Due Diligence

What is Due Diligence?

Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information and to 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 their expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.

From a seller’s perspective

Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves 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 obtain 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, which depends heavily on the complexity of the target company. Costs associated with due diligence are an easily justifiable expense compared to the risks associated with failing to conduct due diligence.

Parties involved in the deal determine who bears the expense of due diligence. Both buyer and seller typically pay for their own team of investment bankers, accountants, attorneys, and other consulting personnel.

Due Diligence Activities in an M&A Transaction

There is an exhaustive list of possible due diligence questions to be addressed. 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)?
• Has the company recently acquired or merged with other companies?
• What is the geographical structure of the company?

2. Financials

Examining historical financial statements and related financial metrics, with future projections

• Are the financial statements audited?
• What do the financial statements imply about the financial performance and condition of the company?
• Are margins for the company increasing or decreasing?
• Are future projections reasonable and believable?
• What amount of working capital is required to run the company?
• What are the current capital expenditures and investments?
• What amount of debt is outstanding and what are its terms?
• Is there any unusual revenue recognition?
• Does the company have enough financial resources to cover the cost of transaction expenses for the deal?

3. Technology/Patents

The quality of the company’s technology and intellectual property

• What patents does the company have?
• What trademarks does 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 for the company?
• Are there warranty issues, and what is the customer backlog?

6. Management/Workforce

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 company’s CEO and CFO

7. Legal Issues

Pending, threatened, or settled litigation

• What is the nature of any pending or threatened litigation?
• What claims, if any, are there against the company?
• Settled litigations and the terms of settlements
• Are there any governmental proceedings against the company?

8. Information Technology

Capacity, systems in place, outsourcing agreements, and recovery plan of the company’s IT

• What software packages are being used by the company?
• What are the annual IT 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 (holders of 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 they 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 related 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 the 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 informed investment decisions.

Other Resources

We hope that reading CFI’s guide to due diligence has been helpful to you. To continue learning more and advancing your financial education, see the following free resources from CFI:

• M&A Considerations and Implications
• Forensic Audit Guide
• Merger Consequences Analysis
• Financial Modeling and Valuation Analyst Guide