplies12-13. Characteristics Of Major Suppliers12-14. Summary Of Largest Outstanding Purchase Orders12-15. Summary Of Largest Outstanding Purchase Contracts12-16. Purchasing Policies And Procedures12-17. Trend In Purchasing Staffing; Purchasing Department Financial Performance12-18. Inventory Control And Purchasing Information Request12-19. Summary Of Observations Of Inventory Control And Purchasing Activities12-20. Notes Regarding Observations Of Inventory Control Activities12-21. Notes Regarding Observations Of Purchasing Activities12-22. Potential Impact Of An Acquisition On Inventory Control Organizations12-23. Potential Impact Of An Acquisition On Purchasing Organizations

Section 13: Production13-01. Production Organization13-02. Resumes Of Key Production Personnel13-03. Compensation Of Key Production Personnel13-04. Production Methods And Processes13-05. Production Facilities13-06. Production Equipment13-07. Future Production Equipment Requirements13-08. Surplus Production Equipment13-09. Trend In Production Equipment Acquisitions And Accounting Policies With Respect To Major

Equipment Items13-10. Production Tooling13-11. Production Capacity And Utilization; Potential Impediments To Nearby Expansion13-12. Production Planning And Control13-13. Quality Control13-14. Stockroom Operations

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13-15. Production Training Programs13-16. Production Cost Accounting13-17. Intra-Company Material Transactions13-18. Subcontracting To Others13-19. Plant Safety13-20. Utility Services13-21. Plant Maintenance13-22. Trend In Production Staffing13-23. Production Department Financial Performance13-24. Trend In Production Productivity13-25. Competitive Production Environment13-26. Production Information Request13-27. Summary Of Observations Regarding Production Activities13-28. Summary Of Major Production Strengths And Weaknesses13-29. Potential Impact Of An Acquisition On Production Organization

Section 14: Physical Distribution14-01. Physical Distribution Organization14-02. Resumes Of Key Distribution Personnel14-03. Compensation Of Key Distribution Personnel14-04. Physical Distribution Activities14-05. Warehouse Facilities14-06. Major Distribution Equipment14-07. Trend In Distribution Equipment Acquisitions; Accounting Policies With Respect To Major

Equipment Items14-08. Trend In Distribution Staffing; Distribution Financial Performance14-09. Distribution Of Outbound Transportation By Type Of Carrier; Competitive Distribution

Environment14-10. Distribution Information Request14-11. Summary Of Observations Regarding Distribution Activities14-12. Summary Of Observations Regarding Distribution Activities—Notes14-13. Summary Of Major Distribution Strengths And Weaknesses14-14. Potential Impact Of An Acquisition On The Distribution Organization

Section 15: Computer, Communications And Information Systems15-01. Organization Of Computer, Communications And Information Systems15-02. Resumes Of Key Computer, Communications And Information Systems Personnel15-03. Compensation Of Key Computer, Communications And Information Systems Personnel15-04. Computer Applications15-05. Outside Computer Services15-06. Planned New Computer Applications15-07. Computer Inventory15-08. Communications Applications15-09. Major Communications Equipment—Other Than Regular Telephones15-10. Integrated Computer/Communications Systems15-11. Information Systems15-12. Integrated Computer/Communications/Information Systems15-13. Trend In Computer/Communications/Information Systems Staffing15-14. Trend In Computer/Communications/Information Systems Expenses15-15. Competitive Computer/Communications/Information Systems Environment15-16. Computer/Communications/Information Systems Information Request15-17. Summary Of Observations Regarding Computer/Communications/Information Systems15-18. Summary Of Computer/Communications/Information Systems Strengths And Weaknesses15-19. Impact Of An Acquisition On The C. C. & I. Organization

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Section 16: Financial Management16-01. Financial Organization16-02. Resumes Of Key Financial Personnel16-03. Compensation Of Key Financial Personnel16-04. Accounting Policies And Procedures16-05. Financial Controls16-06. Foreign Exchange Transactions16-07. Internal Audit Function16-08. Financial Planning And Budgeting16-09. Financial Reporting16-10. Financial Activities16-11. Investor Relations16-12. Investment Management16-13. Insurance Management16-14. Tax Management16-15. Trend In Finance Department Staffing16-16. Trend In Finance Department Expenses16-17. Financial Operations Information Request16-18. Summary Of Observations Regarding Financial Operations16-19. Summary Of Financial Strengths And Weaknesses16-20. Potential Impact Of An Acquisition On The Finance Organization

Section 17: Legal Affairs17-01. Legal Organization; Compensation Of Key Legal Personnel17-02. Resumes Of Key Legal Personnel17-03. Legal Department Activities17-04. Litigation Summary—Entity Is Plaintiff17-05. Litigation Summary—Entity Is Defendant17-06. Potential Litigation—Entity Is Plaintiff17-07. Potential Litigation—Entity Is Defendant17-08. Recently Concluded Litigation—Entity Was Plaintiff17-09. Recently Concluded Litigation—Entity Was Defendant17-10. Patents, Copyrights And Trademarks17-11. Licensing Agreements17-12. Regulatory Affairs17-13. Regulatory Compliance Actions17-14. Officers’ And Directors’ Background Information17-15. Trend In Legal Department Staffing; Outside Legal Services17-16. Trend In Legal Department Expenses17-17. Legal Activities Information Request17-18. Summary Of Observations Regarding Legal Activities17-19. Summary Of Major Legal Strengths And Weaknesses17-20. Potential Impact Of An Acquisition On The Legal Organization

Section 18: Security And Safety18-01. Security Organization; Safety Organization18-02. Potential Security Problems18-03. Potential Safety Problems18-04. Other Security/Safety Matters

Section 19: Human Resources19-01. Human Resources Organization; Compensation Of Key Human Resources Personnel19-02. Resumes Of Key Human Resources Personnel19-03. Trend In Human Resources Department Staffing; Outside Services19-04. Trend In Human Resources Department Expenses

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19-05. Distribution Of Personnel By Various Categories19-06. Benefit Plans For Active Personnel19-07. Retirement Benefits—Pension Plans19-08. Retirement Benefits—Other Than Pension Plans19-09. Basic Wage And Salary Factors19-10. Incentive Programs19-11. Perquisites; Reimbursement For Relocation Expenses19-12. Employment Contracts19-13. Organized Labor Agreements19-14. Labor-Management Relations19-15. Hiring Policies And Procedures19-16. Termination Policies; Termination Benefits19-17. Training Programs19-18. Local Labor Environment19-19. Human Resources Information Request19-20. Summary Of Observations Regarding Human Resources Activities19-21. Summary Of Major Human Resources Strengths And Weaknesses19-22. Potential Impact Of An Acquisition On The Human Resources Organization19-23. Potential Cost Of Integrating Human Resources Policies19-24. Estimated Personnel Relocation Expenses

Section 20: Land And Buildings20-01. Summary Of Active Domestic Facilities20-02. Summary Of Active Foreign Facilities20-03. Physical Characteristics Of Active Facilities20-04. Financial Characteristics Of Owned Facilities20-05. Financial Characteristics Of Leased Facilities20-06. Miscellaneous Facility Characteristics20-07. Factors Potentially Impacting The Future Value Of Existing Facilities20-08. Production Capacity And Potential Modifications To Existing Facilities20-09. Summary Of Currently Inactive Facilities; Potential Retirement Of Currently Active Facilities20-10. Summary Of Undeveloped Land; Trend In Real Property Taxes20-11. Potential Acquisition Of New Facilities20-12. Property And Facilities Information Request

Section 21: Introduction To Financial Analyses21-01. Summary Balance Sheet As Of ______21-02. Summary Income Statement For The _______

Section 22: Balance Sheet Analysis—Liabilities22-01. Short-Term Notes Payable22-02. Short-Term Debt Service Payments; Principal Balances Of Short-Term Debt22-03. Payable Aging For The Twenty-Five Largest Accounts22-04. Explanation For Overdue Payables22-05. Accounts Payable Analysis22-06. Trend In Unearned Revenues; Trend In Accrued Expenses22-07. Trend In Total Current Liabilities22-08. Long-Term Notes Payable22-09. Features of Bond Issues22-10. Long-Term Debt Service Payments; Principal Balances Of Long-Term Debt22-11. Recent Bond Performance22-12. Other Noncurrent Liabilities

Section 23: Revenues23-01. Trend In Gross Revenues, Revenue Reductions, And Net Revenues

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Section 24: Operating Expenses24-01. Selling Expenses24-02. Selling Expenses As A Percent Of Net Revenues24-03. Variation In Selling Expense With Net Revenues24-04. Comparison Of Selling Expenses As A Percent Of Net Revenues24-05. General And Administration Expenses24-06. General And Administration Expenses As A Percent Of Net Revenues24-07. Variation In General And Administrative Expenses With Net Revenues24-08. Comparison Of General And Administrative Expenses As A Percent Of Net Revenues24-09. Allocation Of Office Occupancy And Office Equipment And Furniture Expenses24-10. Payroll Related Expenses As A Percent Of Payroll Expenses24-11. Comparison Of Payroll Related Expenses As A Percent Of Payroll Expenses

Section 25: Income Taxes25-01. Status Of Income Tax Filings And Audits; Provision For Income Taxes25-02. Elements Of Deferred Taxes; Effective Tax Rate25-03. Availability Of Net Operating Loss; Deficiency Claim Settlements25-04. Income Tax Information Request

Section 26: Net Income26-01. Trend In Net Income; Comparison Of Profit Margin With Industry Averages And With Selected

Companies

Section 27: Capital Expenditures27-01. Trend In Capital Expenditures; Comparison With Depreciation Expense And Net Revenues27-02. Trend In Adjusted Capital Expenditures; Comparison Of Adjusted Capital Expenditures With Net

Revenues

Section 28: Cash Flow28-01. Trend In Cash Flow

Section 29: Financial Ratio Analysis29-01. Profitability Ratios29-02. Stock Performance Ratios29-03. Liquidity Measures29-04. Debt Ratios29-05. Activity Ratios29-06. Trend In Profitability Ratios29-07. Trend In Common Stock Performance Ratios29-08. Trend In Liquidity Measures29-09. Trend In Debt Ratios29-10. Trend In Activity Ratios

Section 30: Income Statement Projections30-01. Projection Of Gross And Net Revenues30-02. Projection Of Cost Of Goods Sold And Gross Margin30-03. Projection Of Selling Expenses30-04. Projection Of General And Administrative Expenses30-05. Projection Of Selling, General And Administrative Expenses30-06. Projection Of Operating Income30-07. Projection Of Other Income And Expenses30-08. Projection Of Unusual And Infrequent Items30-09. Projection Of Unusual, Infrequent And Extraordinary Items30-10. Basis For Projections Of Unusual, Infrequent And Extraordinary Items

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DUE DILIGENCE HANDBOOK xiii

30-11. Projection Of Net Income30-12. Comparison Of Entity’s And Investigator’s Projections

Section 31: Balance Sheet Projections31-01. Projection Of Current Asset Requirements31-02. Projection Of Property, Plant And Equipment31-03. Projection Of Other Noncurrent Assets31-04. Projection Of Short-Term Debt31-05. Projection Of Accounts Payable31-06. Projection Of Unearned Revenues And Accrued Expenses31-07. Projection Of Other Noncurrent Liabilities31-08. Projection Of Shareholders’ Equity Other Than Retained Earnings31-09. Projection Of Change In Retained Earnings31-10. Summary Balance Sheet Form

Section 32: Cash Flow Projections32-01. Projections Of Cash Flow32-02. Monthly Debt Service Payments On Current Short-Term Notes Payable And Current Portion of

Long-Term Debt32-03. Annual Debt Service Payments Based On Current Debt

CHECKLISTS AND OTHER DOCUMENTS

Section 33: Due Diligence Checklists For Acquisitions Or InvestmentsOr Specific Dealings In Selected Industries33-01: Restaurant Businesses33-02: Franchising Companies33-03. Hospitals And Health Care Facilities33-04. Technology-Driven Companies33-05. Outsourcing Technological Services33-06. Private Equity And Hedge Funds33-07. Family And Closely-Held Businesses

Section 34: Transaction-Specific Due Diligence Checklists34-01. Due Diligence Checklists For Joint Ventures/Strategic Alliances34-02. Due Diligence Checklists For Technology Licensing Arrangement34-03. Due Diligence Checklists For Dealership & Distributorship Arrangement

Section 35: Sample Forms Related To Effective Due Diligence35-01. Confidentiality Agreement35-02. Investor Questionnaire In Connection With Private Placement Offerings35-03. Officer And Director (Employee & Non-Employee) Questionnaire To Conduct Due Diligence

Of Existing Board Members Prior To An Offering Or In Connection With An M&A Transaction

Section 36: Due Diligence Checklists For Special Situations36-01. Employee Benefit Plans And ERISA Matters36-02. Hart-Scott-Rodino Questionnaire (Antitrust Compliance Filings)36-03. Environmental Matters36-04. Real Estate And REIT Matters

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DUE DILIGENCE HANDBOOK 1-00

SECTION 1

PREFACE

CONTENTS

SUBJECT TEXT

What’s New In This Edition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

What Is “Due Diligence?” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Overview: The Art And Science Of Due Diligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Why Is Due Diligence Necessary?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Common Due Diligence Problems And Exposure Areas . . . . . . . . . . . . . . . . . . . . . . . . . 7

Common Mistakes Made By The Buyer During The Due Diligence Investigation . . . . . 7

Special Due Diligence Considerations In A Post Sarbanes-Oxley Age. . . . . . . . . . . . . . . 8

The Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Checklist Of Items Post Sarbox . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

Some Useful Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

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SECTION 1

PREFACE

In wake of the Sarbanes-Oxley Act enacted pursuant to the Enron scandal and subsequent events as well asthe changed Mergers and Acquisitions scenario due to the credit crisis, a significant change has been wit-nessed in the practice of due diligence. This has necessitated addition of content in the introductory sectionsof the Handbook, including common due diligence problems, common mistakes made by the buyer and theart and science of due diligence that prominently reflect the practice of due diligence in current times.

Due diligence practice post Sarbanes-Oxley enactment deserves the addition of a separate section in view ofsome onerous disclosure requirements that are now mandatory. An additional section has been inserted pro-viding checklists for potential acquisitions or investment in selected industries and/or businesses. Suchchecklists are provided with a view to educate audiences of special considerations in each of the businessescontained in that section to facilitate a unique due diligence process for each such business. Examples of suchbusinesses include restaurant services, franchising companies, hospitals, outsourcing technical services, pri-vate equity and hedge funds and closely held businesses. With each such business, we seek to cater to a broadaudience of the new series of the Handbook to give useful insights on warning signals before investing oracquiring such specific businesses.

The section on Non-M&A transactions has been added with an aim to make the new series of the Handbookcomprehensive. Adequate and timely due diligence is required not just for transactions that pertain to acqui-sition or investment, but to joint ventures, strategic alliances, licensing technology and entering into dealer-ship or distributorship agreements. Continuing on our intention to cater to a broad audience, the editors of theHandbook seek to leverage on their practical and legal experience in such individualized transactions and pro-vide effective checklists to ensure that potential participants of such transactions are in safe harbor beforesigning on dotted lines of formal instruments.

“Due diligence” is a process whereby an individual, or an organization, seeks sufficient information about abusiness entity to reach an informed judgement as to its value for a specific purpose.

Situations Calling For Due Diligence

Due diligence is performed in a wide variety of situations, e.g.:

• By a firm considering a potential acquisition.

• By an investment banker considering underwriting a public security offering or promoting aprivate placement.

• By a banker considering the making of a loan.

• By a venture capitalist considering an investment.

• By a lawyer preparing an offering statement or a merger proposal for a client.

• By an appraiser who has been retained to estimate the value of a business unit.

• By a business broker offering a company for sale.

WHAT IS “DUE DILIGENCE”?

WHAT’S NEW IN THIS EDITION

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1-02 DUE DILIGENCE HANDBOOK

Situations Calling For Due Diligence (Continued)

• By a public accounting firm in conjunction with an audit performed at the request of a potentialbuyer or in support of a security offering.

• By a security analyst preparing a buy, hold or sell recommendation on a public security.

The due diligence investigation is normally carried out with the knowledge and cooperation of the manage-ment of the entity being investigated.

The Due Diligence Investigation Is Not, By Itself, An Audit

A due diligence investigation may include a detailed audit. However, it is not, in itself, an audit in the man-ner normally conducted by a public accounting firm.

The due diligence investigation is much broader than an audit.

• A due diligence investigation is more concerned with the future profit potential of the entity, where-as an audit is primarily oriented toward determining the financial condition of an entity at a pastmoment in time.

• In a potential acquisition situation, the due diligence investigation will place great importance onprojecting how well the two organizations will function together operationally, in addition to pro-jecting the anticipated financial benefits.

Due diligence work is usually divided between two working teams:

(1) financial and strategic, which is typically managed by the buyer’s accountants and managementteam; and

(2) legal, to be conducted by the buyer’s counsel

The business due diligence focuses on the strategic and financial issues in the transaction, such as confirma-tion of the past financial performance of the seller; integration of the human and financial resources of the twocompanies; confirmation of the operating, production and distribution synergies and economies of scale to beachieved by the acquisition and gathering of information necessary for financing the transaction. The legaldue diligence focuses on the potential legal issues and problems that may serve as impediments to the trans-action, as well as sheds light on how the transaction documents should be structured.

Degree Of “Diligence” Can Not Be Accurately Defined

The degree of diligence that is required in any given investigation cannot be precisely defined. What repre-sents “due” or “sufficient” diligence will vary greatly depending on the purpose for which the investigationis undertaken. Even when the purpose is well defined, the extent of the investigation that is required is ajudgement call.

The difficulty in defining what constitutes sufficient diligence is apparent from the difficulty the Courts havehad in resolving litigation before them.

• Accounting firms and investment bankers are being sued when their clients default on a debt secu-rity or when the market price of an equity security takes a dive.

• Corporate directors and officers are increasingly the subject of litigation when they make whatturns out to be a bad acquisition.

• The savings and loan “crisis” and the several recent bank and insurance company failures arespawning a number of legal actions in which the diligence of the regulators is being questioned.

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Due diligence is not just a process, it is also a reality test—a test of whether the factors driving the deal andmaking it look attractive to the parties are real or illusory. Due diligence is not a quest to find the deal-breakersbut a test of the value proposition underlying the transaction to make sure that the inside of the house is asattractive as the outside. Once the foundation has been dissected, it can either be rebuilt around a deal thatmakes sense or allow the buyer to walk away and prevent the consummation of a deal that doesn’t make sense.Overall, the due diligence process, when done properly, can be tedious, frustrating, time-consuming, andexpensive. Yet it is a necessary prerequisite to a well-planned acquisition, and it can be quite informative andrevealing in its analysis of the target company and its measures of the costs and risks associated with the trans-action. Buyers should resist the temptation to conduct a hasty “once over,” either to save costs or to appeasethe seller. Yet at the same time, they should avoid “due diligence overkill,” keeping in mind that due diligenceis not a perfect process and should not be a tedious fishing expedition. Like any audit, a diligence process isdesigned to answer the important questions, and ensure with reasonable assurance that the seller’s claimsabout the business are fair and legitimate.

• Proper due diligence involves:

• Knowing where to look

• Knowing what to ask

• Knowing what tools to use

• Knowing who to ask

• Knowing how to test premises/answers

• Knowing who should ask

Effective due diligence is both an art and a science.

The art is the style and experience to know which questions to ask and how and when to ask them. It’s the abil-ity to create an atmosphere of both trust and fear in the seller, which encourages full and complete disclosure.In this sense, the due diligence team is on a risk discovery and assessment mission, looking for potential prob-lems and liabilities (the search), and finding ways to resolve these problems prior to closing and/or to ensurethat risks are allocated fairly and openly after the closing.

• The “Art” of Due Diligence:

• Understanding how to extract key information from a person or situation

• Understanding the objectives of the parties and the underlying transaction

• Identifying key hurdles and risks

• Identifying why information might be falsified or omitted

• Targeting the proper sources for disclosure of information

The science of due diligence is in the preparation of comprehensive and customized checklists of the specif-ic questions to be presented to the seller, in maintaining a methodical system for organizing and analyzing thedocuments and data provided by the seller, and in quantitatively assessing the risks raised by those problemsdiscovered in the process.

• The “Science” of Due Diligence:

• Do your homework

OVERVIEW: THE ART AND SCIENCE OF DUE DILIGENCE

5


• Be prepared and well-organized

• Be precise in your requests

• Be persistent in your quest for the truth

• Don’t accept the first answer as the final answer

Poor Record Of Performance

Lack of adequate due diligence is a major cause of the poor financial performances experienced by many ofAmerica’s industrial corporations and financial institutions.

Re: Acquisitions

Nowhere is the lack of adequate due diligence more evident than in the area of corporate acquisitions andmergers.

It is estimated that only 15 to 20 percent of these transactions live up to their expectations. Twenty-five to 30percent are reported to be downright failures - with the acquired entity being resold or liquidated at a losswithin three to five years. The remaining 40 to 50 percent have resulted in little or no apparent benefit to thebuyer’s shareholders.

Re: Leveraged Buyouts

The business press has gone on at length regarding the inevitability that the excessive leverage built into manyof the LBO’s of the 1980’s would result in large scale reorganizations in the 1990’s.

Re: Public Security Offerings

With some notable exceptions, the track record of recent public offerings has not lived up to expectations.

Re: Bank Loans

The recent writeoffs of bad loans has had a significant impact on the reported earnings of some of America’smost respected banks and savings and loan institutions.

Re: Venture Capital Investments

Venture capitalists frequently indicate that their objective is to make enough money from the successful 20 to30 percent of their deals to more than compensate for the losses they experience on the unsuccessful ones.

Re: Insurance Companies

Several large insurance companies experienced financial difficulties due to investments in corporate secu-rities that were deemed to have too high a risk by firms that performed more extensive due diligence.

WHY IS DUE DILIGENCE NECESSARY?

OVERVIEW: THE ART AND SCIENCE OF DUE DILIGENCE (Continued)

6


Re: Sarbanes-Oxley

In the post Sarbanes-Oxley world, due diligence is much wider and deeper in its scope than ever before,especially if the prospective buyer is a public company or a company with plans to go public within the next18 months

And the list goes on . . . . . .

External events, not under the control of the acquirer or investor, are often blamed for these poor performances.However, in most cases, adequate due diligence would have identified the potential impact of these eventswell in advance. Thus their impact could have been avoided or, at the very least, minimized.

There are virtually an infinite number of potential problems and exposure areas for the buyer which may beuncovered in the review and analysis of the seller’s documents and operations. The specific issues and prob-lems will vary based on the size of the seller, the nature of its business and the number of years that the sell-er (or its predecessors) have been in business.

• “Clouds” in the title to critical tangible (real estate, equipment, inventory) and intangible (patents,trademarks, etc.) assets. Be sure the seller has clear title to these assets and that they are conveyedwithout claims, liens and encumbrances.

• Employee matters - there are a wide variety of employment or labor law issues or liabilities whichmay be lurking just below the surface which will not be uncovered unless the right questions areasked. Questions designed to uncover wage and hour law violations, discrimination claims, OSHAcompliance, or even liability for unfunded persons under the Multi-Employer Pension Plan Actshould be developed. If the seller has recently made a substantial workforce reduction (or if you asthe buyer are planning post-closing layoffs), then the requirements of the Worker Adjustment andRefraining Notification Act (WARN) must have been met. The requirements of WARN includeminimum notice requirements of 60 days prior to wide scale terminations.

• The possibility of environmental liability under CERCLA or related environmental regulations.

• Unresolved existing or potential litigation — these cases should be reviewed carefully by counsel.

• A seller’s attempt to “dress-up” the financial statements prior to sale, often in an attempt to hideinventory problems, research and development expenditures, excessive overhead and administra-tive costs, uncollected or uncollectible accounts receivable, unnecessary or inappropriate personalexpenses, unrecorded liabilities, tax contingencies, etc.

1. Mismatch between the documents provided by the seller and the skills of the buyer’s review team.It may be the case that the seller has particularly complex financial statements or highly technicalreports which must be truly understood by the buyer’s due diligence team. Make sure there is acapability fit.

2. Poor communication and misunderstandings. The communications should be open and clearbetween the teams of the buyer and the seller. The process must be well orchestrated.

COMMON MISTAKES MADE BY THE BUYER DURINGTHE DUE DILIGENCE INVESTIGATION

COMMON DUE DILIGENCE PROBLEMS AND EXPOSURE AREAS

7


3. Lack of planning and focus in the preparation of the due diligence questionnaires and in the inter-views with the seller’s team. The focus must be on asking the right questions, not just a lot of ques-tions. Seller’s will resent wasteful “fishing expeditions” when the buyer’s team is unfocused.

4. Inadequate time devoted to tax and financial matters. The buyer’s (and seller’s) CFO and CPAmust play an integral part in the due diligence process in order to gather data on past financial per-formance and tax reporting, unusual financial events or disturbing trends or inefficiencies.

5. Lack of reasonable accommodations and support for the buyer’s due diligence team. The buyermust insist that its team will be treated like welcome guests, not enemies from the IRS! Manytimes buyer’s counsel is sent to a dark room in the corner of the building to inspect documentswithout coffee, windows or phones. It will enhance and expedite the transaction if the seller pro-vides reasonable accommodations and support for the buyer’s due diligence team.

6. Ignoring the real story behind the numbers. The buyer and its team must dig deep into the finan-cial data and test (and retest) the value proposition as to whether the deal truly makes sense. Theymust ask themselves, “Does the real value truly justify the price?” The economics of the deal maynot hold water once a realistic look at cost allocation, inventory turnover, and capacity utilizationis taken into account.

In the 1990s, acquirers rarely had the opportunity to conduct extensive, time-consuming due diligence. Buyerswere seldom granted exclusivity periods, and the typical auction may have allowed the potential buyer onlya day or two in the “data room” (which sometimes had a no-copy rule) and a few hours of management inter-views. After the Enron scandal and a few others hit the American corporate world, the Public CompanyAccounting Reform and Investor Protection Act of 2002, also known as Sarbanes-Oxley Act (“Sarbox”) wasenacted which changed the way businesses were conducted and corporate governance was practiced.

Sarbox lays out a government-mandated disclosure process that is monitored by auditors, certified by top-level executives under penalty of prison and reviewed by the SEC. It addresses corporate responsibility, thecreation of a public company accounting oversight board, auditor independence and enhanced criminal sanc-tions. The effect of Sarbox has been to compel investment banks, regulators, shareholder groups, plaintifflawyers and other parties to now analyze companies with a focus on the broad mandates of Sarbox

Sarbox does not apply only to large publicly traded corporations; privately held companies can also be sub-ject to Sarbox. Lenders and customers can each require a company to adopt Sarbox-style procedures. A com-pany’s accountants and D&O insurance carriers can also prompt a company to do it.

Potential acquirers must be aware of the main federal corporate disclosure requirements: Regulation S-K,FASB No. 5, and Sarbox

I. Regulation S-K issued by the SEC acts as an instruction manual for public companies filing their annual,quarterly and interim reports. The important provisions are as under:

THE DISCLOSURE REQUIREMENTS

SPECIAL DUE DILIGENCE CONSIDERATIONS IN A POSTSARBANES-OXLEY AGE

COMMON MISTAKES MADE BY THE BUYER DURINGTHE DUE DILIGENCE INVESTIGATION (Continued)

8


a) Item 101 requires reporting companies to describe their businesses, products and competition as wellas report on their financial position by industry segments. Companies must discuss transactions out-side of the ordinary course, R&D activities, intellectual property, backlog, foreign operations and theanticipated costs and effects of environmental compliance — both current and projected.

b) Item 103 calls for companies to disclose any large nonroutine legal proceedings to which they area party, and even some routine matters that exceed certain thresholds. Also, Item 303 requires acompany’s management to discuss known trends, events and uncertainties that could have a mate-rial effect on its business

c) Item 402 call for a detailed review of the company’s executive compensation, employee contracts,benefits, options and so on.

d) Item 404 focuses on related party transactions. Material contracts are to be included as exhibits tothe periodic filings, so, many times, credit agreements, joint venture agreements, even real estateleases are on the public record.

II. Statement of Financial Accounting Standards No. 5: Accounting for Contingencies, issued by theFinancial Accounting Standards Board, deals with disclosing loss contingencies. Observing FASB No.5 is part of complying with generally accepted accounting principles, and is a key element in the auditletter process. It requires a company to establish a loss contingency in its financial statements if

(1) available information indicates that it is probable that the company has suffered a loss, and

(2) the amount of that loss can be reasonably estimated.

III. Sarbox introduces stringent disclosure requirements for companies. The main disclosure requirements apotential acquirer must have in mind are as under:

a) Section 302 of Sarbox requires the chief executive officer and the chief financial officer of a com-pany to personally certify certain items about the annual or quarterly report being filed. In summa-ry, they must certify that

• they have read the report,

• the report fairly presents the company’s financial condition and results of operations,

• to their knowledge, the report contains no untrue statements or omissions of material fact thatwould make the statements misleading, and

• they are responsible for and have evaluated the company’s disclosure controls and procedures, andinternal controls over financial reporting.

b) Under Section 906 of Sarbox, senior officers can be subject to potential criminal liability if theyfalsely, knowingly or willfully make an inaccurate Section 302 certification.

These provisions together obligate the buyer CEO and CFO to certify the financial statementsand internal disclosure controls of the combined company as of the end of the first quarter post-acquisition. In major acquisitions, this can be an impossible task if substantial due diligence isnot done prior to the closing.

c) Under Section 404, a company has to establish and maintain adequate internal control structures andprocesses to allow for accurate financial reporting. In the company’s annual report, senior executivesneed to assess and report on the effectiveness of these internal control structures and processes.Further, the company’s auditors must provide an independent report on management’s assessment.

Taken together, these measures require reporting companies (and companies otherwise observing theserequirements) to:

THE DISCLOSURE REQUIREMENTS (Continued)

9


• review and, if necessary, adopt new liability assessment and reporting practices;

• regularly obtain and evaluate insurance company risk assessments for the company’s properties;

• include environmental matters in their Item 303 MD&A;

• discuss pending and threatened litigation and regulatory enforcement actions in their periodic reports;

• disclose and value contingent liabilities in their financial statements, including those related tolegal, operational, warranty and environmental issues;

• implement and periodically evaluate Section 404 internal controls and procedures;

• perform the actions called for by their internal controls and procedures, including maintaining inter-nal records, establishing milestones for regularly evaluating known problem areas, searching out newproblem areas, and providing reports up and down the management chain;

• have all of the above reviewed, evaluated and certified to by senior management; and

• have all of the above formally reviewed and audited by their accountants

• Among other things, audit committees must enact whistle-blowing procedures to report question-able accounting or auditing practices. The buyer should also compare the target’s internal controlswith its own to identify any deficiencies or differences. This will enable the buyer to prepare inte-gration steps to harmonize both sets of control procedures after closing.

In particular, acquiring companies need to:

• expand their review of publicly available information to include the EPA ECHO list and periodicreports filed by the target with the SEC;

• specifically inquire about their target’s internal review processes and procedures;

• review the target’s internal operational, real estate, intellectual property, insurance, litigation andenvironmental policies;

• examine the internal committees charged with monitoring and assessing the target’s Sarbox com-pliance, including getting a list of committee members and their functions;

• consider whether other internal procedures might touch on managerial, financial and operationalissues (for example, as part of the target’s accounting and legal functions);

• inquire about what is generally known as the Disclosure Controls Committee, a general oversightcommittee that may gather and evaluate information generated by the internal review structure;

• obtain all minutes, reports, memoranda and valuations generated by these internal procedures; and

• review the work papers and reports generated by the target’s auditors while assessing the company’sinternal controls.

d) As a result of Sarbanes-Oxley, the duties of the audit committee have substantially increased. A reviewof committee minutes often uncovers potentially important issues. How the committee resolves theseissues may indicate its effectiveness and independence. The process used by the target’s audit commit-tee to select its outside auditor, as well as the target’s relationship with its outside auditor, should alsobe examined. Comparing the amount of money spent on non-audit services to the amount spent on theaudit itself may suggest the relative importance of each to the auditor. If non-audit services are signif-icant, the buyer should consider potential exposure to bias that could affect the integrity of the audit.


10


e) GAAP practices often allow for discretion, and to the extent that the target’s accounting practicesdiffer from the buyer’s, the differences need to be harmonized. The buyer should recognize thepotential impact this may have on the combined company’s earnings. For example, buyers shouldpay attention to the target’s policies for accounting for contingent liabilities. If the buyer’saccounting practices are more conservative (i.e., will result in greater reserves), the impact mustbe understood and taken into account in the buyer’s evaluation.

Thus, Sarbox and the SEC rules promulgated thereunder have profoundly affected important aspects of M&Apractice in a number of ways, including the nature and scope of the due-diligence process and the terms andconditions under which the transaction is effected. In conducting due diligence and in crafting appropriate rep-resentations and warranties in deal documents – particularly with respect to closing conditions and materialadverse effect or change (“MAE” or “MAC”) clauses – public company buyers must consider the followingSarbox-related items:

I. Does the seller maintain effective disclosure controls and procedures?

• Have the disclosure controls and procedures been followed consistently in crafting the seller’spublic disclosures?

• Does the seller have a Disclosure Committee and, if so, what function has it played in reviewing theseller’s public disclosures? What is the role of the General Counsel? What is the outside auditor’srole in the process? Some buyers will insist on having their outside auditors evaluate the seller’sfinancial statements and communicate with the seller’s outside auditors, without seller managementpresent. Access to the seller’s outside auditors will be a critical part of the diligence process.

• Does the Audit Committee, or other independent committee of the board of directors, oversee theeffective operation of the seller’s disclosure controls and procedures? What do the minutes of therelevant committee meetings reflect, if anything, in this regard?

II. Does the seller maintain effective internal control over financial reporting?

• Many companies will have to include a management report on internal control for the first timein their 2004 10-Ks in accordance with Sarbox Section 404 and the SEC’s implementing rules –hence the question has arisen whether the report of buyer’s management must encompass the sell-er’s internal control, even if the seller’s operations may not be fully integrated into those of thebuyer. The SEC staff has acknowledged that it might not always be possible to conduct an assess-ment of a seller’s internal control over financial reporting within the period between the consum-mation of the merger and the date the buyer’s management must make its own internal-controlassessment of the combined company. Question 3 of the SEC staff’s June 2004 FAQs on internalcontrol allows buyer’s management to defer reporting on the seller’s internal control, but only ifthe buyer’s management refers in its 404 report to a discussion in its Form 10-K explaining thebasis for the limited scope of management’s assessment – that is, why the 404 report excludes theseller’s business. Additionally, the staff indicates in this FAQ that the period in which managementmay omit an assessment of an acquired business’s internal control over financial reporting from itsown internal-control assessment may not extend beyond one year from the date of acquisition. Normay such assessment be omitted from more than one annual management report on internal con-trol over financial reporting.

CHECKLIST OF ITEMS POST SARBOX


11


• Notwithstanding the accommodation from the SEC staff, can seller’s management give a “clean”internal control assessment? This must be determined during the diligence process, and providedfor in the seller’s representations and warranties.

• If the seller is a public company, is it likely to receive a “clean” audit from its independent auditoron the seller’s internal control over financial reporting? (As noted, this assessment will be required,for the 2004 fiscal year, from many companies’ management under Section 404 of Sarbox).Companies that report on a calendar-year basis to the SEC, and their outside auditors, alreadyshould be assessing the effectiveness of existing financial reporting controls with a view towardremediation where necessary or appropriate to assure compliance by the end of the 2004 fiscal year(the evaluation date for management’s report). We understand that the Big Four accounting firmshave been signaling to audit clients that they may have material control weaknesses that could pre-clude the auditor from issuing a “clean” report as of the close of the December 31 fiscal year-end.(Nor could management conclude that the company’s internal control was effective, in the event ofa material weakness.)

• If the seller has any internal control problems, how will they be corrected and, even if corrected,is there sufficient potential liability exposure on the part of the buyer to warrant abandonment ofthe deal? What sort of disclosure will be made, at a minimum, in the seller’s pre-closing 10-Q’sand 10-K’s regarding possible control deficiencies identified during the due diligence process?

• Have the CEO and CFO of public sellers provided the required SEC certifications under Sections302 (relating to both disclosure controls and procedures and internal control over financial report-ing) and 906 of Sarbox?

III. Are there any issues relating to the seller’s financial statements that are significant enough to interfere withthe ability of the buyer’s CEO and CFO to certify SEC reports in the future?

• Have there been any recent waivers of or amendments to the seller’s code of ethics under Section 406of Sarbox (applicable to the seller’s CEO, CFO and other senior financial officers)? If the seller’sstock is listed on a national stock exchange or quoted in Nasdaq, has the seller established the broad-based ethics code called for by the exchange or Nasdaq under Sarbox-induced revisions to SRO gov-ernance listing standards? Is there any evidence that either or both codes are not being enforced?

• Have there been any concerns or allegations regarding auditor independence; for example, haveactivist institutions withheld votes from audit committee members because of a perception ofexcessive non-audit fees paid to the outside auditor?

• Has the seller’s audit committee fulfilled its enhanced oversight rule under Sarbox? Note likelyrequests from buyers for access to audit committee meeting minutes, whistleblower procedures anddocumentation of complaints, and pre-approval policies.

• Have there been any recent whistleblower complaints received by the audit committee and, if so,how were they handled and by whom? The buyer may request access to logs and other documen-tation relating to treatment of such complaints, at least where they pertain to accounting and audit-ing matters and/or possible CEO/CFO ethics code breaches.

• If the seller’s stock is listed on the NYSE, AMEX or Nasdaq, are the seller’s corporate governancepractices sufficient under the enhanced governance listing standards adopted by these marketsunder Sarbox?

• If any of the seller’s directors will serve on the buyer’s board, are there any “lack of independence”or “conflicts of interest” issues from the buyer’s perspective?

CHECKLIST OF ITEMS POST SARBOX (Continued)

12


• Are there any loans or extensions of credit to the seller’s executive officers and directors in viola-tion of Section 402 of Sarbox?

Several terms have been used throughout the Handbook that require explanation.

• Entity

• This term has been used to describe the activity that is the subject of the due diligence investigation.

• Since due diligence investigations are not limited to the acquisition of one business byanother, such terms as “candidate”, “target” and “seller” are not appropriate.

• Also, the due diligence investigation may be directed toward a division, a subsidiary or mere-ly a portion of a business organization. Therefore, such terms as “company” or “firm” are toobroad to be generally applicable.

• Investigator

• As noted above, due diligence activities are not limited to acquisitions. Therefore, the term“buyer” is not appropriate.

• As used herein, an “investigator” may be an individual or a member of an investigation team.He or she may be an employee of the company exploring a potential acquisition, an outsidelawyer, an investment banker or accountant assisting a client in a potential acquisition orsecurity offering, an appraiser retained to provide an evaluation of an entity, or any other per-son participating in a due diligence investigation.

• Revenue

• The term “revenue” has been used rather than “sales” since it seems a more appropriate termwhen both services and manufacturing activities are considered.

SOME USEFUL DEFINITIONS

CHECKLIST OF ITEMS POST SARBOX (Continued)

13


SECTION 2

HOW TO USE THE DUE DILIGENCE HANDBOOK

CONTENTS

SUBJECT TEXT

Master Copy / Files On CD. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Page Numbering—Text And Forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Use Of Header Block On Form Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

Use Of Footer Block On Form Sheets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

Suggestions For Conducting The Due Diligence Investigation . . . . . . . . . . . . . . . . . . . . 19

15


SECTION 2

HOW TO USE THE DUE DILIGENCE HANDBOOK

All forms in this handbook are available as customizable Word documents. They are on the CD provided inthe back of the book. It is recommended that these files be considered as a “Master Copy.” Immediately uponreceipt of the handbook, one or more “working copies” of the files for the forms should be made and the“master” files stored on a back-up drive filed in a secure location.

This will avoid having to order new “masters” should someone inadvertently use or misplace an original form.

As a reminder, neither the original purchased copy nor any copies of this copyrighted document are to be sold,loaned, given, or otherwise made available to a person or organization unrelated to the original purchaser, orto a related person or organization located at a different site, without the written permission of the publisher.

Within each numbered section the introductory text pages come first, followed by the blank forms.

Section 1 is the Preface and Section 2 describes in detail how to use this handbook.

* The Preface points out what is new in this edition, gives an overview of due diligence, lists com-mon mistakes made by the buyer during due diligence, and enumerates the main disclosure require-ments mandated by federal regulations.

* Section 2 details how to use the book during the due diligence process and points out specific usesof the forms that begin in Section 3.

The forms begin in Section 3. Each section includes introductory text, where the reader will find a descrip-tion of the forms and their use.

Each section also has its own Table of Contents.

* The page numbers under "Text" refer to the page numbers on the bottom of each page of the hand-book. They list the pages in the introductory text on which particular topics and the forms relatedto each topic are discussed.

* The Form numbers are listed in the column to the right.

The name of the entity being investigated may be entered on the top line. As noted in the definitions provid-ed in Section One, this may be a company, a division or subsidiary of a company, or a product line.

The use of the footer block, extending across the bottom of the form sheets is described on the following page.

USE OF HEADER BLOCK ON FORM SHEETS

PAGE NUMBERING—TEXT And FORMS

MASTER COPY / Files On CD

17


The footer block across the bottom of each form can be used in a variety of ways.

Use Of “Reference” Box

The “Reference” box can be used for various purposes.

• To indicate a project number.

• To indicate the priority for completing the forms, e.g.: “A”, “B”, “C”, . . . . etc.; or “A-l”, “A-2”, .. . . etc.

Use Of “Prepared By” Box

The “Prepared By” box should contain the name or initials of the person primarily responsible for complet-ing the form.

This will facilitate locating the originator of the form in the event a question arises regarding informationprovided therein.

• The preparer can be a member of the investigator’s Due Diligence Team or a person on the staff ofthe entity being investigated.

Use Of “Reviewed By” Box

This box should contain the name or initials of the individual charged with the responsibility of reviewing thecompleted form.

• This can be a staff member of the entity being investigated, the leader of the investigating compa-ny’s Due Diligence Team, or possibly the Chief Executive Officer of either entity. It may also bean outside attorney, accountant, or consultant.

Use Of “Revision” Box

Some forms may be capable of being filled out completely and correctly the first time. Others may undergoseveral revisions.

This box provides a means of keeping track of which form represents the latest information.

• It is recommended that the letter “O”, be placed in this box at the time the “Original” entry is made.

• Subsequent revisions can be numbered “1”, “2”, “3”, . . . etc.

Use Of “Date” Box

This box should contain the date the original form or the indicated “Revision” was completed.

Use of “Section” And “Page” boxes

These boxes can be used to designate the location of the completed form in the investigator’s Due DiligenceReport or other document.

Possible Elimination Of The Header And/Or Footer Block

It may not be desirable to include the information provided in the header and footer during the due diligenceactivity in the final Due Diligence Report. In this case the header and/or footer boxes can be trimmed off andthe remaining portion of the page “pasted” on the appropriate page of the final document prior to duplication.

USE OF FOOTER BLOCK ON FORM SHEETS

18


The due diligence process has been likened to peeling a blemished onion. You investigate one layer at a time.Each phase of the investigation uncovers additional items to be explored further. You then move on to the nextphase - and the next - until you reach a conclusion as to whether to continue or to abandon the investigation.

The keys to an efficient investigation are to bring together a team of qualified, professionally oriented individu-als, to determinine the depth of information required and to establish priorities for its collection.

The Team Approach

It is rare to find one, or even two people, who have the breath of knowledge to carry out a thorough due dili-gence investigation - particularly if time is of the essence, as it always seems to be.

If the team approach is adopted it should consist of individuals with the right combination of experience andprofessionalism suitable to the task.

Breath And Depth Of Information Required

The objectives of the investigation will determine the breath and depth of information required.

• If the objective is to qualify a company for a conservatively structured and well collateralized loan,the investigation need only proceed to the point where the borrower’s ability to meet the debt serv-ice payments, under any reasonable set of assumptions, is assured.

• At the other extreme, if the management and Board of Directors of a public company are goingto put their reputations and their shareholder’s investment on the line in a major acquisition, thedue diligence requirements can be staggering. One need only review the low success rate ofacquisitions to become aware of the complexities and need for thoroughness that is involved. Thepotentially different management styles, the need to project the combined earning potential of twodissimilar companies operating as a single unit, and the ability to determine in advance how bestto integrate the two organizations, add greatly to the due diligence requirements.

• The due diligence requirements associated with underwriting a public offering fall somewherebetween these two extremes. In this case the complexities associated with merging two separateorganizations is not a factor. However, investment bankers have a heavy fiduciary responsibility toboth their client and the investing public. Consequently, their due diligence investigation is a vitalpart of their underwriting activities.

The need to meet these varying demands in a single document explains the extent and detail of the informationrequests identified herein. In many cases only a fraction of this information will be required.

Therefore, the second task - after selection of the Due Diligence Team - is for the Team to identify the depthof information required.

Establishing Priorities For The Due Diligence Investigation

After the information requirements have been established, the third very important activity is to establish thepriorities and responsibilities for gathering the data.

One can readily anticipate the reaction of a potential seller of a business if confronted with a request to fillout even a fraction of the forms in this Handbook.

Therefore, it is vital to prioritize the information requests and determine the appropriate member, or members,of the Due Diligence Team to obtain the information.

The loose leaf format of the Handbook is designed to facilitate the prioritization and assignment process.

SUGGESTIONS FOR CONDUCTING THE DUE DILIGENCE INVESTIGATION

19


Periodic Review Meetings

It is recommended that the Chief Executive Officer, or his designee, schedule frequent meetings with the DueDiligence Team.

The primary objectives of these meetings are:

• To obtain status reports from the Team members on their progress.

• To determine when it becomes appropriate to redirect, cancel or otherwise change the course ofthe investigation.

• To determine whether it is appropriate to assign additional personnel to accelerate the effort.

• To determine if it is timely to bring in outside expertise. For example, if tax or pension plan expertshave not been part of the original Team, is it now time to obtain their assistance?

• When is it appropriate to formalize the results of the investigation in a report to the appropriatelevel of management?

20


SECTION 3

OVERVIEW OF ENTITY

CONTENTS

SUBJECT TEXT FORM

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Background Information On Entity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Form 3-01

Financial Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Form 3-02

21


SECTION 3

OVERVIEW OF INDUSTRY AND ENTITY

Introduction

This section, when completed, will provide information that is ordinarily found in the “ExecutiveSummary” section of a Business Plan, Descriptive Memorandum, Offering Circular or similar document.

The objective is to provide the reader with a quick overview of the entity undergoing the due diligenceinvestigation. All of the data summarized herein will appear in greater detail in the appropriate sections ofthe Handbook.

The level and extent of this general business and strategic due diligence will vary, depending on the experi-ence of the buyer in the seller’s industry and its familiarity with the seller company. For example, a financialbuyer entering into a new industry and with no prior experience with the seller should conduct an exhaustivedue diligence – not only on the seller’s company but also on any relevant trends within the industry that mightdirectly or indirectly affect the deal. In contrast, a management buyout by a group of industry veterans whohave been with the seller over an extended period of time will probably need to conduct only a minimumamount of business or strategic due diligence; in this case, the focus will be on legal due diligence and assess-ment and assumption of risk.

Therefore, for a buyer getting to know the seller’s industry, the following two basic questions must be asked:

1) How would you define the market or markets in which the seller operates? What steps will you taketo expedite your learning curve of trends within these markets? What third-party advisors are qual-ified to advise you on key trends affecting this industry?

2) What are the factors that determine success or failure within this industry? How does the seller stackup? What are the image and reputation of the seller within the industry? Does it have a niche? Is theseller’s market share increasing or decreasing? Why? What steps can be taken to enhance or reversethese trends?

Background Information On Entity - Form 3-01

Form 3-01 will provide the information necessary to properly identify the entity, the principal officers and theparent company if the entity is not a stand-alone operation.

The second page of Form 3-01 will identify the major sources of revenue, the estimated market share held bythe entity and the major competitors.

Space is also provided to list significant events that have impacted the entity’s growth and/or financialperformance.

Financial Summary - Form 3-02

This summary, when completed, will provide an overview of the entity’s financial performance over the pastfive years.

23

ENTITY Form 3-01

25

REF. PREPARED BY REVIEWED BY REVISION DATE SECTION PAGE

BACKGROUND INFORMATION ON ENTITY

HEADQUARTERS INFORMATION

STREET/SUITE

CITY/STATE/ZIP

PHONE FAX

IDENTIFICATION NUMBERS

FEDERAL I.D. NO. STATE I.D. NO.

DUN’S NO.

FORM OF ORGANIZATION (1)

PARENT COMPANY (IF APPLICABLE)

TOP MANAGEMENT

CHAIRMAN PRESIDENT

C.E.O. C.F.O.

STATES IN WHICH ENTITY IS LEGALLY QUALIFIED TO DO BUSINESS

[ ] All 50 States [ ] All except: ______________________________________________________________ .

[ ] Specifically: ___________________________________________________________________________ .

FOREIGN COUNTRIES IN WHICH ENTITY CURRENTLY DOES BUSINESS

Note: (1) Examples: public corporation, subsidiary of public corporation, division of public corporation, private corporation, partnership, unincorporated entity, etc.

ENTITY Form 3-01


26

BACKGROUND INFORMATION (Continued)

PRODUCT LINE / SERVICE SUMMARY (1)

PRODUCT LINE / SERVICE NETREVENUE

($000)

PERCENTOF TOTAL

NETREVENUE

ESTIMATEDMARKETSHARE

MAJOR COMPETITORS

$ % %

Total - Above Revenues $ % – –

Total - Entity Revenues $ 100.0% – –

CHRONOLOGY OF SIGNIFICANT EVENTS

Note: (1) Most recent twelve months ending _____________ . Array in descending order of net revenues.

ENTITY Form 3-02

27


FINANCIAL SUMMARY

YEAR NET REVENUE PRETAX INCOME NET INCOME PRETAX INCOMEAS A PERCENT

OF NET REVENUE

NET INCOME AS APERCENT OF

NET REVENUE

(Dollars In Thousands)

20 $ $ $ % %

20

20

20

20

PERCENTAGE CHANGE FROM PREVIOUS YEAR

YEAR NET REVENUE PRETAX INCOME NET INCOME

20 % % %

20

20

20

20

PRETAX RETURN ON AVERAGE EQUITY

YEAR BEGINNING EQUITY ENDING EQUITY AVERAGE EQUITY PRETAX INCOME AS A PERCENT OF

AVERAGE EQUITY


20 $ $ $ %

20

20

20

20


SECTION 4

COMPATIBILITY WITH INVESTMENT/ACQUISITION OBJECTIVES

CONTENTS

SUBJECT TEXT FORMS

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

Compatibility With Investment/Acquisition Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Form 4-01

Compatibility With Investment/Acquisition Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Form 4-02

Potential Impact Of External Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Form 4-03

Potential Benefits From Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Form 4-04

Potential Impact Of Locational Factors On A Prospective Investment . . . . . . . . . . . . . . . . . 32 Form 4-05

Characteristics You May Wish To Avoid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Form 4-06

Why Is The Entity Available?. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Form 4-07

Comparison With Other Potential Investment/Acquisition Candidates . . . . . . . . . . . . . . 33 Form 4-08

29


SECTION 4

COMPATIBILITY WITH INVESTMENT OBJECTIVES

Introduction

The material requested in this section will be of primary interest to individuals or organizations that are con-templating, or in some way participating in, a potential investment in the entity, e.g.:

• A company or individual contemplating the potential acquisition of the entity.

• An investment banker preparing for a public offering or private placement of the entity’s securities.

• A security analyst preparing an evaluation of the potential future trend in the value of the entity’ssecurities.

• A commercial banker or insurance company evaluating a loan request.

• An appraisal firm establishing the fair market value of the entity for estate planning purposes or asthe basis for a “buy/sell” agreement among business partners.

While the reasons for performing a due diligence investigation are diverse, the beneficiaries of the investiga-tion have a common question:

“HOW WELL DOES AN INVESTMENT IN THE ENTITY MEET MY, OR MY CLIENTS, OBJECTIVES?”

The information requests in this section are intended to provide an initial, nonanalytical, screening mechanism.If the responses to the questions posed here indicate a basic incompatibility with the investor’s objectives,there is no point in pursuing the investment further.

• A great deal of time, expense and frustration can be saved by avoiding the heavy analytical workthat is required for a complete due diligence investigation.

The majority of the responses called for in this section apply primarily to evaluating an entity’s compatibili-ty with a prospective buyer’s objectives in a potential acquisition situation.

This is not an accident As noted previously, the due diligence requirements are greatest in a potential acqui-sition situation. Here one is dealing with all the issues that come into play within each organization operatingseparately - with the added challenge of merging them into a single, finely tuned organization.

Compatibility With Investment/Acquisition Objectives - Form 4-01

Form 4-01 is designed to identify a potential investor’s primary investment objectives. When completed, thisform will provide the basis for an initial screening of alternative investment opportunities.

Needless to say, very few investment opportunities will meet all of a potential investor’s objectives. Therefore,it is desirable to establish a system for ranking the degree of importance a potential investor places on eachof the characteristics.

Compatibility With Investment/Acquisition Criteria - Form 4-02

As long as the potential investors/acquirors are realistic in their expectations, it is anticipated that manyopportunities will pass the “objective” screening. To further reduce the number of opportunities to a man-ageable level, it is desirable to apply selected financial criteria to the potential investments that pass the ini-tial screening. Form 4-02 is provided for this purpose.

31


Potential Impact Of External Factors - Form 4-03

External factors can have a significant impact on the success of an investment. Form 4-03 provides an unso-phisticated, nonanalytical, method for evaluating these potential impacts.

• Check marks can be placed in the appropriate column opposite each of the identified factors.

• A simple count of the number of check marks in each column will provide a clue as to the poten-tial impact of these events and trends.

• While the number of marks alone is not very significant, comparing the number of positive andnegative marks of alternative investments can be meaningful.

Also identifying in advance where the opportunities and risks lie will permit an alert management to maxi-mize the benefits from the positive factors and minimize the impact of the negative factors.

Potential Benefits From Acquisition - Form 4-04

Form 4-04 provide a similar means for determining, on a nonanalytical basis, where the major benefits andrisks may lie in a potential acquisition. Many of the initial responses will be obvious from the nature of theproposed acquisition. However, the final responses to many of the items listed will depend on the results ofanalyses called for in the subsequent sections of the Handbook.

Here again, the primary benefit of this cursory analysis is to alert the potential acquiror’s management to theareas of potential risk so that the impact of these risks can be minimized. This preliminary analysis will alsoinfluence where the Due Diligence Team should concentrate its efforts in the subsequent reviews.

Potential Impact Of Locational Factors - Form 4-05

Many an investment, be it the purchase of shares in a company or the acquisition of the entire company, haslooked good on paper but failed due to locational factors.

• The flight of many companies to the sunbelt areas of the U.S. is one example.

• The recent flight of companies to areas with favorable labor and/or tax environments is anotherexample.

Form 4-05 was developed to identify the benefits and potential problems associated with investments in dif-ferent geographic areas.

Characteristics You May Wish To Avoid - Form 4-06

Form 4-06 list a number of characteristics of businesses you may wish to avoid in your investment strategy.

It is important to point out that many successful businesses have one or more of these characteristics. Therefore,they should not be looked upon as fatal weaknesses, but rather as items that present special challenges.

Some companies have found profitable “niches” in operations that discourage potential competitors. Theimportant consideration is to be aware of how your investment, or your client’s investment, intends to over-come, or benefit from these potential difficulties.

Why Is Entity Available? - Form 4-07

Knowledge of why an entity is available for acquisition is a vital input to the purchase decision. Form 4-07list some of the major reasons why owners of private companies or boards of directors of public companieschoose to sell a business.

Space has been provided to list both the “stated” reason and other possible reasons that may surface during thedue diligence investigation. The important point is: do not accept the stated reason without further investigation.

The answers to the questions posed in the box at the bottom of Form 4-07 can also be revealing - if accurateanswers are forthcoming.

32


Comparison With Other Potential Investment/Acquisition Candidates - Form 4-08

One of the most critical due diligence skills in the ability to compare/contrast investment or transactionalopportunities which as similarly situated or which may offer difficult but equally compelling features. Thischecklists with this analytical process.

33

ENTITY Form 4-01

35


COMPATIBILITY WITH INVESTMENT/ACQUISITION OBJECTIVES

INDUSTRY/BUSINESS PREFERENCES RANK ENTITY FIT

Ranking system: (1) Highly desirable. (2) Desirable. (3) Open to consideration.

CHARACTERISTICS DESIRED RANK ENTITY FIT

Management will stay.

Effective management style.

Depth of management.

Long product life cycle.

Noncyclical.

Little or no seasonal variation.

Not capital intensive.

Not energy intensive.

Not labor intensive.

Nonunion work force.

Low technology.

High technology.

Good product/service reputation.

Minimum market share(s) of _________ %.

No dominant competitors.

State-of-the-art facilities and equipment.

Minimal environmental impact.

Ranking system: (1) Essential. (2) Desirable. (3) Not important.

ENTITY Form 4-02


36

COMPATIBILITY WITH INVESTMENT/ACQUISITION CRITERIA

CRITERIA VALUES SOUGHT ENTITY


Range Of Investment $ __________________ To $ __________________

Potential Three Year Appreciation InCommon Stock Price

Minimum Of _______ %

Dividend Return On Common Shares


Coupon Rate On Preferred Shares Minimum Of _______ %

Interest Rate On Straight Bonds Minimum Of _______ %

Interest Rate On Convertible Bonds Minimum Of _______ %

Annual Net Revenue Minimum Of $ __________________

Five Year Average Revenue Growth Minimum Of _______ %

Annual Pretax Income Minimum Of $ __________________

Five Year Average Pretax IncomeGrowth


Pretax Return On Net Revenues Minimum Of _______ %

Pretax Return On Assets Minimum Of _______ %

Pretax Return On Net Worth Minimum Of _______ %

Pretax Return On Investment Minimum Of _______ %

Debt/Equity Ratio No Greater Than _______ %

Price/Pretax Earnings Ratio Maximum Of _______ : 1

Premium Above Net Worth Maximum Of _______ %

ENTITY Form 4-03

37


POTENTIAL BENEFIT NOIMPACT

NEGATIVE SOMEWHATPOSITIVE

VERY POSITIVE

FOREIGN GEOPOLITICAL FACTORS

Continued conflict in the Middle East

Improvement In relations with Russia

Terrorism

Expansion of NATO

Increasing importance of Pacific Rim countries:

In international trade

In political influence

Integration of the European common market

Strength of euro

Growth of Indian economy

Continued growth of Asian imports to U.S.

Growth of China market

Continued growth of Chinese imports to U.S.

Potential change in relations with Cuba

North American Free Trade Agreement - NAFTA

Global Financial Crises

Increasing foreign investment in U.S. industry

Increasing foreign competition

Privatization of previously government owned activities

POTENTIAL IMPACT OF EXTERNAL FACTORS

ENTITY Form 4-03


38

POTENTIAL IMPACT OF EXTERNAL FACTORS (Continued)



VERY POSITIVE

MAJOR DOMESTIC ECONOMIC AND DEMOGRAPHIC FACTORS

Changing age distribution of the U.S. population

Population movement toward sunbelt regions

Business relocation away from congested urban areas

Increasing participation of women in government,management and the professions

Increasing number of two-wage-earner families

Increasing home employment opportunities

Increasing requirement for child day care facilities

Increasing cost of medical procedures

Increasing trend toward telecommuting

Legislation re balancing the budget

Legislation re health-care reform

Legislation re improving education

Increasing energy costs

Increasingly stringent environmental regulations

Increasing highway congestion

Increasing waste disposal problems

TECHNOLOGICAL FACTORS

Integration of computer and communications systems

Increasing power and lower cost of personal computers

Utilization of world wide web and internet

Development of multimedia technology

Miniaturization of electronic components and equipment

Advances in fiber optic technology

Advances in genetic engineering

Development of electric powered vehicles

Advent of an economic supersonic transport

Development of high speed rail services

Deregulation of previously regulated industries

ENTITY Form 4-04

39




VERY POSITIVE

POTENTIAL ADMINISTRATIVE BENEFITS

Source of needed management skills

Improves age distribution of management staff

Improves depth of management

Enhances individual managers growth opportunities

Permits consolidation of management functions

POTENTIAL DATA PROCESSING BENEFITS

Increases utilization of existing facilities

Justifies acquisition of more powerful system(s)

Permits sale of surplus equipment

POTENTIAL MARKETING BENEFITS

Eliminates a competitor

Improves competitive position

Improves market share

Expands products/services offered to existing customerbase

Expands customer base

Extends geographic boundaries of market - Domestic

Extends geographic boundaries of market - Foreign

Reduces volitility of sales due to economic conditions

Reduces seasonal variation in sales

Reduces impact of inflation

Permits replacement of obsolete and/or slow growth products or services

Reduces dependency on sales to the defense industry

Reduces dependency on sales to other government agencies

Permits consolidation of sales facilities

Permits consolidation of sales personnel

Gains valuable patents, copyrights and/or trademarks

POTENTIAL BENEFITS FROM ACQUISITION

ENTITY Form 4-04


40

POTENTIAL BENEFITS FROM ACQUISITION (Continued)



VERY POSITIVE

POTENTIAL FINANCIAL BENEFITS

Increase growth in earnings

Increase earnings per share:

Immediate post acquisition

Near term expectation

Improve earnings ratios:

Return on equity

Return on assets

Return on sales

Improve stability of revenues and earnings

Reduce seasonal variation in revenues and earnings

Increase cash flow

Enhance cash position from sale of surplus assets

Improve debt/equity ratio

Enhance borrowing capacity

Potential for upgrading undervalued assets

Sale of underperforming activities

Utilization of tax loss carry forwards

Improve credit standing with suppliers

Improve credit rating of debt securities

Improve market valuation of equity securities

Improve price/earnings ratio of shares

Obtain listing on public exchange:

To provide liquidity for existing shareholders

To have vehicle for future public offerings

To provide shares for subsequent acquisitions

To broaden ownership in Company

Qualify for listing on higher level exchange

Reduce ownership of major existing shareholder(s)

ENTITY Form 4-04

41




VERY POSITIVE

POTENTIAL PRODUCTION BENEFITS

Utilization of excess capacity

Obtains needed additional capacity

Increased volume provides economies of scale

Obtains advanced production skills and/or equipment

Justifies purchase of advanced state-of-the-art equipment

Retirement of obsolete facilities and/or equipment

Increased volume results in more favorable prices and termsfrom suppliers

Reduces impact of increasing union demands

Obtains access to lower cost production labor

Reduces inventory levels through elimination of one complement of “safety” stocks

POTENTIAL DISTRIBUTION BENEFITS

Consolidation of warehouse facilities and/or equipment

Justifies acquisition of more automated warehouse equipment

Permits sale of surplus facilities and/or equipment

Increased volume improves ability to negotiate reductions in freight rates

Candidate’s distribution facilities closer to customers

POTENTIAL NEW PRODUCT DEVELOPMENT BENEFITS

Consolidation will Increase utilization of surplus capacity

Adds additional and/or complementary research skills

Adds additional research facilities and equipment

Permits sale of obsolete and/or redundant facilities

Reduction of redundant personnel

Obtains access to candidate’s secret technology

Reduces product development time


ENTITY Form 4-04


42




VERY POSITIVE

POTENTIAL HUMAN RESOURCE BENEFITS

Improve job security for employees

Opportunity to improve fringe benefit package

Enhance employees’ life style through relocation

Reduce vulnerability to increasing union demands

POTENTIAL PUBLIC RELATIONS BENEFITS

Enhance public image

Enhance investor image

OTHER POTENTIAL BENEFITS

ENTITY Form 4-05

43


LOCATIONAL FACTOR NOIMPACT


VERY POSITIVE

Environment for production personnel

Environment for professional personnel

Proximity to customers

Proximity to suppliers

Availability of advanced communication services

Transportation facilities:

Proximity to expressways

Proximity to rail facilities

Proximity to air transportation facilities

Proximity to water transportation facilities

Ability to accommodate expansion:

Availability of existing facilities

Availability of vacant land for new construction

Local construction restrictions

Local construction costs

Local weather conditions

Local energy costs

Local environmental restrictions

Local government financial incentives

Tax concessions

Investment incentives

Revenue bond financing

Underwrite relocation costs

Underwrite training expenses

POTENTIAL IMPACT OF LOCATIONAL FACTORS ON A PROSPECTIVE INVESTMENT

ENTITY Form 4-06


44

CHARACTERISTICS YOU MAY WISH TO AVOID

CHARACTERISTIC DOES ENTITY HAVETHIS

CHARACTERISTIC

AVOID WILLCONSIDER

GENERAL

Business you don’t know.

MANAGEMENT

One man company.

Lack of management depth.

Significantly different management style.

TYPE OF BUSINESS

Short product life cycle

Highly cyclical.

Highly seasonal.

High technology.

Mature product lines.

Heavy government regulation.

Heavy reliance on defense business.

COMPETITIVE ENVIRONMENT

Low market share.

Much larger and/or stronger competitors.

Competitors have significant cost advantage(s).

Poor reputation vis-a-vis competitors

ENTITY Form 4-06

45


CHARACTERISTIC DOES ENTITY HAVETHIS

CHARACTERISTIC

AVOID WILLCONSIDER

PRODUCTION CHARACTERISTICS

Obsolete or rundown facilities.

Obsolete or rundown equipment.

Processes involve environmental problems.

Labor intensive.

High labor cost environment.

Unionized.

Energy intensive.

High energy costs.

FINANCIAL CHARACTERISTICS

Capital Intensive.

Highly leveraged post-acquisition.

Acquisition involves substantial goodwill.

Acquisition will dilute earnings and/or book value per share.

Poor record of meeting financial projections.

OTHER CHARACTERISTICS TO BE AVOIDED

Past hazardous waste disposal practices.

Potentially costly litigation.

CHARACTERISTICS YOU MAY WISH TO AVOID (Continued)

ENTITY Form 4-07


46

WHY IS THE ENTITY AVAILABLE?

REASON NOT APPLICABLE

STATED REASON(S)

OTHER POSSIBLEREASONS

OWNERS PERSONAL REASONS

Wishes to retire:

Has no heirs to take over.

Employees are not financially able to fund the acquisition.

Wants to “go fishing.”

Has a health condition.

Tired of working long hours.

Wishes to get into less demanding activities.

Tired of the heavy responsibility.

Desire for liquidity:

To get estate in order.

To invest in another activity.

Offered a more attractive opportunity.

Involved in a divorce settlement.

BUSINESS REASONS

Business is not currently producing adequate level of earnings.

Increasing competition from stronger and/or lower cost producers.

Future earnings are expected to deteriorate due to:

Increasing wage and/or benefits demands by labor.

Increasing operating costs.

Increasing debt service costs.

Increasing taxes.

Cannot, or does not wish to make the heavy expenditures required to:

Expand and/or automate facilities to remain competitive.

Develop new and/or updated products.

Meet new environmental regulations.

Meet new OSHA regulations.

ENTITY Form 4-07

47


REASON NOT APPLICABLE

STATED REASON(S)

OTHER POSSIBLEREASONS

BUSINESS REASONS (Continued)

Dispute between partners or controlling shareholders.

Expectation that the current selling price is potentially greater than can be anticipated in the future.

Poor market conditions for raising needed capital infusion.

Deteriorating revenue and/or earnings trend.

Unsettled market for equity offering.

Potential loss of control to obtain required funds.

High interest cost associated with debt offering.

Severe restrictions imposed by potential lenders.

Anticipated benefits from being associated with a stronger, morediversified, firm.

To avoid having to file for bankruptcy.

To avoid an unfriendly takeover.

OTHER REASONS

EXPERIENCE TO DATE IN SELLING THIS ENTITY

Is it common knowledge that this entity is available? [ ] Yes [ ] No.

How long has the entity been on the market? __________ months.

What other companies are known to have looked at this entity? __________________________________

Is the entity known to have received any firm offers? [ ] Yes [ ] No.

If so, from whom? ______________________________________________________________________

WHY IS THE ENTITY AVAILABLE? (Continued)

ENTITY Form 4-08


48

COMPARISON WITH OTHER POTENTIAL INVESTMENT/ACQUISITION CANDIDATES

WHAT OTHER ENTITIES MEET MOST OF THE SAME INVESTMENT/ACQUISITION CRITERIA?

HOW DOES THIS ENTITY RANK AGAINST OTHER SIMILAR INVESTMENT/ACQUISITION CANDIDATES?

ENTITY RANK ENTITY RANK

WHAT ARE THE PRINCIPAL REASONS THIS ENTITY SHOULD BE GIVEN PREFERENCE FOR FURTHERCONSIDERATION?


SECTION 5

CAPITALIZATION AND OWNERSHIP

CONTENTS

SUBJECT TEXT FORM

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Summary Of Capitalization. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Form 5-01

Capitalization - Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Form 5-02

Common Stock - Miscellaneous Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Form 5-03

Common Stock - Dividend Record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Form 5-04

Common Stock - Price And Trading Volume . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Form 5-05

Common Stock - Holders Of More Than Four Percent Of Shares. . . . . . . . . . . . . . . . . . 55 Form 5-06

Capitalization - Preferred Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Form 5-07

Preferred Stock Dividend Record . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Form 5-08

Capitalization - Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Form 5-09

Bond Yields And Major Bond Holders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Form 5-10

49


SECTION 5

CAPITALIZATION AND OWNERSHIP

Introduction

This section, when completed, will describe the elements of the entity’s capital structure and the ownershipof the securities that are an integral part of this structure.

Summary Of Capitalization - Form 5-01

Form 5-01 will provide an overview of the entity’s capital structure. Additional details, related to the long-term debt and equity components, are described in Sections 22 and 23 of this Handbook.

Before launching into a discussion of the individual elements of the capital structure, it is important toreview the major obligations that are included in the entity’s long term debt.

• The long-term portion of notes due banks, insurance companies and other lenders.

• The long-term portion of debt securities.

• The long-term portion of mortgage loans.

• The long-term portion of capitalized leases.

• The long-term portion of accrued warranty costs.

The comments below suggest what to look for in this completed form.

WHAT TO LOOK FOR

Debt/Equity RatioThe financial community places great emphasis on the overall ratio of long-term debt to share-holders’ equity. As will be noted in Section 29, many analysts get nervous if the long-term debtexceeds the shareholders’ equity.

While this should be considered a “red flag,” it should not, by itself, be the sole determinantof an entity’s long-term credit worthiness.

Other measures, such as the number of times the projected “free cash flow” covers the debtservice payments, should be given consideration. This measure is also discussed in greaterdetail in Section 29.

Interest RatesThe entries in the long-term debt section of this form will indicate what the entity is payingfor the funds it has borrowed from banks, insurance companies and other long-term lenders -and from the investing public on its bonded debt. Needless to say, the higher the interest rate,the greater the drag on profits and cash flow.

Compare the interest rates with the amount of the debt they represent. If abnormally high inter-est rates apply to the largest portions of the debt, they will have a greater impact on profits andcash flow.

As will be noted subsequently, bonded debt frequently contains a “call” feature: bank andinsurance company notes can frequently be paid off before maturity with little or no penalty.Consequently, if the entity is generating sufficient cash, it may be appropriate to liquidate orrefinance the high interest rate obligations.

51


Summary Of Capitalization - Form - 5-01 (Continued)

The features to look for in the individual forms of debt and equity securities are discussed below.

Capitalization - Common Stock - Form 5-02

Form 5-02, when completed, will provide a reconciliation of the number of authorized shares of commonstock, the number of shares outstanding, and the shares that are reserved for various purposes.

If more than two classes of common stock have been issued, additional forms will be required.

WHAT TO LOOK FOR

Potential DilutionIt is particularly important to focus on the number of reserved shares in comparison to the num-ber of currently outstanding shares. These shares, if and when issued, may represent a signifi-cant dilution in the value of the previously issued shares.

This potential dilution is important to individual shareholders, who may suffer a loss in themarket value of their shares.

Management’s position on shares reserved for employees is that the benefits that result frommore motivated employees offset the potential dilution.

The rationale behind the shares reserved for potential conversion of other securities is that theyprovide a “sweetener” that reduces the cost of the funds generated from the sale of the underlying security.

The potential dilution can also be of major significance in valuing an entity’s shares in aprospective acquisition situation. The potential dilution will impact the share price in a pur-chase of stock acquisition and the exchange ratio in a stock-for-stock transaction.

Consequently, depending on the timing and the precise terms of the various purchase or con-version agreements, it may be appropriate to base all investment decisions on the fully dilutedvalue of the shares.

Acceleration Of Purchase and/Or Conversion DatesIt is important, in a potential acquisition, to review the underlying employee stock purchaseplans and convertible security documentation. Some of the plans and securities provide for theacceleration of the purchase or conversion dates in the event the entity is acquired by, or merg-ered with, another firm.

Restricted StockIf restricted stock represents a significant portion of the total shares, the reasons for the restric-tions and the terms under which the restrictions can be lifted, should be obtained.

WHAT TO LOOK FOR (Continued)

Preferred Stock Coupon RateIn most cases preferred stock is issued by companies that have fairly consistent and predictableearnings. Consequently, coupon rates (equivalent to the interest rates on bonds) are usually onthe low side.

However, if they appear out of line on the high side, they should receive the same treatment ashigh interest debt obligations. This is particularly true if they have a “call” feature.

52


Common Stock - Miscellaneous Information - Form 5-03

It is often assumed that “common stock is common stock.” That is, all common stock issued by a companyhas virtually the same features. Not so! Form 5-03 identifies some of the major differences that can exist.

Theoretically the existence or nonexistence of many of these features should impact the market’s evaluation ofthe shares. As a practical matter most shareholders do not know whether their shares carry or don’t carry theseprovisions. A surprisingly high percentage of shareholders do not appreciate the significance of these factors.

These features can, however, become very important in an acquisition situation.

The history of recent common stock offerings, presented in the the middle table on Form 5-03, will helpgauge the investment community’s past response to the entity’s public offerings. A favorable trend will makeit much easier for a buyer to finance the acquisition if outside funds are necessary.

Common Stock - Dividend Record - Form 5-04

A stock’s dividend record is of paramount importance to a large segment of the investment community. Form5-04 is provided to record this information.

WHAT TO LOOK FOR

Cash DividendsA steady increase in the dividend over time is preferred to one that fluctuates, even though thepeak rate may be higher. No one objects to an increase in a firm’s dividend. However, the needto subsequently reduce the dividend can play havoc with the stock’s market price. Therefore,in establishing the dividend, management should select one that can be sustained under veryconservative earnings projections without depriving the company of funds needed for prof-itable expansion opportunities.

Dividend Payout RateThe dividend payout rate is the percentage relationship between the dividends paid and theentity’s earnings.

Investors looking for long term market appreciation do not like to see a consistent dividendrecord being maintained at the expense of too high a payout rate. Too high a payout canadversely impact the entity’s ability to fund potential growth opportunities.

Dividend YieldInvestors looking for current income pay particular attention to the yield represented by thedividends.

WHAT TO LOOK FOR

In a potential acquisition situation the percentage of shareholders that is required to approvesuch an action is of obvious importance.

If shareholder’s have appraisal rights, this feature can result in an expensive and time consuming valuation.

Restrictions on transferability, or using the shares as collateral, can also present problems.

A thorough review of the Security And Exchange Commission’s mandated RegistrationStatement(s) by a qualified corporate attorney is highly recommended.

53


Common Stock - Dividend Record - Form 5-04 (Continued)

Common Stock - Price And Trading Volume - Form 5-05

Form 5-05 provides for recording the high and low prices of the entity’s common stock by quarter over thelast five years, the annual price/earnings ratio and the trading volume in number of shares and averageannual turnover.

WHAT TO LOOK FOR

Price RangeThe per share price generally reflects investor’s expectations with respect to future earnings pershare. Consequently, the more volatile the expectations the greater the spread between the highand low price range. Therefore, the lower the spread the better.

If there have been changes in the number of shares outstanding due to splits or reverse splits,it is important that the appropriate adjustments be made prior to being recorded here.

The price per share has no significance for comparative purposes since firms have varyingnumbers of shares outstanding.

Price/Earnings RatioThe price/earnings ratio, on the other hand, has significance for comparative purposes. Theinvestor’s view of the quality of the earnings (i.e.: stability, accounting conservatism, etc.) andthe company’s growth potential are the major determinants of the multiplier the investmentcommunity will assign to the firm’s earnings, regardless of the number of shares.

Trading Volume And TurnoverAs is the case with the per share price, the absolute value of the trading volume has little sig-nificance. However, the turnover in the shares, as a percentage of the total shares outstanding,is indicative of the market action.

An important trend to look for in a potential acquisition situation is the near-term activity in theentity’s shares. An abnormally high turnover may indicate that one or more other companies havedesigns on the entity. It may also indicate that the word has gotten out that someone is consider-ing acquiring the entity - and they are hoping to benefit from the increasing stock price that oftenaccompanies such a transaction.

WHAT TO LOOK FOR (Continued)

Stock DividendsThe bottom chart on Form 5-04 requests information on stock dividends. The issuance of a stockdividend may reflect a temporary cash shortage. The firm may not have sufficient cash to pay acash dividend - yet wishes to maintain a record of uninterrupted dividends.

It is important, however, to gather the facts before concluding that a stock divided this is a neg-ative event. Rather than pay a cash dividend, management may have rightly concluded that itwas more opportune to use the funds elsewhere - for example, to paydown high interest debt,to upgrade its facilities or to make an acquisition.

54


Common Stock - Major Shareholders - Form 5-06

Form 5-06 provides for the listing of all shareholders who own more than four percent of the entity’s common shares.

The form also provides for the identification of any relationships, either personal or business, that suggest thatany of the individually identified shareholders may vote their shares as a group.

Preferred Stock - Forms 5-07 And 5-08

In the event the entity has issued preferred stock, the characteristics of the issue (or issues) should be enteredin Form 5-07. The dividend record on these securities should be entered in Form 5-08.

The periodic dividend payments on this type of security generally represent a fixed charge. Therefore, theyare frequently issued by firms whose future earnings are fairly predictable, e.g.: public utilities.

Where they are issued by firms whose earnings are less predictable, they usually represent a relatively smallportion of the total capitalization.

WHAT TO LOOK FOR

Dividend PaymentsIn the event the dividend payments represent a significant portion of an entity’s earnings orcash flow, consideration should be given to “calling” the shares at an early date. The existenceof specified call and/or conversion dates in the Registration Statement does not preclude thecompany from making an offer to repurchase and/or exchange these securities at any time aspart of a refinancing package.

Dividend PayoutMost preferred stocks have a fixed dividend. However, some “participating” or “income” pre-ferred stocks have been issued.

Dividend YieldAs noted in the comments on common stock, investors looking for current income pay partic-ular attention to the yield represented by dividends.

WHAT TO LOOK FOR

Who Is In ControlControl of a corporation will generally rest with the shareholders who appear on this list.

This will be particularly true in the case of a potential acquisition of a publicly held corporation.Most by-laws require that a sale or merger of the company must be approved by a majority ofthe shareholders. In such cases the Board Of Directors may recommend approval or disapprovalbut cannot consummate the transaction without the required shareholder acceptance.

Potential AlliancesAlthough an individual shareholder on this list may not appear to be in a controlling position,they may be allied with other shareholders so as to represent a controlling force. Therefore, itis important to identify such alliances and their combined shareholdings.

55


Bonds - Forms 5-09 And 5-10

Form 5-09, when completed, will summarize the most common characteristics of corporate bonds. However,the fertile minds of the investment banking community are constantly coming up with new twists.Consequently, if the entity has some of these hybrid securities outstanding, it may be necessary to list theircharacteristics on a separate page.

Form 5-10 will provide information on the current yield and ownership of the entity’s bonds.

WHAT TO LOOK FOR

If the entity is covering the debt service payments on its bonds with a comfortable margin, andcan confidently be projected to do so in the future, the main concern may be to determine ifprofits can be improved by refinancing the bonds to take advantage of lower interest rates thatmay be available.

However, if the bonds are in default, or could possibly be in default at some future time, some ofthe terms and conditions contained in the Indenture Agreement can have serious consequences. Aqualified corporate attorney should review these Agreements on all outstanding issues.

Security ProvisionsAlthough defaulted secured bondholders may not have voting rights, if the security they holdis vital to the ongoing operation of the company, they are in an extremely strong position to dic-tate how the company is reorganized. As an alternative they may be able to demand (somemight call it “extort”) favorable redemption terms.

Consequently, the form of the security and its terms under default conditions can becomevery important.

Debt Service RequirementsRequirements for sinking funds and/or serial retirement of the bonds can have a significantimpact on the entity’s cash flow.

Potential DilutionThe exercise of warrants that may be attached to the bonds and/or conversion features may rep-resent substantial future dilution of the current shareholders’ equity. (See Form 5-02.)

56

ENTITY Form 5-01

57


SUMMARY OF CAPITALIZATION

Notes: (1) As of _________________ . (2) As of _________________ , [ ] Audited [ ] Unaudited.

FORM OF CAPITAL AS OF MOST RECENT AUDIT

(1)

AS OF LATESTQUARTER

(2)

LONG-TERM DEBT

$ $

Less Current Portion $ $

Total Long-Term Debt $ $

PREFERRED STOCK

$ $

COMMON STOCK

$ $

ADDITIONAL SHAREHOLDERS’ EQUITY

Additional Paid-In Capital $ $

Retained Earnings

Adjustments (Currency translation, pension funds, etc.)

Treasury Stock At Cost

Total Shareholders’ Equity $ $

Total Capital (Long-Term Debt + Shareholders’ Equity) $ $

ENTITY Form 5-02


58

CAPITALIZATION - COMMON STOCK

DESCRIPTION SINGLE CLASS OR CLASS A

CLASS B NOTES

NUMBER OF SHARES AND SHAREHOLDERS

Currently Outstanding

Reserved For Stock Option/Bonus Plans

Reserved For Stock Purchase Plans

Reserved For Employee Stock Ownership Plan

Reserved For Conversion Of Warrants

Reserved For Conversion Of Preferred Stock

Reserved For Conversion Of Bonds

Reserved For Other Purposes

Total Outstanding And Reserved

Treasury Stock

Total Currently Authorized

Number Of Restricted Shares

Number Of Shareholders

LISTING INFORMATION

Exchange Where Listed

Stock Symbol

Lead Underwriter(s)

NOTES

ENTITY Form 5-03

59


COMMON STOCK - MISCELLANEOUS INFORMATION

SHAREHOLDER RIGHTS

Shareholders’ meeting notice period. Days

Percent of shareholders required to approve sale or merger. %

Do shareholders have preemptive rights?

Do shareholders have liquidation preference?

Do shareholders have dividend preference?

Do dissenting shareholders have appraisal rights?

Is there cumulative voting for directors?

Are director’s terms staggered?

PAR VALUE

Par Value - Dollars/Share

RECENT COMMON STOCK OFFERINGS

ITEM MOST RECENT NEXT MOST RECENT THIRD MOST RECENT

Effective Date

Number of shares

Price per share

Market value

Net proceeds

MISCELLANEOUS ITEMS

Are all the shares validly issued, fully paid, and nonassessable? [ ] Yes [ ] No If not, please explain:

Are there any restrictions on transferability? [ ] Yes [ ] No If so, please explain:

Are there any restrictions against the use of these shares as collateral? [ ] Yes [ ] No If so, explain:

Are there any “buy-sell” agreements between shareholders? [ ] Yes [ ] No If so, please explain:

ENTITY Form 5-04


60

COMMON STOCK - DIVIDEND RECORD

Note: (1) As of ___________________ .

DIVIDEND RECORD - DOLLARS PER SHARE

PERIOD 20 20 20 20 20

First Qtr. $ $ $ $ $

Second Qtr.

Third Qtr.

Fourth Qtr.

Year $ $ $ $ $

DIVIDEND PAYOUT

YEAR 20 20 20 20 20

Dividends Per Share $ $ $ $ $

Earnings Per Share

Dividend Payout % % % % %

CURRENT YIELD (1)

Indicated Annual Dividend Per Share $

Price Per Share $

Indicated Yield %

STOCK DIVIDENDS

Has the Company issued stock dividends during the last five years? [ ] Yes [ ] NoIf so, please provide the details.

ENTITY Form 5-05

61


PERIOD 20 20 20 20 20

PRICE - HIGH/LOW lN DOLLARS PER SHARE

First Qtr. / / / / /

Second Qtr. / / / / /

Third Qtr. / / / / /

Fourth Qtr. / / / / /

AVERAGE ANNUAL PRICE / EARNINGS RATIO

Annual Ratio : 1 : 1 : 1 : 1 : 1

TRADING VOLUME - NUMBER OF SHARES

First Qtr.

Second Qtr.

Third Qtr.

Fourth Qtr.

Year

AVERAGE ANNUAL TRADING TURNOVER AS A PERCENT OF TOTAL SHARES OUTSTANDING

Annual Turnover % % % % %

YEAR-TO-DATE PERFORMANCE

PRICEPERFORMANCE

HIGH/LOW LAST YEAR

HIGH/LOW THIS YEAR

P/E RATIO LAST YEAR

P/E RATIO THIS YEAR

As Of _______ / / : 1 : 1

TRADINGVOLUME

VOLUME - LASTYEAR-TO-DATE

VOLUME - THISYEAR-TO-DATE

TURNOVER LAST YEAR

TURNOVER THIS YEAR

As Of _______ % %

COMMON STOCK - PRICE AND TRADING VOLUME

ENTITY Form 5-06


62

COMMON STOCK - HOLDERS OF MORE THAN FOUR PERCENT OF SHARES

Note: (1) Array in order of declining percentage ownership.

(2) Percentage based on total of ____________________ shares outstanding.

Note: If the group is represented by one or more board members, please identify them.

SHAREHOLDER SHARESHELD(000)

PERCENT OFTOTAL

SHAREHOLDER SHARESHELD(000)

PERCENT OFTOTAL

(As Of ___________________ )

% %

Total Shares Owned By Above Shareholders (2) %

DESCRIBE ANY RELATIONSHIPS THAT SUGGEST THAT ANY OF THE ABOVE INDIVIDUAL SHAREHOLDERS MAY VOTE AS A GROUP

Family Relationships, Company Management, Shares In Same Voting Trusts, Etc.

ENTITY Form 5-07

63


CAPITALIZATION - PREFERRED STOCK

DESCRIPTION ISSUE OF_______________

ISSUE OF_______________

DISTRIBUTION OF SHARES

Shares Outstanding

Number Of Shareholders

FEATURES

Par Value $ per share $ per share

Coupon rate % %

Are dividends current?

Are dividends subordinated?

If so, to what?

Are dividends cumulative?

Is there a sinking fund requirement?

Do these shares participate in earnings?

Do these shares currently have voting rights?

Will they have voting rights if dividends are in arrears?

Are these shares convertible into common stock?

Are there staggered conversion dates and prices?

What is the earliest conversion date?

What is the earliest conversion price? $ per share $ per share

Are these shares callable?

Are there staggered call dates?

What is the earliest call date?

What is the earliest call price? $ per share $ per share

Who were the lead underwriters?

LISTING INFORMATION

Public or private placement

Exchange where listed

Stock symbol

ENTITY Form 5-08


64

PREFERRED STOCK - DIVIDEND RECORD

DIVIDEND RECORD - DOLLARS PER SHARE

PERIOD 20 20 20 20 20

First Qtr. $ $ $ $ $

Second Qtr.

Third Qtr.

Fourth Qtr.

Year $ $ $ $ $

DIVIDEND PAYOUT

YEAR 20 20 20 20 20

Dividends Per Share $ $ $ $ $

Earnings Per Share

Dividend Payout % % % % %

CURRENT DIVIDEND YIELD (1)

Indicated Annual Dividend Per Share $

Price Per Share $

Indicated Yield %

DIVIDEND ARREARAGES

Has the entity or its parent experienced an arrearage on its preferred dividends during the last five years?

[ ] Yes [ ] No If so, when, what amounts, and for how long?

Note: (1) As of ___________________ .

ENTITY Form 5-09

65


CAPITALIZATION - BONDS

DESCRIPTION ISSUE OF__________________

ISSUE OF__________________

DISTRIBUTION OF BONDS

Bonds Outstanding

Number Of Bondholders

FEATURES

Denomination $ per bond $ per bond

Interest rate % %

Are payments current?

Are bonds secured or unsecured?

Are payments subordinated?

If so, to what?

Is there a sinking fund requirement?

Are there serial maturities?

Do these bonds participate in earnings?

Will bonds have voting rights if payments are in default?

Were warrants attached to these bonds?

If so, for how many shares?

When can they be exercised?

What is the exercise price?

Are these bonds convertible into common stock?

Are there staggered conversion dates and prices?

What is the earliest conversion date?

What is the earliest conversion price?

Are these bonds callable?

Are there staggered call dates and prices?

What is the earliest call date?

What is the earliest call price?

Who were the lead underwriters?

Public or private placement?

ENTITY Form 5-10


66

BOND YIELDS

ISSUE ___________________________ ISSUE ______________________________

NAME BONDSHELD

PERCENTOF TOTAL

NAME BONDSHELD

PERCENTOF TOTAL

Totals % Totals %

CURRENT YIELD (1)

ITEM ISSUE ISSUE

Annual Interest Payment Per Bond $ $

Current Price Per Bond $ $

Current Yield % %

Note: (1) As of ____________ .

MAJOR BOND HOLDERS

Note: Total bonds outstanding as of _____________: _____________ and ________ respectively.


SECTION 6

ORGANIZATION AND MANAGEMENT

CONTENTS

SUBJECT TEXT FORM

Board Of Directors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 Form 6-01

Board Of Directors - Other Affiliations And Compensation . . . . . . . . . . . . . . . . . . . . . . 69 Form 6-02

Board Of Directors - Current And Prospective Security Holdings. . . . . . . . . . . . . . . . . . 69 Form 6-03

Corporate Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Form 6-04

Management Style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 –

Corporate Management Resumes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Form 6-05

Recent Compensation History Of Corporate Management Personnel . . . . . . . . . . . . . . . 73 Form 6-06

Company Security Holdings Of Corporate Management Personnel . . . . . . . . . . . . . . . . 73 Form 6-07

Organization And Management Information Requests. . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Form 6-08

Board Of Directors Opinions Of Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Form 6-09

Board Members Apparent Position Regarding Potential Acquisition. . . . . . . . . . . . . . . . 73 Form 6-10

Overall Management Assessment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Form 6-11

Assessment Of Individual Management Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Form 6-12

67


SECTION 6

ORGANIZATION AND MANAGEMENT

Board Of Directors - Forms 6-01 Through 6-03

There is increasing importance being placed on the governance of publicly held corporations. Consequently,knowledge of the makeup of the board and the conduct of its activities is a paramount concern.

Form 6-01 provides for the listing of the members of the entity’s Board Of Directors, their age, years servedas a director and their participation on the various board committees.

Form 6-02, when completed, will list the board members’ current affiliations, and Form 6-03 their currentpositions in the entity’s securities.

WHAT TO LOOK FOR

Age And Years As Director

It is desirable to have a fairly uniform distribution of age and years of service as a director. If a largepercentage of the board is reaching, or will reach, retirement age within a short span of time, thecompany will lose the benefit of their collective experience.

At the other end of the age and service spectrum, it is important to have several younger boardmembers who will bring in fresh ideas. They will also serve as representatives of their generation’sresponse to the entity’s activities.

Board And Committee Membership

Government and investor pressures are greatly increasing the importance, and workload, of theboard of publicly owned companies. No longer will the board, or its committees, be a “rubberstamp” for management proposals.

When appropriate, members of the due diligence team may wish to meet with the key committeemembers in their areas of mutual expertise.

Other Affiliations

Government and investor pressures are also impacting the makeup of the boards of public compa-nies. The trends are to separate the Chairman and Chief Executive roles, and to have a majority ofoutside directors. Consequently, the quality and experience of the outside directors will take onincreasing importance.

Security Ownership

The conventional wisdom is that directors who have a stake in a company will do a better job forthe shareholders at large.

A conflicting viewpoint is that a shareholder/director may not be as objective as a truly independ-ent director. Short term profitability may take preference over what are sometimes referred to as“social responsibilities.”

Whichever side of the debate you are on, knowledge of the directors’ security positions are of interest.

Director Intentions In An Acquisition Situation

There may not be a role for outside directors in the post-acquisition organization, in which case thedesires or intentions of a prior director become moot.

If the acquiror plans to maintain the entity as a separate unit, it may be advantageous to retain somemembers of the entity’s prior board. The acquiror may also invite one or more of the acquired enti-ty’s board members to join its board.

In these latter cases, knowledge of the individual director’s desires is important.

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Corporate Organization - Form 6-04

The top management organization chart should be presented in Form 6-04. Individual departmental organiza-tion charts will be discussed in the appropriate sections which follow.

It is important to note that the published organization chart does not necessarily reveal how an organizationactually functions. Frequently, this chart merely represents how the Chief Executive wants the organization tobe perceived.

It will require astute observation and discussions with employees at various levels of management to deter-mine how an entity carries out its activities on a day-to-day basis.

Management Style

Book stores and libraries are bursting with conflicting theses on this subject. There is no reason to add to thedebate here.

However, the due diligence activity will not be complete if it does not focus on at least two of the most impor-tant management considerations:

• Span of control.

• Delegation.

Each of these characteristics will be discussed briefly below.

Span Of Control

“Span of control” refers to the number of functions that are under the direct supervision of an individual- be they the Chief Executive Officer or the Supervisor Of Plant Maintenance.

As a general rule, five to seven “direct reports” are considered optimum for a chief executive. A typical lineup is as follows:

• Someone to produce the product or service - an “operations” or “production” manager.

• Someone to market the product - a “sales” or “marketing” manager.

• Someone to provide the necessary funds and to keep score - a “finance” manager.

• Someone to provide the personnel - a “personnel” or “human resources” manager.

• Someone to keep the organization out of legal difficulties - a “chief council.”

• In small companies this function is often performed by an outside attorney.

Depending on the nature and complexity of the business, the CEO may have one or more additional positionsreporting to him, e.g.:

• A company with a high degree of public exposure can often justify a top level public relationsposition.

• A technically oriented business will often have the chief technologist report directly to the CEO.

• CEO’s of highly diversified and/or growth oriented companies often benefit from having a corpo-rate development executive on their direct staff.

• Today’s emphasis on environmental issues has resulted in a few potentially vulnerable companiesraising this function to the top corporate level.

The important point is, there should be good reasons for extending the CEO’s direct control over more func-tions than are required by the basic nature of the business.

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the ama of due diligency

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