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How Buyers Evaluate Risk: Due Diligence 101

Meghan Daniels Axial | July 17, 2019

Buying a business is a complex proposition. There are dozens of considerations, tangible and intangible, that must be taken into account when evaluating whether a transaction is a good fit. Due diligence is the process by which buyers attempt to dig into all these factors before signing off on a deal. In this article, we’ll outline some of the basic components of a typical due diligence process in an M&A transaction. 

In a sense, M&A due diligence begins as soon as a buyer becomes aware of a potential deal. Every subsequent interaction — from the first Google search of the company name to the initial phone call with their investment banker to the first meeting with company executives — informs whether an acquirer decides to move forward with a deal. However, most consider the formal due diligence process to begin once the buyer and seller sign a LOI. 

Due diligence usually focuses on a few main areas (though the process will vary depending on the industry, the business, and the acquirer). These include: 

  • 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. 

As part of due diligence, potential acquirers typically request a wide range of documents from companies. These include but are not limited to:

  • Financial statements
  • Tax records
  • Organization charts 
  • Articles of incorporation
  • Detailed information about company assets
  • Contracts with suppliers and customers
  • Insurance coverage and any recent claims
  • IT information, including software agreements and system analyses
  • Recent press releases and articles about the company
  • Information on pending or past litigation
  • Information on product/service offerings and current/past customers
  • Licenses and permits
  • Environmental issues 
  • Real estate information 
  • Intellectual property information 
  • Information on employees and benefits 
  • Information on current/projected revenue streams 

Download a comprehensive due diligence checklist for acquirers here >> 

For sellers, working with an investment bank will help ensure you are prepared with all the necessary information ahead of time, and put your best foot forward during the due diligence process. 

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. Traditionally, acquirers would set up a physical data room to account for the mountains of paperwork required to evaluate a deal, but today, virtual data rooms are the norm, allowing sellers, acquirers, and advisors to securely store and access all the documents related to the transaction online. 

Ultimately, in addition to verifying concrete information about the business, acquirers use due diligence as a time to evaluate the fundamentals of the business and gain as strong a grasp as possible on the intangible factors that are likely to play a significant role in its future success (or failure). What’s the management style of the leadership team? How engaged are its employees? How loyal are its customers? Who manages the company’s relationship with vendors and customers? Is information documented transparently, or does it live in the owner’s head? What is the market’s perception of the business, and how does it line up with its competitors? 

The timeline for due diligence varies. Often LOIs will set out a timeframe between 30-90 days for the process; however, the process often stretches beyond this (much to the chagrin of sellers). 

For more on due diligence, check out these related articles: 

 

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