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What is Due Diligence in an M&A Transaction?

By Generational Equity

Due Diligence

A couple of articles ago we explored the contents and importance of a Letter of Intent (LOI) in an M&A event. As you may recall, the LOI is the document that the buyer and seller negotiate and then sign which triggers the next and most important portion of a deal closing: Due Diligence. 

This 2-3 month period is where most deals collapse for a variety of reasons. Sellers get fatigued by the ongoing, unceasing back and forth with buyers on a variety of topics; buyers lose momentum because of a lack of information being fed back to them or inaccuracies and inconsistencies in the documentation.

It is a serious time in any transaction and unprepared sellers often have a very tough time going through due diligence. This how our friends with Axial describe it:

At its core, due diligence is about uncovering and evaluating risk. During the process, acquirers try to confirm the accuracy of the information the company has provided, as well as unearth any potential risks not detailed — whether intentionally or unintentionally.  In addition to reviewing the paperwork the company provides, most acquirers will also do some form of on-site due diligence in order to speak with company employees and get a better sense of how the organization functions on a day-to-day basis.

I have highlighted the end of the first sentence above because ultimately the level of risk a buyer sees in your business will serve to increase the discount rate the buyer will apply to your future earnings. This in turn, all things being equal, will reduce the payout when the deal closes and/or impact the terms of the deal.

In some cases, if the risk is considered substantial, you may be required to stay with the firm for 3-5 years under an earn-out tied to revenue and/or earnings targets being hit (some of which you will not have direct control over). 

So how do buyers evaluate risk during due diligence? As Axial reiterates, by closely analyzing key areas such as:

Business/operations: How sustainable is your company’s revenue and cash flow? What is your growth trajectory? How do your customers view your product/services?

Accounting: Most acquirers will conduct a “Quality of Earnings” review of the sellers’ financial statements (usually with the help of an outside accounting firm) to arrive at a comprehensive understanding of the target’s historical revenues, cash flows, and earnings.

Legal: Acquirers will engage a lawyer to review a variety of legal documents — including organizational documents, customer/supplier contracts, past litigation, real estate leases, and more — to look out for any current or potential legal liabilities.

IT: IT due diligence varies depending on the type of company, and will obviously be more extensive for software or tech-enabled businesses. A few common focuses include security vulnerabilities, ownership/structure of proprietary technology and/or custom software, and software and employee device inventories.

Environmental: What environmental risks are associated with the business? Depending on the company’s industry and risk factors, acquirers will conduct environmental site assessments of any company properties to determine potential contamination, litigation risks, and more.

And believe me, this is just the tip of the iceberg! Most due diligence punch lists contain 200-300 initial questions with, as the process unfolds and risk factors are identified, dozens of follow-up queries. 

So preparation by the seller is critical. The worst thing you can do as a seller is not have your documents in order and delay getting back to the buyer in a timely manner. That in and of itself is a risk factor that makes buyers cringe.

Since due diligence can be so difficult to navigate, we strongly recommend that sellers engage an experienced M&A firm long before you reach that stage. Our clients often tell us that they had no idea going into it how challenging it would be and how, without our assistance, close to impossible it would have been to survive. Don’t take my word for it, have a listen to a few of our clients about it:

In these videos the two key themes you hear are:

  • Be Prepared
  • Hire a Professional Firm to Represent You

Our process begins with a full evaluation of the firm by our award-winning evaluation team. This 3- to 4-month process is really a mini version of the due diligence you will have to eventually endure. Not only do we place a value on the company, but the questions we ask are also very similar to what buyers will ask. So for us, it becomes a key part of the eventual success in closing the deal.

If you are interested in learning more about the services we provide to business owners, give us a call at 972-232-1121 or visit our web page, give us your contact info, and we will reach out to you.

And if you decide to work through due diligence alone without help, remember to be prepared in advance to answer tough questions that are designed to ferret out risk. If you are not prepared, they will find it!

Carl Doerksen is the Director of Corporate Development at Generational Equity.

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