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 & 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.
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.
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:
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 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.
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.
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.