Denis O'Connor, partner, transaction services, PricewaterhouseCoopers and Peter McCann, partner, Grant Thorton, give their advice.

Denis O'Connor:Chris Johns has identified enough problems to make him fear that he is going to the bearer of bad news to his chief executive, who appears to be too emotionally attached to the acquisition and as a result is overlooking significant potential issues. However, in this case, bringing bad news today may be good news tomorrow for IBW.

The primary objective of financial due diligence is to confirm the reliability of the information used in making an investment decision. Any change in the key assumptions should lead IBW to question whether it should proceed with the transaction.

In making the decision to acquire Selerino, Barry Murray has placed too much reliance on his review of Selerino's historical financial statements. Audited financial statements are prepared only to comply with statutory and tax requirements or for a general purpose use rather than for a specific transaction. To understand the reality behind the reported numbers and the true quality of earnings and prospects, an in-depth review of the business and its detailed management accounts must be performed.

To his credit, Johns has completed some analysis of the quality of earnings for the year to date in 2006 and identified a number of items which indicate IBW's trading performance has been "dressed up" for sale. On the downside, he has not extended this analysis back to earlier years to confirm his findings, nor has he factored in the loss of a key sales contract or the questionable value of intangible assets.

In addition, he has not attempted to analyse Selerino's balance sheet and its net asset value other than noting the deteriorating trend in net debt. IBW needs to find out if this deterioration is driven by a downward trend in profitability or poor working capital control or a combination of the two. IBW also needs to understand Selerino's future funding requirements and ensure that the share purchase agreement includes provision for sufficient working capital to be left in the business.

The information in the data room was limited as is often the case, however, this is not always the end of the world for due diligence if a comprehensive expert-based approach is adopted. By limiting the scope of work to turnover, revenue streams and gross profit, IBW has limited its due diligence and is not taking account of potential taxation, pensions, employee and technical issues, to mention just four key areas.

The limitations in the scope of the due diligence in the data room and the resultant knowledge gaps should be first on Johns' agenda for the meeting. Johns needs to appeal to the non-executive directors by pointing out the poor underlying earnings in the period to 31st October, 2006, the apparent "dressing up" of Selerino for sale, the declining margin, the loss of a key customer, possible balance sheet issues in relation to the valuation of intangibles and the deteriorating net debt position - all of which warrant further investigation.

The loss of a key customer is a critical factor, particularly given the change of control clauses in other customer contracts. A question to be raised is whether IBW should be talking directly to key customers prior to completing the deal? Growing revenues is, afterall, one of the chief executive's key strategic assumptions for a combined entity. The weaknesses in systems for stock provisioning and credit control should also be highlighted as a warning for IBW.

If IBW is to fully understand Selerino, it also needs to assess the future by considering the future trading performance, financial position and funding requirements of the enlarged entity. As with historical due diligence, such an analysis is best performed by an independent expert who can analyse the available information from an external perspective.

Johns' conclusion should be that he does not have the expertise to complete the due diligence on his own. He should recommend to the board of directors that either more due diligence is required with assistance from experienced professionals or that the process should be terminated. Fortunately, IBW have a clause in the heads of terms which makes any completion of the acquisition dependent on successful due diligence. They should not feel pressurised by Selerino to complete the deal without access to further information.

Finally, a word of warning - acquiring a business is a difficult, complex and stressful process and not something IBW should be undertaking lightly. Preparation and planning are the critical success factors in all business acquisitions and best done with expert independent help. Time spent performing a due diligence is rarely wasted and, at worst, will provide useful additional information about the target. It will be too late for IBW to discover issues after it has written the cheque.

Peter McCann:The board has been presented with a difficult decision. The acquisition represents an excellent opportunity for IBT to increase market share. There is potential for synergetic savings post acquisition, however these may be insufficient to counter Selerino's overall financial position. Despite 32 per cent compounded annual growth in turnover, gross margin has declined year on year.

In addition, EBITDA margin and net debt have both deteriorated dramatically. The upside of these factors for IBT may be a significant discount on the consideration payable for Selerino. However, in pursuing the acquisition, IBT need to consider whether they have the required resources to curtail Selerino's financial crisis post acquisition.

In addition to Selerino's weakening finances, the review by Johns revealed a number of serious issues which require board consideration prior to proceeding with the transaction. Change of control clauses may have the effect of restricting the combined entities future growth.

If a customer takes umbrage to the acquisition and invokes the contractual change of control provisions, the resulting loss in revenues may hugely impact on the group's overall future profitability.

Furthermore, the balance sheet at 31 October, 2006, contains significantly overvalued stock and debtor balances. IBT should ensure that this issue is reflected in the share purchase agreement. The consideration paid should adequately reflect the necessary stock and debtor write downs.

The issue of most concern is the treatment of research costs as at 31 October, 2006. This represents a clear case of window dressing. By capitalising these costs, the vendors are massaging profits to make the business more attractive to potential purchasers. Tactics of this nature should set alarm bells ringing.

IBT should take time to consider the trustworthiness of the vendors and the motives underlying the sale. As with any other transaction, the principles of caveat emptor apply. To minimise risk, IBT should strongly consider the appointment of an independent professional transaction services team to conduct a thorough review of the target.

Due diligence offers the buyer comfort on their proposed transaction. A team of advisors can analyse and validate the company's historical performance, advise the buyer on potential deal adjusting factors and comment on potential post acquisition synergies.

Financial and legal due diligence ensure that any "holes" are identified and warranted in the agreed share purchase agreement, offering the buyer peace of mind. A small investment in professional fees pre acquisition may result in huge long term savings.