Ways to assess a company's capabilities and financial performance
One of the most important and lengthy processes in an M&A deal is Due Diligence. The process of due diligence is something that the buyer conducts to confirm the accuracy of the seller’s claims. A potential M&A deal involves several types of due diligence.
Due diligence (DD) is an extensive process undertaken by an acquiring firm in order to thoroughly and completely assess the target company’s business, assets, capabilities, and financial performance. There may be as many as 20 or more angles of due diligence analysis.
The main types of due diligence inquiry are as follows:
Administrative DD is the aspect of due diligence that involves verifying admin-related items such as facilities, occupancy rate, number of workstations, etc. The idea of doing due diligence is to verify the various facilities owned or occupied by the seller and determine whether all operational costs are captured in the financials or not. Admin DD also gives a better picture of the kind of operational cost the buyer is likely to incur if they plan to pursue expansion of the target company.
One of the most important types of due diligence is the financial due diligence that seeks to check whether the financials showcased in the Confidentiality Information Memorandum (CIM) are accurate or not. Financial DD aims to provide a thorough understanding of all the company’s financials, including, but not restricted to, audited financial statements for the last three years, recent unaudited financial statements with comparable statements of the last year, the company’s projections, and the basis of such projections, capital expenditure plan, schedule of inventory, debtors and creditors, etc.
The financial due diligence process also involves analysis of major customer accounts, fixed and variable cost analysis, analysis of profit margins, and examination of internal control procedures. Financial DD additionally examines the company’s order book and sales pipeline in order to create better (more accurate) projections.
Many acquirers have a separate section of financial analysis focused on the target company’s debt situation, evaluating both short-term and long-term debt, applicable interest rates, the company’s ability to service its outstanding debt and secure more financing if needed, along with an overall examination and evaluation of the company’s capital structure.
Another type of due diligence conducted is asset DD. Asset due diligence reports typically include a detailed schedule of fixed assets and their locations (if possible, physical verification should be done), all lease agreements for equipment, a schedule of sales and purchases of major capital equipment during the last three to five years, real estate deeds, mortgages, title policies, and use permits.
Human resources due diligence is extensive. It may include all of the following:
Due diligence related to environmental regulation is very important because if the company violates any major rule, local authorities can exercise their right to penalize the company, up to and including shutting it down operationally. Hence, this makes environmental audits for each property owned or leased by the company one of the key types of due diligence. The following should be reviewed carefully:
Due diligence in regard to tax liability includes reviewing all taxes the company is required to pay and ensuring their proper calculation with no intention of under-reporting of taxes. Additionally, verify the status of any tax-related case pending with the tax authorities.
Documentation of tax compliance and potential issues typically includes verification and review of the following:
Almost every company has intellectual property assets that they can use to monetize their business. These intangible assets are something that differentiates their products and services from their competitors. They may often comprise some of the company’s most valuable assets. A few of the items that need to be looked at in a due diligence review are:
Legal due diligence is, of course, extremely important and typically includes examination and review of the following elements:
As customers or clients are the lifeblood of any business, the types of due diligence invariably include a close look at the target company’s customer base, with examination and analysis of the following:
Acquirers are generally also very careful about exercising due diligence in regard to evaluating how well the target company fits in with the overall strategic business plan of the buyer. For example, a private equity firm considering a new acquisition will ask how well the proposed target will complement the firm’s existing portfolio of companies. A large corporation eyeing a possible M&A deal considers how easy (or how difficult) it is likely to be to successfully merge the target company into the buyer’s total corporate organization.
The following are some of the key strategic fit issues that acquirers look at and evaluate:
Other areas of due diligence research include IT networks, issues of stocks and/or bonds, research and development (R&D), and sales and marketing. Conducting thorough due diligence is critical to any successful acquisition. Without complete and intimate knowledge of the target company, it is impossible to make the best-informed decisions on mergers and acquisitions.
In a proposed merger or a situation where shares of stock in the acquiring company constitute a major part of the purchase transaction, the target company may look to perform its own due diligence on the acquirer.
Thank you for reading CFI’s guide to Types of Due Diligence. To learn more about mergers and acquisitions, the following CFI resources will be helpful: