In short:
- Due diligence is an essential activity for both buyer and seller success in M&A
- The investigative process reveals upsides — and red flags — in areasincluding finance,operations, strategy, risk, culture and more
- Our primer covers all the basics of due diligence: what it is, what to expect, whyit’s important
What Is Due Diligence?
Due diligence is a broadly used term across multiple disciplines, particularly in the legaland corporate realms. In the context of business, it refers to the investigation performedby an interested party, including venture capital and private equity firms, into a merger oracquisition target or to vet companies for potential investments.
Though less common than its obligatory buy-side counterpart, due diligence may also refer tothe investigation performed into a buyer by a seller, referred to as “sell-side duediligence.”
The due diligence period is also a time for acquirers to learn more about a targetcompany’s products, prospects, value and how it will mesh with their companies orportfolios. Failure to perform adequate due diligence may result in an overvaluation, missedopportunities for synergies(opens in new tab) andintegration difficulties.
While it may appear that due diligence primarily protects the purchaser, it provides benefitsfor sellers as well. The investigation may find a mismatch of goals, culture or other issuesthat could doom the combined company.
For our purposes, we are looking at buy-side due diligence in the scope of M&A. Thisin-depth process allows for buyers to evaluate a potential acquisition across many areas,typically including finance, operations, strategy, risk, culture and more.
What Are Due Diligence Risks?
Sometimes both sides focus too much on the due diligence process, not enough on the all-important cultural fit betweenboth businesses and their customers. Other times, the target company must be responsive tosuch a large volume of questions and requests for documentation that it neglects coreoperational activities.
Oh, and due diligence is expensive. Both sides need to deploy lawyers, accountants,investment bankers and other consultants.
To justify those expenses and allot enough time for the due diligence process, the buyer andseller usually agree to an “exclusivity period.” Also known as a “no shopclause(opens in new tab),” this provisionprevents sellers from soliciting another, morecompetitive, offer or continuing any other negotiations. The seller agrees to accept the noshop clause as a gesture of good faith(opens in new tab) tothebuyer.
But exclusivity during the due diligence process, particularly when it’s poorlynegotiated, can be detrimental to the seller. If the deal falls through, the company isforced to start over. Meanwhile, it may have missed out on better offers.
Ultimately, due diligence can prove to be a complex, stressful and exhausting process on bothsides — for a result that’s not guaranteed. Still, the only thing worse isentering adeal blind and living to regret it.
Do the Advantages of Due Diligence Outweigh Disadvantages?
We’ve seen the “marriage” analogy in business before, often when discussing privateequity relationships.
M&A is no different. Mergers and acquisitions have an infamously high failure rate, withmost studies placing the risk of a nasty divorce in the 70% to90% range(opens in new tab). A longer anddeepercourtship period improves the chances of success onboth sides of the equation by facilitating an informed decision.
The due diligence process allows an acquirer to identify and assess risks, liabilities andbusiness problems in the target company before finalizing the transaction, potentiallyavoiding losses and bad press later on. Just like in a marriage, after you’ve enteredinto a contractual obligation is no time to figure out you don’t mesh.
When Should You Start, and How Long Should Due Diligence Take?
The first part is straightforward: Due diligence starts when both parties have agreed, inprinciple, to a deal but have not yet signed a binding agreement. Instead, they will sign aLetter ofIntent (LOI)(opens in new tab).
An LOI is a document outlining the intent of both parties, rules of the negotiation periodand the basics of the final deal. While the letter of intent signals that a buyer is seriousabout a potential purchase, it is often not legally binding. Instead, negotiations areconducted in good faith. The exception is when parties include terms that specify, or couldbe construed as specifying, that the companies are legally bound.
Depending on the acquisition in question, the due diligence process can last 30 to 60 days, though in a more complex business it could takeup to 90 days(opens in new tab). To shorten thetimeframe, experts advise being preparedfor the process — even before a buyer comes knocking.
What Are the Elements of Due Diligence?
A comprehensive appraisal examines numerous aspects of the company, with specific focus onthe following areas. We didn’t put these in any specific order, because the relativeimportance will vary based on company and deal type.
General:
Examines general records and the provided business plan to understand the corporate structureand standing of a company. This broad initial step sets the stage for the more in-depth andtargeted due diligence investigation.
Organization and ownership:
Delves into the structure of a company from a personnel perspective. The organizational duediligence phase provides perspective surrounding the ownership of the business, which willbe critical to consider when acquiring or merging with a company.
Compliance and regulation:
Assesses regulatory or compliance issues with the target company or the overall deal. Thisprocess is particularly important in heavily regulated industries or with large parties inplay. Look in particular for any antitrust risks(opens in newtab) thedeal may present.
Administrative:
Covers administrative information about a company, like the business facilities, occupancy rate and number of workstations(opens in new tab).
Accounting/financial:
Confirms seller’s financial performance by examining historical statements, detailed trialbalances(opens in new tab), general ledgers,currentoperating results, business plans, budgets andforecasted financial information. Typically, the scope includes working capital and capitalexpenditure requirements, an analysis of the historical quality of earnings (such asEBITDA), quality of net assets, net debt and projected future performance. The objectivehere is to identify any unreported liabilities, understand the target’s currentfinancial position and determine if earnings are sustainable. These activities help ensure arealistic valuation of the target and justification of the purchase price.
Operational:
Examines the target company’s systems and processes to identify risks arising fromexecution of the business function. Here, buyers assess the effectiveness of thetarget’s operating model — including sales, marketing, technology, supply chainandproduction — to determine gaps and potential areas where investment or development areneeded. The goal is to see if the current state of operations can support the business planprovided by the target company.
Tax:
Delves into the target’s tax profile by analyzing tax returns and the company’stax structure. It typically focuses on income and non-income tax areas, including sales and use,employment/payroll, property and transfer tax items(opensin newtab). Tax examination is a highlyemphasized area of due diligence, as the acquiring company will be liable for any tax issuesit inherits. Overstated net operating losses, underreported tax liabilities, non-filingexposures, failure to charge sales tax or pay use tax and payroll tax errors are the mostcommon risks.
Legal:
Includes a review of legal matters facing a company and related risk around contracts orlitigation. Legal due diligence greatly affects how, or if, a deal will move forward. Issueslike restrictive and/or breached contracts, noncompete clauses and past or pendinglitigation will influence the structure of a deal. After all, post-transaction, the buyer isgoing to be liable for any obligations, contingencies and restrictions.
Types of Due Diligence
| Hard due diligence is all about the numbers. The soft duediligence process focuses on people: employees, customers, partners. | |
|---|---|
| Hard | Soft |
| Concerned with data and numbers | Concerned with the people and the “human element” of acompany |
| Considered the “traditional approach” | Has come into increasing focus as an integral component of M&Asuccess |
| Majority of due diligence falls into this category | Looks at the culture of an organization and the roles, capabilities andattitudes of its people |
| Financial/accounting, tax and operational due diligence are all examplesof hard due diligence | Culture and human resources due diligence are the main examples of asoft approach |
Technological:
Analyzes the company’s IT assets (or lack thereof) to assess sustainability, value,costs, scalability and evolution capabilities, as well as how systems would integrate intothe buyer’s company or portfolio. People and processes need to be proven effective andadaptable. As cybercrime proliferates, an increasingly important focus is the vulnerabilityinherent in the IT infrastructure — .
Physical assets:
Verifies the tangible assets possessed by the target and their value based on appraisals,leases, mortgages, permits, surveys and zoning approvals. Companies should also look into atarget’s fixed assets(opens in new tab)(such asvehicles, machinery and office furniture) anddocument the description, date acquired, price, depreciation years, accumulateddepreciation, net book value and location(opens in newtab). Lastly, inventory is also considered amaterial asset; it will be assessed to establish quantity, value and condition.
Intellectual property:
Particularly in technology-driven industries, a target company’s IP portfolio largelydetermines its value and relevance to the combined company. Common things to look for hereare questions of licensing agreements, ownership, reliance on open-source code, patents,trademarks, copyrights and chain-of-ownership documentation.
Human resources:
The people component is a critical part of the due diligence process. It takes into accountinformation like total number of employees, demographics, compensation, benefit plans, human resource policies(opens in newtab), contracts and organizational structure. Arethere any employee-relations issues that need to be addressed? Are there contracts in placethat the acquirer will be grandfathered into? What about severance packages, particularly goldenparachutes(opens in new tab)? What stockpurchase andstock option benefits do employees hold, and dothey comply with 409A(opens in new tab)? Arethere keypersonnel in place? If so, how do you ensure thatthey stay? This is particularly important in acqui-hire situations(opens in newtab).
Commercial:
Examines the target’s ecosystem to determine its place in the market. Usually conductedby third-party analysts, this process delves into market conditions, trends, competitors,opportunities/threats and differentiators. Consumer sentiment data, such as NPS and churnrate, are also critical here. What is the customer’s perception of and loyalty to theproduct or service? Does consumer demand validate the company’s claims about itsgrowth potential?
Environmental:
Identifies environmental, health and safety issues that could directly affect the value andreputation of the target business. Factors include compliance with environmental laws, theabsence of contamination, research into the history of the property and assessments of anysustainability issues. This will likely include on-site inspections and a review of propertyrecords.
Cultural:
Cultural due diligence accounts for the more subjective and emotion-based “human element(opens in newtab)”of a company. It seeks to understand thecultural dynamics of a potential acquisition in areas like values, perceptions, traditionsand working styles. .
Strategic:
Strategic due diligence takes a cumulative view of all other due diligence results andattempts to answer the million-dollar question: How does this company mesh with my currentbusiness/portfolio? Current profitability is irrelevant if the target doesn’tstrategically fit. What are the value drivers of this transaction? Are there redundanciesthat will need to be eliminated to achieve synergy? Will the business plan hold up to marketrealities? Will likely outcomes be worth the effort put into integration and transition?
For more details on what will be needed in the process, refer to our duediligence checklist.
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Bottom Line: Clearly, done properly, due diligence is a painstaking process.The temptation can be to skim over some areas to save time and money. However, theinvestment in thorough due diligence early on can help prevent costly surprises later on—and increase the chances of M&A success.
Megan O’Brien is Brainyard’s business & finance editor, covering thelatest trends in strategy for CFOs. She has written extensively on executive topics as aformer content creator for Deloitte’s C-suite programs. Reach Meganhere.
