Due Diligence in M&A: Definition, Types, Process, Importance

Engaging in due diligence is a critical step in M&A transactions as it helps the buyer to ascertain important facts about the seller. Through due diligence, buyers can examine the seller's contracts, finances, and customers, among other things. This in-depth analysis enables buyers to make informed decisions and secure a deal with confidence.

All parties involved in a potential M&A deal must comprehend the risks and advantages that may arise from the transaction. To make educated decisions, thorough and dependable due diligence must be carried out to gather the necessary data and insights.

When two parties enter into a potential merger or acquisition, due diligence typically begins with the signing of a letter of intent (LOI). Completing a thorough due diligence process is a crucial step in the M&A process, as it enables both parties to assess all the risks and benefits of the proposed transaction. Understanding the importance of due diligence in mergers and acquisitions, as well as the steps involved, can help ensure that all parties are informed and prepared.

What is Due Diligence?

Prior to any financial transaction or agreement, an audit or investigation known as due diligence is conducted to confirm facts that may influence a buyer's decision. This process involves researching all pertinent information to ensure it is accurate before proceeding.

The Due Diligence process is an essential part of mergers and acquisitions, as it allows the buyer to properly assess the target company before committing to a financial transaction or agreement. During the investigation, the buyer needs to obtain a full understanding of the company’s obligations and liabilities, such as leases, debt, potential and pending litigation, distribution agreements, warranties, long-term customer agreements, employment contracts, and compensation agreements.

Of particular importance is the IT due diligence audit, which focuses on the company’s IT infrastructure, software, hardware, resources, networks, locations, processes, data protection organization, projects, and more. Moreover, for private companies, buyers must also conduct due diligence to identify potential risks in financial statements, cybersecurity and data privacy issues, labor obligations, and intellectual property. Ultimately, due diligence helps the buyer to make an informed decision before entering into a business agreement.

Due Diligence Steps

The length of due diligence for mergers and acquisitions can vary from a few weeks to several months depending on the complexity of the situation.

1. Hire a due diligence team
2. Gather necessary documents
3. Taking care of all the buyer’s concerns and questions
4. Final evaluation

Hire a due diligence team

To ensure the M&A process is conducted properly, the buyer will require a specialized team of legal and financial professionals. This team, known as a due diligence team, typically consists of accountants, investors, personal advisors, lawyers, and various service providers depending on the industry in which the company operates.

After signing a confidentiality agreement, the due diligence team will create a detailed checklist of the documents needed and the time frame in which they are due, and formally request them from the target company. To further assess their compatibility, the buyer and the target may then agree to a meeting or series of meetings to discuss the M&A process and the required documents. At these meetings, both parties can better evaluate if the buyer is making a sound investment.

Gather necessary documents

The due diligence process requires the buyer to review various documents from the target company to gain a solid understanding of its financial health, operating assets, legal matters, and strategic position. The exact documents requested may vary depending on the company's size and type, but typically include corporate documents, intellectual property contracts, shareholder information, a history of litigation, regulatory, insurance, lease, and other financial information. If any of the data provided is a problem, the deal may not proceed. Questions the buyer may have about the documents should be addressed during this time.

Taking care of all the buyer’s concerns and questions

During the due diligence process, the target company should be prepared to provide various documents that are necessary for the buyer to have a full understanding of the company's financial health, operating assets, legal matters, and strategic position.

This could include corporate documents, intellectual property contracts, shareholder information, a history of litigation, regulatory data, insurance information, lease details, and other financial documentation. If the buyer is not satisfied with any of the information provided, the deal may not go through. Thus, it is essential for the target company to be able to answer any questions or address any concerns the buyer might have about the documents.

Final evaluation

The buyer will now assess the report from the due diligence process to determine whether or not the acquisition is a sound investment as a final step. If the buyer is satisfied with the findings, the transaction will proceed as planned. If the buyer finds any issues that need to be addressed, they may request an adjustment to the deal. If the issues are too difficult to resolve, the buyer may choose to abandon the deal.

Types of Due Diligence

It can be challenging to know how to start an audit that covers all aspects of a business. To ensure a thorough assessment, the following eight types of investigations should be conducted:

Financial Due Diligence is widely regarded as one of the most important forms of audit. In this process, firms examine the accuracy of the financial data presented in the Confidentiality Information Memorandum (CIM). The objective is to gain insight into the overall financial health and stability of the target, as well as to uncover any potential problems.

Legal Due Diligence helps determine whether the target company is compliant with legal requirements or entangled in legal issues.

The focus of Human Resources (HR) Due Diligence is on the employees, who are the company's most valuable asset.

The purpose of Operational Due Diligence is to assess a company's operations, including technology, assets, and facilities, in order to identify any potential risks or liabilities. The overall goal is to ensure the company is in good condition.

The purpose of Environmental Due Diligence is to ensure that a company's processes, equipment, and facilities are all in compliance with environmental regulations, in order to avoid possible fines or even more severe penalties such as plant closures.

Through Business Due Diligence, the acquiring firm can gain insight into a target company's customer base and the industry it operates in. This allows it to assess the potential risks that the transaction may cause to its existing customers and to make informed decisions.

Due Diligence Assessing Strategic Fit evaluates if the target company is compatible with its desired outcomes and ambitions.

Frequently, Self-Assessment Due Diligence is disregarded by firms. Nevertheless, it is one of the most essential steps and should be implemented from the very beginning when evaluating any potential investments or integrations. This is an internal process where firms must ask themselves, “what are our objectives from this transaction?” Ultimately, a self-assessment is equivalent to making a grocery list before going shopping.

What to Expect During the Due Diligence Process

This process can take anywhere from three to six months, depending on the complexity of your operations and financial circumstances. Being aware of what to anticipate throughout the process can help ensure that it runs smoothly. Here are a few points to bear in mind:

Prepare yourself beforehand: Before beginning the process of selling your business, it is important to ensure that you have all the necessary information organized. This includes details regarding finances, operations, human resources, legal matters, intellectual property, technology, customers, insurance, and more. Not preparing this information beforehand can lead to delays in the selling process. Make sure to organize all documentation, especially financial information, prior to starting the process. By taking the time to get organized ahead of time, you will be better able to present a clear and accurate picture of your business to potential buyers.

Know your numbers in and out: Do not allow a bidder to dictate how much money you make! To accurately assess your financial performance, you and your accountant should be aware of your company's EBITDA and its normalized value. The term "normalized" is an amalgamation of art and science, meant to account for any one-time or atypical costs or revenues.

Carefully share information with tactical bidders: When considering a logical buyer for your company, a strategic buyer that can benefit from potential cost-cutting synergies is a good choice. However, it is crucial to be cautious when disclosing information during the diligence process, as the information could be used against you if the sale were to fail. It's best to limit the amount of proprietary information shared, only providing information necessary for valuation and excluding customer lists and pricing details. It is also important to have a legally-binding non-disclosure agreement (NDA) in place to protect you during the process. Although an NDA can offer some protection, it is impossible to take back information once it has been revealed.

Be prepared for numerous meetings and calls: Before the transaction is finalized, the investor will be sure to have multiple in-depth discussions with you and the other leaders of the business. This will allow all parties to ask questions and get a better understanding of the company's mindset and future plans. Additionally, the investor might wish to speak with current customers and vendors in order to validate the data provided and learn more about the company's relationships with them.

Remember, Diligence is a 2 way thing: As the potential buyer is studying the particulars of your business, you should also be researching them to ascertain if they are who you think they are. They should give you the details of other investments they have made and introduce executives from other companies they have bought or invested in for you to contact as references.

Importance of Due Diligence in M&A

The benefits of performing M&A due diligence are numerous. Doing so allows buyers to better adjust their expectations based on a company's individual situation. Additionally, having access to relevant data reduces the risk of any unexpected legal or financial issues cropping up. Furthermore, due diligence can help build a relationship between the buyer and seller during the negotiation process. It is also important to conduct due diligence to uncover any essential information that could affect the buyer's decision, as mergers and acquisitions can be complex and lengthy.

Final Words

Undergoing M&A due diligence is beneficial for many reasons. Not only does it allow buyers to adjust their expectations based on the unique details of a company, but it also provides protection from unexpected legal and financial issues. Additionally, due diligence can foster a working relationship between the two parties due to the high level of communication it requires. Ultimately, due diligence is an effective way for buyers to protect themselves from potentially risky business deals.