M&A Due Diligence Explained

If it is your first time selling a company, the M&A due diligence process can be overwhelming. The amount of time spent responding to buyer’s questions might make you question if you choose the right buyer, or if you want to sell your company at all. But as time consuming as due diligence is and as frustrating as it can feel, every buyer requires it. It is a necessary step to move from offer to closing. Successful transactions are often the result of successful diligence processes. Business owners and management teams can use the process as an opportunity to show how great your business really is, and how capable the senior employees are.

So, with that in mind, how can you make it go as smoothly as possible? Below we discuss what to expect, so you can prepare for the process.

M&A Due Diligence Process

Most broadly, due diligence is the deeper investigation of a matter under consideration. In the world of M&A transactions, due diligence means reviewing every aspect of a company that could impact the deal’s integrity. This review is in-depth and wide ranging, from reviewing and confirming financial performance, to physical inspection of assets, to environmental and legal review. It is not uncommon for the due diligence request list to span many pages.

Why is the process so lengthy? Simply put, a buyer must verify that its understanding of a company’s historical performance and its assumptions about future performance are justifiable. Without doing so, the buyer risks dealing with unpleasant surprises down the road. Lenders also require due diligence, and a quality of earnings report prepared by a third party provider is often a key component of their underwriting decision. And of course, due diligence is necessary to draft all of the relevant legal purchase documents. In sum, the deal could not close without due diligence.

M&A Due Diligence Checklist

The due diligence checklist, or request list, varies by buyer and situation. In the case of smaller transactions, where you are selling just a product line for example, the list may be shorter. As a seller, you should anticipate receiving a detailed list of questions from the buyer. There are certain actions you can take early in the sale process to make the due diligence process smoother. If you know you will begin the M&A due diligence process soon, it helps to create a data room and start collecting items that you know the buyer will need to review. These materials can be conveniently stored digitally in the data room. Examples of items commonly requested include:

Financial Information

The buyer will request several years of historical financial information, including annual and monthly balance sheets, income statements, cash flow statements, tax returns and more. They will also ask if there have been any changes in accounting practices over time, and for future financial projections. Exact requested documents vary, but the goal is to verify the company’s financial health. The buyer will want to understand topics such as seasonal working capital needs, if the company’s projections for the future are reasonable, and if the operating profit margin is increasing or decreasing.

Intellectual Property

Some companies have valuable intellectual property such as copyrights, trademarks, and patents that protect a company’s earning power. If you do, the buyer will likely request evidence of these, as well as applications for additional intellectual property protection. Another key question is, how does the company protect trade secrets? The buyer will also request information related to supposed infringement of any copyright, trademark, or patent.

Management and Employees

This category consists of a thorough background on the company’s management team, general employee policies, and how employees and executives are compensated. Employee compensation details include benefits, such as bonuses, commissions, retirement benefits, or vacation time. It is common for a buyer to review all benefit programs, and employee handbooks as well.

Environmental Matters

Does your company work with any hazardous materials or waste? If so, then you will need to provide documentation for the handling of wastewater, air emissions, solid and hazardous waste, environmental permits, and more. Is the facility owned or leased? Does the facility have any known previous contamination?Is the facility “clean”? These reviews might include hiring third party experts to conduct Phase I— or more— environmental studies.

Other Tips

In addition to collecting documents in the data room, it is also helpful to prepare a team of employees and outside advisors to help with the diligence process and the transaction. Transaction teams often include the CEO, CFO, outside legal counsel, outside accountants, and other key employees who can help with the process. Responding to due diligence requests can feel like a full-time job on top of the one you already have, making outside counsel that much more helpful. Hiring outside help also allows you to focus on keeping the business running smoothly— a critical task to ensure the buyer’s confidence in your company remains high.

Due diligence is an important and mandatory step in the process from deciding to sell your company to successfully doing so. Rather than dreading the process, embrace it and use it as an opportunity to highlight your organization, its people, and your command of your business. A great diligence process can be a sales tool, further convincing the buyer how valuable your company is. If you have any questions or concerns on the due diligence or selling process, contact us and we would be happy to help.