Written by Curtis Harper
When considering the purchase of a manufacturing company, it’s up to the Buyer to look for any red flags.
Here are some things I have found most useful in performing a due diligence on a manufacturing company once a purchase contract is in place. I would do these things in parallel to a detailed financial review, which could be a whole article unto itself.
The first place I always go is the OSHA 300 log. Is it readily available? Is it filled out completely and in a timely fashion? Are there incident investigation reports for each injury? Do they identify the root cause of the injury? If the answer is “No” to any of these questions, that is a huge red flag. If every incident report identifies the root cause as failure to follow procedures, there is something deeper going on. Are there multiple injuries or illnesses on the same piece of equipment or location? If so, then that also is a huge area of concern. It tells me the management team does not take these incidents seriously and has not been properly trained on root cause analysis.
Why do I check a facility’s safety record first? It’s simple to do, and I have never been in a manufacturing facility that had a poor safety record that also did not have poor quality, morale, and eventually, customer satisfaction. The safety of the employees is management’s responsibility. If the management team does not care about the safety and well-being of the people they work with every day, will they genuinely care about their customers whom they may only see occasionally or maybe never?
Does a poor safety record cancel a sale? No—it’s just an indication of the state of the company. It can be a great opportunity for the Buyer to come in and make a statement about who they are and that they do care about people. Safety performance can also be one of the easiest things to turn around.
I would also check for environmental or regulatory lapses, warnings, or penalties. Are there issues pending, and what is the likely resolution, timing, and cost both in penalties and any required remediation? If the company routinely uses large quantities of solvents and cleaning fluids, or processes hazardous materials, a Phase II environmental survey will likely be required.
So where do we go next? Let’s take a tour of the facility. I look for three things:
(a) Are there shop towels/rags around most of the equipment soaking up oil or hydraulic fluids? If so, that tells me the maintenance program needs a complete overhaul. I would look closely at maintenance logs for a couple key pieces of equipment and up time records. I would look to see what percent of maintenance is preventative versus break down.
(b) Are the laboratories or other testing areas neat and clean and are procedures readily available? Check to be sure all testing instruments are routinely calibrated or certified. If not, the quality program is likely not functioning properly. I would look at records for customer complaints or claims. Are operating procedures readily available at work stations and are they up to date?
(c) Is the overall condition of the plant in good shape? How is the order and arrangement of the facility? A place for everything and everything in its place: One would expect it to be as good as it gets for a Buyer tour. Whatever you see, expect it to be worse when visitors are not there. I look for holes in fencing or painting that is long overdue or significant cracks in concrete floors.
None of the above is necessarily a deal breaker, but more likely an indication that the management team needs help or redirection and maintenance expenditures have been deferred.
Now that I have a sense for the operation, I will look at the customer base. Is there a high degree of customer concentration? If so, has the customer been with the company a long time or are there long-term contracts in place? Other factors to consider are barriers to entry, proprietary processes or intellectual property used to meet customer orders and certifications, or regulatory hurdles for a competitor to overcome. Significant customer concentration may be an opportunity to renegotiate the price and/or terms. See how many new customers have been acquired in the last twelve months and, more importantly, how many left and why did they leave.
After reviewing these items, I would want to look at the inventory. How often do items turn?
I would be concerned if more than ten percent of the inventory was turning two times slower than the average items. Large blocks of inventory being held as customer returns or quality holds can be a real problem, both in terms of the potential for write-down or an indication that there are issues in the order fulfillment process or quality systems.
Finally, I would try to determine two things:
(a) Are key employees committed to the transition to the new Owner? Check to see if they have bonuses in place or other incentives to stay until the company sells or for a certain time period after the sale. Do they even know it is for sale? In many cases they may not and the Buyer and Seller must develop a transition plan prior to completing due diligence.
(b) Why is the Seller truly selling? If they say they are retiring, ask about retirement plans: travel, hobbies, relocation, etc. If for family reasons—divorce, illness, etc.—try and verify if possible. The true reason for sale needs to be in synch with the stated reason for sale. If they don’t match, there may be a huge underlying issue that is motivating the Seller, likely a financial or customer issue.
After doing the above, we will have a good indication of the current state of the operation and can estimate what resources will need to be applied to fix any issues we have uncovered. We should be able to infer what improvements can be made short term and what will flow to the bottom line by implementing these improvements.
Curtis Harper is owner/Broker-In-Charge at Sirius Realty, LLC, in Greenville, South Carolina.
