What is Due Diligence?
Due diligence is a process of verification, investigation or audit of a potential deal or investment opportunity to confirm all facts, financial information, and verify anything else that was brought up during an M&A deal or investment process. Due diligence is completed before a deal closes to provide the buyer with an assurance of what they’re getting.
Importance of Due Diligence
Transactions that undergo a due diligence process offer higher chances of success. Due diligence contributes to making informed decisions by enhancing the quality of information available to decision makers.
From a buyer’s perspective
Due diligence allows the buyer to feel more comfortable that his or her expectation of the transaction is correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence will substantially increase the risk to the purchaser.
From a seller’s perspective
Due diligence is conducted to provide the purchaser with trust. Therefore, it is not uncommon for sellers to prepare due diligence reports prior to potential transactions.
Reasons For Due Diligence
There are several reasons why due diligence is conducted:
- To confirm and verify information that was brought up during the deal or investment process
- To Identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
- To gain information that would be useful in valuing the deal
- To make sure that the deal or investment opportunity complies with the investment or deal criteria
Costs of Due Diligence
The costs of undergoing a due diligence process depend on the scope and duration of the effort. They depend heavily on the complexity of the target company. However, costs associated with due diligence are an essential expense to minimize risks of not conducting due diligence. Parties involved in the deal determine who bears the expense of doing due diligence.
Due Diligence Activities in an M&A Transaction
There is an exhaustive list of due diligence questions. Additional questions may be required for industry-specific M&A deals while fewer questions may be required for smaller transactions. Below are typical due diligence questions addressed in an M&A transaction:
1. Target Company Overview
Understanding why the owners of the company are selling the business
- Why is the owner selling the company?
- Have there been efforts to sell the company before?
- What are the business plan and long-term strategic goals of the company?
- How complex is the company (in terms of products, services, subsidiaries)?
- Have the company recently acquired or merged with other companies?
- What is the geographical structure of the company?
Historical financial statements and related financial metrics with future projections
- Are the financial statements audited?
- What do the financial statements imply about financial performance and condition of the company?
- Are margins for the company increasing or decreasing?
- Are future projections reasonable and believable?
- What working capital is required to run the company?
- What are current capital expenditures and investments?
- What amount of debt is outstanding and what are its terms?
- Are there any unusual revenue recognition?
- Does the company have enough financial resources to cover the cost of transaction expenses of the deal?
The quality of the company’s technology and intellectual property
- What patents do the company have?
- What trademarks do the company have?
- What copyrighted products and materials does the company use or own?
- How are trade secrets preserved?
4. Strategic Fit
How the company will fit into the buyer’s organization
- What synergies will be obtained?
- What products or services will be provided that the buyer does not already have?
- Will there be a strategic fit?
5. Target Base
The company’s target consumer base and the sales pipeline.
- Who are the company’s top customers?
- What consumer risks are apparent to the company?
- Are there warranty issues and what is the customer backlog?
The company’s management, employee base, and corporate structure.
- What is the current compensation structure for officers, directors, and employees?
- What are the current employee benefits?
- What are the management incentives or bonuses?
- What are the policies and employee manuals?
- Detailed background on the CEO and CFO
7. Legal Issues
Pending, threatened, or settled litigation
- What are the pending and threatened litigation?
- What are the claims against the company?
- Settled litigations and the terms of these settlements?
- Are there any governmental proceedings against the company?
8. Information Technology
Capacity, systems in place, outsourcing agreements, and recovery plan of company’s IT
- What software packages are being used by the company?
- What are the annual maintenance costs?
- What is the capacity of the usage level of existing systems?
- Is there a disaster recovery plan in place?
9. Corporate Matters
Review of organizational documents and corporate records.
- Charter documents of the company?
- Who are the current officers and directors?
- Who are the security holders (options, preferred stocks, warrants) of the company?
- Are there subsidiaries of the company?
- Current stockholders and voting agreements?
- Are securities properly issued and in compliance with applicable laws?
- Are there any recapitalization or restructuring documents?
10. Environmental Issues
Environmental issues that the company faces and how it may affect the company.
- Are there hazardous substances/materials used in the company’s operations?
- Does the company have environmental permits?
- Are there any environmental claims or investigations to the company?
- Are there contractual obligations relating to environmental issues?
11. Production Capabilities
Review of the company’s production-related matters.
- Who are the company’s most significant subcontractors?
- Who are the company’s largest suppliers?
- What is the monthly manufacturing yield?
- What materials are used in the production process?
- Are there agreements or arrangements related to testing of company products?
12. Marketing Strategies
Understanding the company’s marketing strategies and arrangements.
- Are there any franchise agreements?
- What are the current marketing strategies in place?
- Sales representative, distributor, and agency agreements?
Why Due Diligence Matters
Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to investment decisions.