Four Main Areas For Due Diligence

Four Main Areas For Due Diligence

An image with a due diligence team of four separate members, getting ready to conduct due diligence in four main areas.

Key Takeaways

This guide will introduce you to four main areas where due diligence is most commonly conducted in middle-market M&A deals. Here are some key takeaways about due diligence:

  • In mergers and acquisitions, when someone refers to "due diligence," they are referring to the process that a buyer takes to confirm that the business they intend to buy is as the seller has represented it to be.  
  • We will focus on four main areas: financial due diligence, operational & HR due diligence, tax due diligence, and legal, environmental, and IT due diligence.
  • This article is adapted from our full guide: Due Diligence: A Seller's Perspective. This guide aims to give sellers a comprehensive understanding of what to expect during due diligence.

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Introduction To Due Diligence:

In mergers & acquisitions, due diligence describes the process that the buyer (acquiring company) takes to verify and confirm that the business they are buying is what they presume it to be.

The formal due diligence process begins after the buyer and seller agree to a mostly non-binding offer—called a letter of intent (LOI). This agreement is intended to formally summarize points of negotiation up until this time. It's normal that a purchase price, terms of the payment, and other items are already agreed to.  Additionally, buyers will normally include a list of items they intend to vet during due diligence. LOIs are "mostly" non-binding because while most of the agreement is non-binding, typically the buyer and seller will agree to a period of exclusivity (seller can't entertain other offers) and there are normally additional confidentiality agreements which are binding agreements.

During due diligence, the buyer is looking to address the fact that they know far less about the business they are buying than the seller does. Here, they will have the opportunity (usually around 3 - 4 months) to examine operations more thoroughly.

Conducting thorough due diligence significantly reduces the risk of failure in an M&A deal.

To learn more about what due diligence is, we recommend our guide: Due Diligence in M&A.

Overview Four Main Areas For Due DIligence:

This section of our guide will introduce you to the four main areas of due diligence. It's important to note that there are many things happening simultaneously during the due diligence process and these four areas aren't happening in any particular order. Generally, the highest priority will be financial due diligence. During the due diligence phase, the final definitive purchase agreement to close the deal is being negotiated along the way.

Financial Due Diligence - Financial due diligence, designed to assess the financial strength of the target business is a critical step for prospective buyers. It is normally the highest priority during due diligence because the buyer will almost certainly take on debt to finance the transaction. It is comprised of three primary components: quality of earnings, net debt & debt-like items, and net working capital. While not as detailed as an audit, financial due diligence does validate the truthfulness of the seller's earnings representations.

Operational & HR Due Diligence - The buyer's team will also conduct due diligence surrounding operations and human resources. The buyer needs to understand the quality and sustainability of the business's revenue and cash flow. They need to understand the KPIs that drive your business. They also need to understand your organizational structure, key employees, attrition rates, and the measures taken to retain talent.

Tax Due Diligence - Here, the buyer's due diligence team will look at the potential tax liabilities of the deal. During this phase, the final contract to close on the deal is being created and both the structure of the deal as well as the purchase price allocation will have an impact on taxation.

Legal, Environmental, and IT Due Diligence - In addition to the above areas, the buyer will conduct legal, environmental, and IT due diligence. Legal due diligence is an audit of the legal risk the business could face in the future, and it is used to draft and negotiate parts of the final purchase agreement. Specifically, legal due diligence lends itself to the structure of the representations and warranties the seller will make to the buyer and the indemnification clause. Additionally, the buyer will conduct due diligence surrounding the risk of environmental issues as well as cyber security threats. IT due diligence also looks at the potential cost to grow and scale the business' infrastructure.

Financial Due Diligence:

When buyers conduct financial due diligence, they're ultimately looking to determine if the cash flow stream they're paying you a premium to acquire is reliable, sustainable, and has growth potential.

Buyers are concerned with three main areas of financial due diligence:

  • Quality of Earnings - Normally, in M&A deals, adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) is used as a proxy for cash flow. In effect, the buyers are willing to buy the business because this cash flow is valuable. Given this, our calculation for Adjusted EBITDA is important. Adjusted EBITDA is EBITDA where we've added back or removed certain items in order to reflect a more accurate picture of the business's earnings. For more information about quality of earnings, we recommend our guide: Due Diligence: Quality Of Earnings.
  • Net Debt & Debt-Like Items - Debt is a more straightforward component of financial due diligence, so we won't belabor this point. To begin with, what can be considered debt? Some of the more obvious items are bank debt, long-term debt, and other traditional forms of indebtedness (cash that has to be repaid at some point). Additionally, some items adjusted from EBITDA that will result in cash paid after closing need to be considered. Some examples could be severance, restructuring, transaction costs, etc. While debt is probably an easier concept to understand than quality of earnings assessments, you want to make sure you understand how this will impact the final purchase agreement.
  • Net Working Capital - In addition to quality of earnings and net debt, to understand what buyers are looking for during financial due diligence, we also need to look at net working capital. Net working capital (NWC) is the difference between a business’s current assets and current liabilities (found on its balance sheet). To learn more about this, we recommend our guide: Due Diligence: Net Working Capital.

Operational & HR Due Diligence

Questions concerning operational and human resources due diligence are aimed at understanding how the business makes money, the operating procedures and business systems that support this, and the people who run those systems.

If the prospective buyer is ultimately buying the business for the future cash flows it will produce, they want to be as certain as they can be that those cash flows will be reliable moving forward. They also want to understand what it will reasonably take to grow the business. Are their growth projections realistic? What would that growth require from an operations standpoint?

To learn more about this important area of due diligence, we recommend our guide: Operational & HR Due Diligence.

Tax Due Diligence:

Tax due diligence is another major area of focus. Keep in mind that there will be many things happening at once, during this phase of the deal. The buyer's due diligence team for tax-specific due diligence will likely be an accounting firm.

The main areas that will make up tax due diligence are the deal structure (asset vs stock deal), and purchase price allocation.

  • Deal Structure - At this stage, there has almost certainly been some discussion about the structure of the proposed deal. These discussions are usually summarized in the letter of intent before the formal due diligence process begins. However, the final contract, the definitive purchase agreement, is still being worked out and the deal structure will be an important topic negotiated throughout the due diligence process. Ultimately deals are structured as either stock purchase agreements or asset purchase agreements. The decision to structure the deal as an asset purchase vs a stock purchase will have tax implications for both sides.
  • Purchase Price Allocation - The majority of deals in the lower-middle market are asset purchase agreements. When we talk about purchase price allocation, we are in effect talking about how much of the purchase price will be allocated to which assets the buyer is buying. Ultimately there will be different tax implications based on the value assigned to different assets. The seller's accountant and M&A advisor normally negotiate this with the accounting firm on the buyer's due diligence team.

These two areas will make up the primary focus of tax due diligence, but we’ll explore some additional areas and considerations as well. Again, business owners need to be able to see the due diligence process through the eyes of the prospective buyer.

  • Legal Structure Of The Transaction - While this may not be a point of negotiation with the seller, how the buyer chooses to structure the transaction on their end will have tax implications. For example, private equity groups often employ a platform/roll-up strategy. Basically, they acquire a larger business (think mid- or upper-middle market) and they use that business to acquire smaller businesses (think lower-middle market). This strategy allows them to operate more like a strategic buyer vs a traditional financial buyer. In this circumstance, the choice to use corporations versus flow-through entities would impact taxes.
  • Non-Income Based taxes - Not all taxes are directly linked to income. In some cases, how the business legally employs workers (independent contractors vs full-time employees) may open the business up to a potential tax liability.
  • Uncovering Tax Credits - On the other side of the coin from risk, some of tax due diligence is also related to uncovering potential tax credits/savings. There are a large number of potential tax credits and it's unlikely that a lower-middle market business has uncovered them all. This is especially true if the business doesn't have a full-time CFO.

Legal, Environmental, and IT Due Diligence:

Here, we'll explore legal, environmental, and IT due diligence in more detail.

Legal Due Diligence - A team of attorneys will thoroughly examine all contractual agreements to identify any terms or conditions that may pose a risk or impact the business. Additionally, they will conduct a comprehensive review of leases, ongoing or past litigation, corporate records, ownership of stocks and assets, as well as all relevant company documentation.

IT Due Diligence - The buyer's due diligence team will assist the buyer in understanding the significance of technology for your business. These experts will evaluate the state of your IT networks, analyze historical spending patterns, project future budget expectations, and identify any potential infrastructure risks that could pose a threat to your operations. Additionally, the buyer is trying to understand the implications that growth and operational scale could have on your IT infrastructure, as well as the costs associated with that growth.

We cover legal and IT due diligence in more detail in our guide: Legal & IT Due Diligence.

Environmental Due Diligence - Third-party consultants will thoroughly assess publicly available information, perform on-site inspections, and meticulously examine any previous claims or issues in order to gain a comprehensive understanding of existing environmental liabilities and the potential for future liability.

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