Qualitative Analysis
May 3, 2024
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This guide explains what due diligence is in mergers and acquisitions. It also explains why due diligence is important, the role of due diligence in M&A, and it briefly explains how the due diligence process is performed.
In deals where the acquisition target is a publicly traded company, detailed financial information is already available to the public, so a potential buyer can conduct more thorough analysis from the start. When we’re referring to privately held companies, due diligence comes into play later into the M&A process.
The term due diligence refers to the process the buyer (acquiring company) uses to verify and confirm that the target company is what the seller has represented it to be.
In our guide: The M&A Process Explained we go over the M&A process in detail and we explain where due diligence comes into the picture in the timeline of an M&A transaction. To learn more about this, we recommend that guide.
To briefly explain where due diligence fits in on the timeline of an M&A transaction, understand that the buyer and seller have already agreed to a potential deal (merger or acquisition) before due diligence can be conducted (unless it’s a publicly traded company). The buyer and seller have already signed a non-disclosure agreement, and the seller has provided the buyer with enough information about their business for the buyer to do financial modeling and determine the price it can offer the seller. This agreement is pending the buyer’s confirmation of all the information the seller has provided.
The buyer (acquiring company) does due diligence to verify and confirm for themselves that the business is worth what they are going to potentially pay for it.
If the buyer goes through their due diligence and finds discrepancies or they determine that the deal is worth less to them than they originally thought, they will go back to the negotiating table and present the seller with a new offer, reflecting what they learned in the due diligence process.
Due diligence is important because it greatly reduces the risk that the M&A deal will fail. A substantial number of M&A deals fail in the end.
M&A deals are made with the intention that the transaction will produce a better company after the deal is complete. Put another way, if Company A buys Company B, it’s doing so in order to create value and its assumption is that Company A will be more valuable after the transaction than it would be without doing it.
Part of the inherent risk in an M&A deal comes from the fact that the seller knows substantially more about their own business than the potential buyer does. The due diligence process is designed to reduce the asymmetry of information between the seller and the buyer and give the buyer the confidence it needs to move forward with the transaction.
So, from the buyer’s perspective, due diligence is about mitigating risk and confirming that any expectations for the deal are realistic. From the seller’s perspective, due diligence is used to create trust between the buyer and the seller. Trust is an important element in any business deal and the buyer will not move forward and complete the deal if they don’t trust the seller’s representation of the business.
Sellers often conduct their own due diligence audit of their own company—before they start looking for potential buyers because this due diligence process is a more holistic way to estimate the fair market value of their business.
At this point, we’ve covered what due diligence is, why it’s important, and we’ve explained the role of due diligence in the M&A process. This section summarizes what a buyer is looking to confirm with their due diligence.
This is a non-exhaustive list, and the acquiring company will obviously have specific questions and concerns unique to each M&A deal. However, this section summarizes some of the most common things a buyer is looking to confirm and gain insight into with the due diligence process.
The first thing a potential buyer is looking to confirm and gain as much insight into as possible is the financials. With publicly traded companies, this due diligence has been largely completed earlier on in the process as much of the information has already been made publicly available. However, accounting standards leave room for interpretation and the acquirer will still want to conduct financial due diligence. In privately held transactions, the buyer will perform exhaustive due diligence.
The buyer is looking to confirm both historical financial performance and also review the seller’s projections for future growth. Detailed revenue analysis, cash flow analysis, and analysis of the company’s assets and liabilities, real estate, leases, etc. will be evaluated.
Additionally, prospective buyers will visit the company’s headquarters in person and conduct more qualitative due diligence. This often includes analysis of the management team, a breakdown of the organizations employees and compensation structure, customer lists, key accounts, as well as a strategic, industry, and competitive analysis. Financial information is extremely important, but it doesn’t provide the whole picture. During the due diligence phase, prospective buyers will want to conduct qualitative analysis of the company as well.
Legal and tax due diligence is another major area of focus for prospective buyers. During this due diligence, particular attention will be paid to research and development, ownership of patents, employee and supplier contracts, loan agreements, as well as any outstanding litigation. On a more technical note, contributors to taxation that may or may not be inherited in an acquisition are examined as well. This can be extremely complicated depending on how the deal is structured. (For more on deal structure, read our guide: Asset Purchase vs Stock Purchase)
