People in the know call due diligence “due dili,” As in, “I’m only 180 hours of due dili away from some sleep.”
Due Diligence in M&A: Introduction
Due diligence is the process by which the buyer solicits information that reduces this asymmetry. Broadly speaking, the due diligence process seeks to aid the buyer in determining whether it wants to proceed with an acquisition, and at what price.
There is massive information asymmetry between the buyer and seller when acquiring a company: The seller knows everything about its own business and the buyer knows far less. Making matters worse, the seller is incentivized to hide or downplay negative aspects of the business and exaggerate the positives.
M&A Due Diligence: Investment Banking Checklist
Naturally, due diligence is primarily done by the buyer to the seller. However, the seller also performs due diligence on the buyer when buyer stock is used as part of the merger consideration. That’s because the seller will now have an interest in the buyer’s business. Sellers may also perform some basic due diligence in a cash sale to ensure the buyer will be able to finance the acquisition.
Due diligence is unique to each transaction, but a thorough due diligence process usually involves:
1) Financial Due Diligence
- Historical financial performance (usually the last 3 years)
- Revenue analysis: Customers, products, distribution channels, geography, pricing strategy, key contracts, etc.
- Expenses: Analysis of cost of sales, SG&A, R&D, corporate overhead, key suppliers
- Analysis of company’s assets and liabilities including leases, plants and real estate assets
- Analysis of company cash flows
- Seller assumptions and projections (quarterly over next 3 years)
- Review and sensitivity of key assumptions on income statement, balance sheet and cash flow statement
2) Business Due Diligence
- Analysis of seller’s industry, competitive position, strategic plan
- Analysis of key customers and affiliates
- Review of company products, product sourcing strategy and suppliers
- Review of company’s research and development and marketing and sales programs
- Compensation of management and key employees
- Ownership: Analysis of key shareholders
3) Legal, Accounting and Tax Due Diligence
- Legal: Review of IP, patents, outstanding or potential litigation, incorporation documents, employment contracts, key customer and supplier contracts and loan agreements
- Accounting: Understanding seller’s accounting policies, controls and cash management
- Tax: Review of tax attributes (like NOLs) that may be inherited or lost in an acquisition
4) Integration and Operational Due Diligence
- Analysis of synergies and integration planning
- Cultural fit, retention and compensation of management and employees and location of offices
- Impact of acquisition on customers, partnerships and suppliers (i.e. channel conflicts, change of control issues)
- Treatment of options and other dilutive securities, capitalization table
- Visits to seller’s headquarters and facilities
- Meetings and discussions with seller’s management, shareholders and other key stakeholders
Learn More → Investment Banking Guide
Due Diligence in M&A: Public vs. Private Sellers
When the seller is a public company, the diligence can be thought of as a two-phase process:
- The buyer can conduct a primary diligence process (sometimes before even engaging with the seller) by using public filings (10Ks and 10Qs, proxy statements) to learn about the seller’s financials, operations, and shareholders.
- Private information is shared. This is provided by the seller once the buyer and seller sign a confidentiality agreement (CA), also called a non-disclosure agreement (NDA).
When the seller is a private company, there’s very little due diligence that can be performed (beyond perhaps a sector or industry analysis) until the seller willingly provides nonpublic information. Comprehensive due diligence can only begin once the CA is signed.
