CFO

Due Diligence Explained: Advantages, Types and Processes

By Megan O’Brien, Brainyard Business & Finance Editor
April 27, 2020
Magnifying Glass

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 areas including finance, operations, strategy, risk, culture and more
  • Our primer covers all the basics of due diligence: what it is, what to expect, why it’s important

“Caveat emptor” needs to go beyond verifying that financial information presented by a seller is accurate. The due diligence burden extends to critically analyzing a potential acquisition to ensure it aligns strategically, financially and culturally with the buyer’s business objectives.

What not to do examples abound: A lack of the “buyer beware” mindset on Quaker Oats’ end resulted in a severely overinflated growth potential estimate for Snapple — and Quaker taking a $1.4 billion loss. Mattel and The Learning Company? Independent analysts found that Mattel’s due diligence missed red flags, including slowing sales, rising levels of account receivables and a lost licensing agreement. Not only did Mattel sell The Learning Company at a major loss, it was sued for over $120 million by its own shareholders.

Remember AOL and Time Warner? The merger resulted in the largest annual loss ever reported by a company at the time. A rushed due diligence process here didn’t miss anything illicit. But it did overlook something glaring: The companies simply weren’t right for each other. Mismatched cultures and people issues resulted in a whopping $99 billion loss.

We could go on. So how did so many big companies get things so wrong?

To some extent, blame the go-go VC and PE mindset of the twenty-tens. At the end of 2019, private equity firms were sitting on nearly $1.5 trillion, according to Preqin. The VC industry had deployed $136.5 billion to U.S.-based companies by the end of 2019, says the Pitchbook-NVCA Venture Monitor. A decade ago, venture capital invested only $27.4 billion. That’s an increase of nearly 400%.

It’s reasonable to expect post-COVID-19 M&A transactions to move with more deliberation, though without a crystal ball, we can’t say for sure. What we can say is that due diligence is a time-consuming and intensive process, on both sides of the table. Sellers spend valuable time and resources compiling information, which buyers must then rigorously vet.

It’s also absolutely critical.

Primer: What Is Due Diligence?

Due diligence is a broadly used term across multiple disciplines, particularly in the legal and corporate realms. In the context of business, it refers to the investigation performed by an interested party, including venture capital and private equity firms, into a merger or acquisition target or to vet companies for potential investments.

Though less common than its obligatory buy-side counterpart, due diligence may also refer to the investigation performed into a buyer by a seller, referred to as “sell-side due diligence.”

The due diligence period is also a time for acquirers to learn more about a target company’s products, prospects, value and how it will mesh with their companies or portfolios. Failure to perform adequate due diligence may result in an overvaluation, missed opportunities for synergies and integration difficulties.

While it may appear that due diligence primarily protects the purchaser, it provides benefits for sellers as well. The investigation may find a mismatch of goals, culture or other issues that could doom the combined company.

For our purposes, we are looking at buy-side due diligence in the scope of M&A. This in-depth process allows for buyers to evaluate a potential acquisition across many areas, typically including finance, operations, strategy, risk, culture and more.

Due Diligence Risks

Sometimes both sides focus too much on the due diligence process, not enough on the all-important cultural fit between both businesses and their customers. Other times, the target company must be responsive to such a large volume of questions and requests for documentation that it neglects core operational 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 and seller usually agree to an “exclusivity period.” Also known as a “no shop clause,” this provision prevents sellers from soliciting another, more competitive, offer or continuing any other negotiations. The seller agrees to accept the no shop clause as a gesture of good faith to the buyer.

But exclusivity during the due diligence process, particularly when it’s poorly negotiated, can be detrimental to the seller. If the deal falls through, the company is forced 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 both sides — for a result that’s not guaranteed. Still, the only thing worse is entering a deal blind and living to regret it.

Advantages of Due Diligence Outweigh Disadvantages

We’ve seen the “marriage” analogy in business before, often when discussing private equity relationships.

M&A is no different. Mergers and acquisitions have an infamously high failure rate, with most studies placing the risk of a nasty divorce in the 70% to 90% range. A longer and deeper courtship period improves the chances of success on both sides of the equation by facilitating an informed decision.

The due diligence process allows an acquirer to identify and assess risks, liabilities and business problems in the target company before finalizing the transaction, potentially avoiding losses and bad press later on. Just like in a marriage, after you’ve entered into 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, in principle, to a deal but have not yet signed a binding agreement. Instead, they will sign a Letter of Intent (LOI).

An LOI is a document outlining the intent of both parties, rules of the negotiation period and the basics of the final deal. While the letter of intent signals that a buyer is serious about a potential purchase, it is often not legally binding. Instead, negotiations are conducted in good faith. The exception is when parties include terms that specify, or could be 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 take up to 90 days. To shorten the time frame, experts advise being prepared for 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 on the following areas. We didn’t put these in any specific order, because the relative importance will vary based on company and deal type.

General: Examines general records and the provided business plan to understand the corporate structure and standing of a company. This broad initial step sets the stage for the more in-depth and targeted due diligence investigation.

Organization and Ownership: Delves into the structure of a company from a personnel perspective. The organizational due diligence phase provides perspective surrounding the ownership of the business, which will be critical to consider when acquiring or merging with a company.

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Compliance and regulation: Assesses regulatory or compliance issues with the target company or the overall deal. This process is particularly important in heavily regulated industries or with large parties in play. Look in particular for any antitrust risks the deal may present.

Administrative: Covers administrative information about a company, like the business facilities, occupancy rate and number of workstations.

Accounting/financial: Confirms seller’s financial performance by examining historical statements, detailed trial balances, general ledgers, current operating results, business plans, budgets and forecasted financial information. Typically, the scope includes working capital and capital expenditure requirements, an analysis of the historical quality of earnings (such as EBITDA), quality of net assets, net debt and projected future performance. The objective here is to identify any unreported liabilities, understand the target’s current financial position and determine if earnings are sustainable. These activities help ensure a realistic valuation of the target and justification of the purchase price.

Operational: Examines the target company’s systems and processes to identify risks arising from execution of the business function. Here, buyers assess the effectiveness of the target’s operating model — including sales, marketing, technology, supply chain and production — to determine gaps and potential areas where investment or development are needed. The goal is to see if the current state of operations can support the business plan provided by the target company.

Tax: Delves into the target’s tax profile by analyzing tax returns and the company’s tax structure. It typically focuses on income and non-income tax areas, including sales and use, employment/payroll, property and transfer tax items. Tax examination is a highly emphasized area of due diligence, as the acquiring company will be liable for any tax issues it inherits. Overstated net operating losses, underreported tax liabilities, non-filing exposures, failure to charge sales tax or pay use tax and payroll tax errors are the most common risks.

Legal: Includes a review of legal matters facing a company and related risk around contracts or litigation. Legal due diligence greatly affects how, or if, a deal will move forward. Issues like restrictive and/or breached contracts, noncompete clauses and past or pending litigation will influence the structure of a deal. After all, post-transaction, the buyer is going to be liable for any obligations, contingencies and restrictions.

Types of Due Diligence
Hard due diligence is all about the numbers. The soft due diligence process focuses on people: employees, customers, partners.
Hard Soft
Concerned with data and numbers Concerned with the people and the “human element” of a company
Considered the “traditional approach” Has come into increasing focus as an integral component of M&A success
Majority of due diligence falls into this category Looks at the culture of an organization and the roles, capabilities and attitudes of its people
Financial/accounting, tax and operational due diligence are all examples of hard due diligence Culture and human resources due diligence are the main examples of a soft 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 into the buyer’s company or portfolio. People and processes need to be proven effective and adaptable. As cybercrime proliferates, an increasingly important focus is the vulnerability inherent in the IT infrastructure —the security risk in M&A is a critical factor.

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 a target’s fixed assets (such as vehicles, machinery and office furniture) and document the description, date acquired, price, depreciation years, accumulated depreciation, net book value and location. Lastly, inventory is also considered a material asset; it will be assessed to establish quantity, value and condition.

Intellectual property: Particularly in technology-driven industries, a target company’s IP portfolio largely determines its value and relevance to the combined company. Common things to look for here are 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 account information like total number of employees, demographics, compensation, benefit plans, human resource policies, contracts and organizational structure. Are there any employee-relations issues that need to be addressed? Are there contracts in place that the acquirer will be grandfathered into? What about severance packages, particularly golden parachutes? What stock purchase and stock option benefits do employees hold, and do they comply with 409A? Are there key personnel in place? If so, how do you ensure that they stay? This is particularly important in acqui-hire situations.

Commercial: Examines the target’s ecosystem to determine its place in the market. Usually conducted by third-party analysts, this process delves into market conditions, trends, competitors, opportunities/threats and differentiators. Consumer sentiment data, such as NPS and churn rate, are also critical here. What is the customer’s perception of and loyalty to the product or service? Does consumer demand validate the company’s claims about its growth potential?

Environmental: Identifies environmental, health and safety issues that could directly affect the value and reputation of the target business. Factors include compliance with environmental laws, the absence of contamination, research into the history of the property and assessments of any sustainability issues. This will likely include on-site inspections and a review of property records.

Cultural: Cultural due diligence accounts for the more subjective and emotion-based “human element” of a company. It seeks to understand the cultural dynamics of a potential acquisition in areas like values, perceptions, traditions and working styles. Read our Brainyard article for more on the importance of culture in M&A.

Strategic: Strategic due diligence takes a cumulative view of all other due diligence results and attempts to answer the million-dollar question: How does this company mesh with my current business/portfolio? Current profitability is irrelevant if the target doesn’t strategically fit. What are the value drivers of this transaction? Are there redundancies that will need to be eliminated to achieve synergy? Will the business plan hold up to market realities? 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 due diligence checklist.

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, the investment 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 the latest trends in strategy for CFOs. She has written extensively on executive topics as a former content creator for Deloitte’s C-suite programs. Reach Megan here.

  

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