What is Due Diligence?
If you are embarking on an M&A transaction, detailed Due Diligence (DD) is a key aspect of risk management.
DD is an intrinsic part of project evaluation. The focus is on understanding the risk profile of the deal and being clear about the risk/reward balance in your valuation of the target and the structuring of the deal.
The overall objectives of DD are to confirm historical statements and status of the business operations of the target company and thereby help assess future standalone value, whilst also enabling a refinement of the estimate of any potential synergies initially identified post combination. It serves to confirm or correct the initial macro level valuation estimate and highlight areas of potential risk, to be mitigated and/or taken account of with pricing or deal structuring.
As you learn more during DD, you should still try to make your offer as clean as possible, but build in a balance of protection, where required. You should aim to be thorough during the DD process and any impacts on the valuation. It is a ‘one-time’ opportunity to get things right.
Many people think DD is all about financial statements. Sure, this can form a material part of DD but it is by no means limited to just that. In reality, DD encompasses a broad range of topics that are crucial to understand when buying a business. A few of the key areas are as follows (however, a given transaction may require other areas to also be investigated): Commercial position (markets, products, customers); Financials (historical accounts, future financial forecasts, net assets, loans, creditors, debtors); Tax status; Operations (age and condition of assets, assessment of production, supply chain, procurement, back office, technology); Legal (any pending litigation, contracts (customer, supplier, leases etc), asset titles, licensing agreements, environmental obligations); Intellectual Property status; Human Resources (organisation details, employee contracts, benefits, pension obligations); Information Technology. It will likely also involve interviews with management, to further understand the business in depth and get a feel for the culture of the company.
Throughout the process of due diligence, it is important to thoroughly assess the risk profile of the target and use the information derived from DD to refine the preliminary financial valuation of the target and thus link DD to ongoing negotiations around price and terms and conditions of the deal.
If instead you are looking to sell your business, you should also be very aware of what the due diligence process entails, and understand what a potential buyer will be looking for. Be ready for requests for a copious amount of information. It is recommended to pre-empt this and compile as much information as possible in advance of a planned exit, rather than reactively once the process has commenced. It’s true that whatever you prepare, it will never cover all the questions a potential buyer might ask, but well thought out preparation of the expected documentation requirements in advance will make the journey ahead less stressful. Poorly prepared due diligence information or responses to buyer Q&A, may even be the difference between deal and no deal, if the potential buyer cannot get comfortable with the level of information available to carry out their risk assessment.