How to Conduct Buy-Side Due Diligence + Template

In cases where management claims that a deal wasn’t successful, for example, ‘because of cultural issues,’ ‘because we paid too much for the target,’ or ‘because of issues related to integration,’ this usually means that they didn’t perform sufficient due diligence.

All of the factors you might think of, related to a successful deal, as well as the price, are derived from good due diligence.

We at DealRoom assist many firms with performing due diligence, and in this article, we’ll share our experience.

What Is the Difference Between Buy-Side and Sell-Side Due Diligence?

It’s quite common for the buy-side to be the first to initiate the due diligence process after the letter of intent (LOI) is signed.

To the buyer, performing due diligence is the all too crucial chance to really understand the target company.

For example, a full understanding of the target company's business, including the nature of its products and services, its management style, its major players, its suppliers, its customers, and its marketing strategies.

Moreover, it’s the time for the buyer to obtain a full financial picture of the company. This will also help the buyer ensure that the offer price is appropriate.

Lastly, due diligence is used as a means of identifying any red flags and other risk factors. Once the buyer is aware of the above, it will position itself in a position to achieve success in the future and will set the stage to achieve synergies.

In order to conduct due diligence, the buy-side must have or obtain a due diligence team. The team is composed of individuals, both internal and external.

For the sell-side, the purpose is to utilize due diligence as a means of risk mitigation, in order to ensure that the risks don’t end up working against the deal and, in turn, reducing the purchase price. For example, the sell-side should answer the following questions in order to get started with the process:

• Why am I selling?
• What’s the value of the company right now?
• What are the current areas of the company that could potentially pose a risk to a deal?
• Can the above areas of the company be remedied easily?
• Who will I have on my team in the life cycle of the deal?

In other words, the buy-side is looking to identify risks, and the sell-side is looking to mitigate those risks.

Why You Need To Conduct Buy-Side Due Diligence

In conducting buy-side due diligence, you’re actually protecting yourself against becoming another casualty of the M&A process, and ensuring that the deal is as valuable as it can be. You can expect that some uncomfortable truths will be uncovered by conducting due diligence.

After all, it would be surprising if they didn’t have at least a few. However, they must be taken into consideration.

Below, we’ve compiled a list of the key areas that you cannot afford NOT to include as part of your due diligence process.

Buy-Side Due Diligence Process (Overview)

Arbitrary due diligence ‘how to’ guides suggest that the due diligence process can be broken down into about three or four key areas that the due diligence process must address: tax, legal, finance, operations, etc.

These are the minimum due diligence areas that must be addressed. And, depending on the target business, they could take a considerable amount of time to complete.

As we have said, they must be included. In our previous article on the buy side due diligence process, we provided an exhaustive list of the types of documentation that could be requested as part of the due diligence process.

Let’s borrow from that article for a moment. As we said, the due diligence process must address the following areas: 

• Legal
• Commercial
• Financial
• Human Resources
• Intellectual Property
• Information Technology
• Environmental, Health & Safety
• Tax
• Marketing
• Compliance & Regulatory

The due diligence areas that must be addressed, what buyers review, and examples of the types of questions that are asked for each of the due diligence areas are outlined below:

The people directly responsible for each of these areas should be the first ones to ask the questions in that area.

So, for instance, while your legal department can add great value to this process, it’s actually better to get your HR department to ask questions related to human resources.

Also, by the same token, don’t be afraid to bring new people into this process if they can add value to it. For instance, while it’s unlikely that many companies have their own IP experts, if you’re acquiring a company with patented technology, then it might be worth bringing someone in for this part.

There are a few overarching themes which we believe apply to everyone involved in buy-side acquisitions:

1. Develop an action plan

While it’s likely that no matter how well-planned your plans for conducting due diligence are, there will be hold-ups, but it’s still important to have an action plan.

The amount of analysis will depend upon how quickly the target company is sending over their documents; deadlines and emergencies with your own business mean that, unfortunately, it might be impossible to do some parts of this at the time they’re scheduled.

At least, however, by having an action plan, you can tick off sections as you go, and then come back to others which require more attention.

2. Know your red-line issues

There would be no point in undertaking the process of due diligence in the first place if you’re going to go out and acquire the target firm no matter what you discover along the way.

Due diligence isn’t research for its own sake. This could be down to a number of things, such as a simple lack of integrity. If you’re the type of person that feels that you have been misled over an issue that’s not necessarily a red-line issue in the first place, then you should ask yourself whether you are comfortable with the thought of being misled in this way when the company is acquired.

There could also be other issues that are red-line issues, such as big contracts that are up in the near future, legal cases that are looming, or the intellectual property not being as waterproof as the company has led you to believe.

3. Quantify the qualitative

To paraphrase Robert Norton and David Kaplan, the authors of the Balanced Scorecard:

‘Whatever can be measured, should be measured.’

Before asking the target firm to provide you with information, it’s useful to have a system in place that will enable you to measure the qualitative issues in relation to your own company and other firms in the industry.

This could include anything such as “how many members of your staff are trained in program X,” which will give an indication of the number of hours you’ll have to spend training the staff in the first place. Alternatively, it could be the score that they have obtained from their ex-employees via Glassdoor.com, which will give an indication of the culture that is present in the company.

And finally, in every due diligence process…

4. Efficiency rules

Due diligence is expensive for your business in terms of time and money. Many times, it’s also inconvenient for the company being acquired. Ironically, the people managing the companies without skeletons in the closet are usually the ones in the greatest hurry.

Set two time limits for your due diligence process. The first time limit should be the time you tell the target company that you expect to complete your due diligence process. 

The second time limit should be the time you expect to complete the process – usually a little less than the time you originally told the target company (perhaps two to three weeks less). This will ensure that you complete the process more quickly than the target company expected, and it will also ensure that you complete the process more quickly than you originally expected.

Buy-Side Due Diligence Timeline

Rarely does the due diligence process go off as smoothly as expected. Expect the process to take longer than expected. Expect the documents to be delivered late. 

Expect the data room to be a dumpster fire of half-finished Excel documents. Expect your eager and excited advisors to try and push you into making an offer before your team has even made the most cursory of verifications. 

Expect the process to take longer than expected. A well-designed timeline will ensure that everyone stays disciplined throughout the process. Due diligence usually has four phases. 

Each of the phases builds upon the last. Not completing the due diligence process in the beginning will always come back to haunt you (and stress you out) later in the process when the issues of valuation and deal risk start to come into play. 

Phase 1: Pre-LOI Preparation

This should be done before the actual negotiations begin. In this phase of the process, your company decides if the target company is even worth pursuing. This usually takes one to two weeks.

Start with market structure. Look at growth rates, competitive concentration, and any regulatory risks. Look at how the target company stacks up relative to its peers in terms of revenue growth, margin profile, customer concentration, etc. Public companies within the same industry can be a great resource here.

Next, look at strategic fit. Your management team should understand why this deal makes sense for your company. Are you looking to grow revenue? Enter a new geographic market? Obtain a new product capability? If not, you’re going to struggle to know how to conduct your diligence.

Phase 2: Initial Diligence

This phase of the process should take about two to three weeks. After signing the LOI, your team is granted greater access to the target company’s information. You go from researching a company to working with actual numbers.

Start with historical financial information. Review income statements, balance sheets, and cash flow statements from three to five years. Are there any anomalies in revenue growth versus cash flow growth?

A growing business should have a strong fixed cash flow. Take notes on any significant variances.

You should also seek to validate commercial information, especially if possible. Talk to customers. Churn rates? Contract lengths? Overall pricing strategy? Monthly recurring revenue, renewal rates, etc. These are all critical metrics if they’re a subscription-based business.

This is usually where you’re going to find the first deal risk. This could be a high customer concentration risk (i.e., a customer base greater than 20% of overall revenue). This could also be a high revenue recognition risk (i.e., a high dependence on a single distributor).

Phase 3: Due Diligence Deep Dive

Subject matter experts will review each of the functions at this stage. It may take several weeks to complete this stage. Three to six weeks is a good place to start with your timeline.

Legal diligence includes contracts, intellectual property, regulatory diligence, and litigation. It’s not unheard of for contracts to slip through the cracks that negatively impacted deal economics by millions of dollars.

Operations diligence is heavily dependent on the industry.

Many manufacturing companies have a concentrated supply chain. What’s the production capacity? Are suppliers concentrated? Keep an eye out for things like this.

IT diligence includes review of IT systems, cyber risk, and software licenses. Legacy systems often create the largest integration risk when it comes to technology.

Human resources diligence is focused on understanding the risk of losing employees. Are employees paid fairly? What about the CEO? Are contracts strong? If your CEO decides to quit a month after closing, integration will not go smoothly.

Workstreams will begin to overlap at this stage. What the operations team finds may impact the overall valuation. Legal diligence may require changes to the overall deal structure.

Phase 4: Closing Diligence

It’s time for your team to confirm the major findings and negotiate the purchase agreement. Many of the risks your team identified in the third stage of the buy-side due diligence process need to be verified.

• Financial models will be reviewed again. 
• Updated figures will be placed on known legal risks. 
• Dependencies will be identified for the integration teams.
• Valuation will be adjusted. 
• Earnouts will be created. 
• Working capital will be adjusted. 
• Escrows will be used to offset unknown risks.

While this phase, in most instances, is one to two weeks in duration, it’s essential to remain flexible. Don’t rush this process. You would not believe the number of instances in which contracts were missed or revenue was misunderstood. Missing one or the other could drastically alter the deal dynamics.

By the time you have completed phase four, your team should have a thorough understanding of how the company really works. Not based on what’s read in the press or what’s said in a sales presentation, but based on a thorough investigation of the inner workings of the company.

Common Mistakes Made During Buy-Side Due Diligence

There are common mistakes that are made in buy-side due diligence, and most failed deals will follow a similar pattern. Common mistakes made during buy-side due diligence include:

Overreliance on seller-provided data

The seller is the gatekeeper of the data. Financial models, customer lists, and sales pipeline are all provided by the target company.

Be skeptical of every number. Every number is a starting point, not a given.

Verify the revenue with bank statements, tax returns, and invoicing records. We’ve seen the company’s revenue reduced by hundreds of millions of dollars at closing due to back-end payments and canceled contracts. 

Underestimating the complexity of integration

Buyers will spend weeks analyzing the target company. Integration will get a few slides towards the end of the due diligence process. That’s a mistake that is made far too often.

The problems with integration start at the systems and processes level. Finance systems don't integrate. HR systems don't integrate. Reporting structures fail within the first month of closing the deal. 

The successful acquiring companies have a separate integration diligence track and perform integration diligence upfront. This means that the acquiring company documents systems, processes, organizational structures, and key workflows before the deal is signed. This is similar to preparing a project plan before the project is executed.

Rushing financial analysis

When the closing date is imminent, the financial advisors rush to put their findings together in a summary document. The acquiring company wants the deal to close, and the management wants the deal to close, too. 

The most common mistake is the way the acquiring company handles the revenue quality. The acquiring company often doesn't understand the top-line revenue. 

The way the contract value converts annually is glossed over, and the way the customer base is changing is ignored. What was once growing revenue is now decreasing when adjusting for the deferred revenue and customer churn. 

The real revenue diligence looks at the customer base, the customer churn, and the margins at the product level. If this isn’t clear, then the assumptions used in the valuation will be shaky at best. 

Ignoring cultural fit

The cultural fit is rarely discussed within the data room. This is a “soft” issue for the leadership teams. 

The problems with integration often start with the leadership teams having misaligned visions and approaches. 

The response time, the way the company is structured, the way the company is incentivized to perform – these things vary significantly from company to company. The company that was started by five guys in the garage will operate very differently from the company that’s a publicly traded company with many approval levels within the company. 

The acquiring company needs to interview the VPs that were not included in the executive leadership team. The acquiring company needs to understand the way the company makes decisions on a day-to-day basis.

Inadequate technology diligence

Technology diligence is just as soft. Teams focus too much on the surface of the technology issues, server capacities, licenses, and network diagrams. 

The key issues lie beneath the surface. What is the financial system not dependent upon? What are the security issues? 

Many financial systems rely on old technology platforms. Be cautious of legacy systems and custom code only accessible to internal developers. Acquirers sometimes assume they will acquire the developers, only to see the developers leave one month into the deal. 

The IT diligence teams need to document the system dependencies, code ownership, critical third-party vendors, and cybersecurity practices. Not having this information is tragic for operational issues. 

Poor communication across diligence teams

There are many work streams in any deal. The financial teams, the legal teams, the commercial teams, the operational teams, the technology teams – each group creates their own report. 

If the teams don't communicate, the commercial teams will see customer contracts that are restrictive. The financial teams will also see high growth rates based on the customer relationships. How will the legal teams know to ask the right questions? They don't attend the meetings with the commercial due diligence teams. 

The teams need to communicate their findings each week. The teams need to update the deal assumptions and analyze the deal impacts across the model.

Even better, consider using a centralized deal management platform to make collaboration easier. DealRoom’s M&A Platform eliminates fragmented deal information that’s currently scattered across several tools. Instead, our platform provides your team with a single source of truth for all deal information, allowing you to seamlessly organize all deal information from deal start to close. 

Your financial, legal, ops, tech, and other teams can all have the latest information at their fingertips without having to sift through countless Excel spreadsheets or email threads.

Internal communications stay organized within the collaborative platform. No longer do team members need to spend hours searching through documents to find that one critical contract.

Buy-Side Due Diligence Checklist (Questions That Should Be Asked)

Get access to our pre-made Buy-Side Due Diligence Checklist here:

How DealRoom Supports the Buy-Side Diligence Process

Technology has dramatically changed the way some parts of the M&A process work, particularly the part of it known as due diligence. The right software can significantly improve the way a buy-side team works through the process of due diligence.

Here are a few ways software, particularly software designed for M&A, can help a team work through the process of due diligence effectively:

Eliminate work - One of the easiest ways to make a team more productive is to use software that eliminates duplicate requests. In addition, being able to perform actions such as uploading documents in bulk, generating PDFs and Excel reports with the click of a button, assigning tasks with the click of a button, and live linking documents can also help a team eliminate work, saving time in the process.

Break teams out of silos/improve communication - M&A software can help a team work out of a single hub, breaking them out of the silos that can cause problems with communication.

Cut costs - Eliminating work, breaking out of silos, and improving communication all add up to a smarter way of working through the process of due diligence, saving costs in the process. In addition, the best software for M&A, particularly the part of it known as due diligence, moves away from the antiquated way of charging by the page.

Frequently Asked Questions

How long does buy-side due diligence take? 

Due diligence could take anywhere between 4 weeks to 3 months. For a small deal, it will take less time, whereas a bigger deal with a lot of negotiation will take longer.

The first 2 to 3 weeks will involve financial and commercial due diligence. Legal, operational, and technology due diligence will involve the majority of the remaining time.

The last week or two will involve last-minute validation and negotiation.

Who should be on a buy-side due diligence team? 

Buy-side due diligence is normally done by the corporate, finance, and legal departments. However, the acquiring company will hire other advisors to help them in the process. Accountants will help the finance team with the financial due diligence, and the list goes on.

The acquiring company will also hire other people, such as the operations, technology, and HR teams, especially in a bigger deal. Ensure that you have the integration team in the meetings. Integration experts are the only people who will see the risks, as they’re the ones who will see the post-closing scenario.

What’s the difference between buy-side diligence and sell-side due diligence? 

Buy-side due diligence is a risk identification process and also ensures that the valuation is correct.

Sell-side due diligence is entirely different. Before selling the company, the company will first prepare the financial and operational due diligence, which will help them in organizing the process and also in telling the story of the company.

Buyers then conduct due diligence to verify the information.

What are common buy-side diligence red flags or deal breakers? 

Revenue concentration is always a red flag. Any company with one customer representing more than 20% of the total revenue is a potential deal breaker.

Aggressive revenue recognition and inconsistent financial reporting are also potential deal breakers. Many legal issues, such as lawsuits, ownership of intellectual property, and regulatory compliance issues, tend to surface late in the due diligence process.

Operational issues also tend to surface during the due diligence process. Supplier issues, outstanding negotiations for supplier contracts, and old equipment also tend to reduce the overall valuation of the company.

How do I prioritize due diligence tasks? 

The first priority is the activities that will have the most significant impact on the overall valuation of the company. This includes the company's financial performance, customer concentration, and supplier concentration.

The second priority is the legal issues and the overall regulatory compliance issues facing the company. Once the deal is not dead, then the operational issues, technology issues, and HR issues come into play.

Don't waste too much time on issues that have the least amount of impact on the overall valuation of the company.

When do buyers start their due diligence? 

Buyers start their due diligence once the letter of intent is executed. This is the only time when the due diligence process is acceptable, and the company is willing to provide information to the potential buyer.

Buy-side due diligence, however, should start before the initial offer is made. Market research and overall financial research should be conducted before the initial offer is made.

What’s the best way to manage communication across diligence teams? 

Buyers should use a central tracking system to ensure that the overall communication is efficient throughout the due diligence teams. Many companies tend to use a shared diligence platform to ensure that each group involved in the deal is able to see each and every request and document that’s being reviewed throughout the due diligence process.

Weekly diligence meetings are also beneficial. All the advisors should meet to share their findings. Most often, the findings of one team will affect the findings of another team.  

How can we avoid wasting time on duplicate document requests? 

Duplicate requests are often the result of diligence teams working in isolation with spreadsheets and email threads. Someone on the finance team asks for a document that the legal team has already asked for. The seller is asked the same question by two different teams. It’s chaos.

When diligence is run in a centralized manner with a platform such as the DealRoom M&A Platform, the teams work together in the same list of diligence requests that is connected to the virtual data room. 

Since all the advisors are entering their requests into Dealroom in the same shared space, they can see the entire request history for the financial, legal, operational, and technology diligence requests. 

There is no need for one party member to consolidate the requests from all the advisors. When entering a new request, the advisor can see the entire request history. In addition, documents that the seller uploads are automatically linked to the request.

Key Takeaways

• Effective buy-side due diligence is a highly disciplined, cross-functional process that seeks to validate the assertions that the seller is making. The purpose of due diligence is to uncover unknown risks and validate that the target will actually help the buyer achieve their strategic and financial objectives. 
• Planning, collaborating, and working together with a unified platform to eliminate duplicate tasks and requests can greatly improve the way the due diligence is conducted.

The buy-side due diligence is what makes or breaks your deal. Technology incompatibility? Accounting issues? Leases rolling over at the factory? The randomness of risk is why due diligence is so important.

The DealRoom M&A Platform enables your team to control due diligence requests from one location. Your advisors can view the list of requests, who also requested the same information, and the status updates.

Productivity occurs quicker when all parties can view the requests, who made the request, and the status. Request a demo to learn how DealRoom can help streamline your buy-side due diligence.