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The Ultimate Guide to the Due Diligence Process in M&A

Due Diligence Checklist
Ensure you’re asking the right questions during the diligence process of your next transaction

Due diligence is the process that allows buyers to fully understand target companies in mergers and acquisitions.

For confidentiality purposes, companies do not disclose every detail of their operations to every company that expresses an interest.

Thus, the due diligence process allows the buyer to gain more insight into the company, its people, and how it operates.

If you’d like to know more about how DealRoom can transform your company’s due diligence process, click the link and visit our due diligence solution page.

What is Due Diligence Process?

Due diligence process is a solid review or audit of a company, usually undertaken before a financial transaction, usually merger or an acquisition. The aim of due diligence in business is to ensure that any decision taken regarding the company in question is an informed one, maximizing your chances of adding value in an M&A transaction.

Due Diligence Phase of M&A Transaction

Due Diligence Review

The due diligence process throws up lots of information on the target company, across all of its operational areas. The goal of the due diligence review is to piece together all of this information into a coherent story.

This usually involves the people in charge of the due diligence process convening and deciding if there’s anything that was disclosed in the process that changes their initial opinion on a deal.

For example:

  • can the deal still go ahead?
  • should it go ahead with a certain set of covenants?
  • what concerns should be raised with the target company?

These are typical of the questions that will arise during the due diligence review.

The History of Due Diligence

“I like not fair terms and a villain’s mind.”

This line from Shakespeare’s Merchant of Venice shows that some form of due diligence existed all the way back to 1605.

In fact, the first known usage of the term ‘due diligence’ came shortly before Shakespeare’s play in 1598. But due diligence may be as old as transactions themselves - with the transaction itself creating a need to know more about the other side.

It wasn’t until the 20th century that due diligence took on the more structured form that we know today. The first time that due diligence is mentioned in SEC documents was 1933, but it is fair to assume that the arrival of more sophisticated management accounting methods in the second decade of the twentieth century, saw the first tentative steps in modern due diligence.

What Types of Due Diligence are There?

In mergers and acquisitions, we typically think of four major types of due diligence:

  • Financial due diligence: Focusing on the financial performance of the company until the present date and ensuring that the numbers presented in the financial statements are accurate and sustainable.
  • Legal due diligence: Focusing on all legal aspects of the company and its relationships with its stakeholders. Areas typically analyzed include licences, regulatory issues, contracts, and any legal liabilities that may be pending.
  • Operational due diligence: Focusing on the company’s operations - essentially looking at how the company turns inputs into outputs. This is generally considered to be the most forward looking type of due diligence.
  • Tax due diligence: Focusing on all of the company’s tax affairs and ensuring that its tax liabilities are paid in full to date. Due diligence in tax also looks at how a merger would affect the tax liabilities of the new entity created by the transaction.

Why is Due Diligence Important?

A merger or acquisition is the biggest corporate transaction that any business will undertake.

Due diligence enables companies to undertake these transactions from an informed standpoint.

It can add significant value for the buyer by showing where the target company’s weaknesses (or red flags) are as well as identifying some opportunities within the target company that it previously wasn’t aware that existed.

which departments get the most scrutiny during due diligence and which the least?

What are the Challenges of Due Diligence?

Gaining an in-depth understanding of a company can be a highly specialized process beyond most people without experience in the field.

There tend to be a myriad of challenges, but the following are usually among the most commonly encountered:

  • Not knowing what questions to ask: It is vitally important to know in advance what the issues are and what diligence questions need to be asked to investigate them properly.
  • Slowness of execution: Asking sellers to acquire documentation or information can take time, often with the consequence of delaying the transaction’s closing.
  • Lack of communication: Sellers, even willing sellers, tend to regard due diligence as a hassle, leading to impatience, poor communication, and even friction.
  • Lack of expertise: There is a good chance that you’ll have to bring in some hired hands tor at least some parts of the due diligence process (e.g., an IP expert).
  • Cost challenges: Due diligence can be expensive, running into months and extensive specialist hours, making many erroneously think that they can cut corners.


Conducting Due Diligence

Conducting due diligence is an essential component of any M&A transaction.

To conduct due diligence means to thoroughly analyse a commercial business. It is done typically by a potential buyer prior to business transactions.

How to conduct due diligence on a company differs by transaction, but there are certain steps that are common to each deal. As a general rule, the larger and more complex the deal, the more due diligence will be required.

DealRoom has been a catalyst for due diligence in hundreds of M&A transactions, and the following steps for due diligence were present in each of them:

  • Income statements
  • Balance sheets
  • Partnership agreements
  • Existing contracts
  • Profit/loss records
  • Annual reports
  • Tax filings
  • Business and operational practices

You can find the detailed due diligence checklist below.

Due Diligence Checklists

DealRoom's Due Diligence Reports and Playbooks help team efficiently manage due diligence from the start. Diligence incorporates many moving parts and it is critical to a deal's success.

Our library of pre-built ready to use playbooks enables teams to thoroughly and effectively collect necessary diligence information.

Access the Diligence Templates Gallery

Due Diligence Process Steps, Policies and Procedures

due diligence process

Due diligence in M&A is a lengthy and intimidating process that involves multiple parties and phases. Listed are general due diligence process steps.

1. Evaluate Goals of the Project

As with any project, the first step delineating corporate goals. This helps pinpoint resources required, what you need to glean, and ultimately assure alignment with the firm’s overarching strategy.

This involves introspective questions revolving around what you need to gain from this investigation.

2. Analyze of Business Financials

This step is an exhaustive audit of financial records. It ensures that documents depicted in the Confidentiality Information Memorandum (CIM) were not fluffed.

Additionally, it helps gauge the company’s asset health, asses overall financial performance and stability, and detect any red flags.

Some of the Items inspected here include:

  • Balance sheets and income statements
  • Inventory schedules
  • Future forecasts and projections
  • Revenue, profit, and growth trends
  • Stock history and options
  • Short and long-term debts
  • Tax forms and documents
  • Valuation multiples and ratios in comparison to competitors and industry benchmarks

The detailed financial due diligence checklist could be found here.

3. Thorough Inspection of Documents

This due diligence step begins as a two-way conversation between buyer and seller. The buyer asks for respective documents to audit, conducts interviews or surveys with the seller, and goes on site visits.

Responsiveness and organization on the seller’s end are key to expedite this process. Otherwise, it may create an arduous experience for the buyer.

Following, the buyer examines the information collected to ensure proper business practices as well as legal and environmental compliances. This is the major part of due diligence process.

Overall, the buyer gains a better understanding of the firm as a whole and can better appraise long term value.

4. Business Plan and Model Analysis

Here, the buyer looks specifically at the target company’s business plans and model. This is to assess whether it is viable and how well the firm’s model would integrate with theirs.

5. Final Offering Formation

After information and documents are gathered and examined, individuals and teams collaborate to share and evaluate their findings.

Analysts utilize information collected to perform valuation techniques and methods. This substantiates the final dollar you are willing to offer during negotiation.

6. Risk Management

Risk management is looking at the target company holistically and forecasting risks that may be associated with the transaction.

How Long is Due Diligence Period

While road mapping, it may seem difficult to forecast how much due diligence is enough.  Despite its comprehensive nature, the due diligence process should only last between 30 and 60 days.

This is achievable if delegated to an efficient, dynamic team from multiple business functions. Ultimately, you want to close the deal as soon as possible, while also being thorough.

But, in reality, it is impossible to uncover all issues and potential complications during the investigation. Some items will not be uncovered until integration. However, the same idea applies to potential benefits.

This reinforces the importance to be energetic and efficient while maintaining quality to meet the due diligence period deadline.

How Many Due Diligence Requirements are There

Cultivating good organization and strategizing is key when trying to navigate due diligence process and meet the necessary requirements.

So you can stay systematic, outlined below is a typical due diligence management folder structure for M&A transactions:

  1. Transaction Related Documents
  2. Corporate Documents
  3. Contracts and Agreements
  4. Customers, Sales, and Marketing
  5. Procurement (Suppliers)
  6. Property and Equipment
  7. Environmental
  8. Legal, Litigation, and Regulatory
  9. Intellectual Property
  10. Financial
  11. Tax
  12. HR and Employees
  13. Insurance
  14. Operations
  15. Information Technology
  16. Industry and other

How to Do Due Diligence on a Private Company

No two M&A deals are the same.

Each incorporates its own character of size, business owner and leadership personalities, culture, and industry to create a unique transaction.

One factor that makes transactions more complex and due diligence process more complicated is when a company is privately held.

Unlike publicly traded companies, private companies are not auctioned and traded conventionally on the stock market.

Investors cannot easily buy shares unless they are founders, employed there, or have invested via venture capital or private equity firms.

Aside from it being more difficult to invest in private companies, they are not obligated to publicly disclose as much information. Compared to private companies, public companies are also held to stricter business and accounting practice standards.

While buying out privately owned companies and startups may have a high payoff and rewards, they come with distinct complexities. These may affect or hinder the M&A process.

To save some headaches down the line, detailed here are some best practices for the private equity due diligence process:

  • Understand Your Financial Situation - Before even researching companies or drafting out an LOI, you need to look at your own books. Do you have enough resources to complete the transaction and bounce back if it does not work out? If not, maybe consider a smaller scale investment or wait a little while.
  • Accounting Procedures and Financial Statements - Publicly held companies must abide by GAAP and IFRS and are audited regularly to ensure compliance. Regulations on privately held companies are not as strict. This allows them to use different accounting procedures or even practices off the beaten path. Rather than traditional accrual accounting, it may not be unusual to see cash-basis or something else more arbitrary.
  • Size - Private companies are almost always smaller than public. This doesn’t only mean fewer employees and less office space, but also likely smaller revenues.
  • Human Resources Practices - Smaller, younger businesses may not have standardized HR processes. Here, you want to check out items such as questionable terminations, harassment charges, hiring practices, and if/what workplace policies exist.
  • Legal - The last thing you want from any investment is to soon find that it is riddled with legal issues. Some details to consider here are tax compliance, any past or outstanding lawsuits, and overall obedience to applicable jurisdictions.
  • Valuation - Valuation methodologies are the same between private and public companies. However, you have to adjust for lack of liquidity and publicly available market caps.
  • Management and Leadership - The company you are considering buying could have been the brainchild of siblings or friends. Meaning, they could be a little protective. You will want to meet and get to know them to determine if there is any hostility associated with the transaction. By and large poor, disgruntled management will trickle down the m&a buy side due diligence process and negatively impact the business.
  • The Business - Overall, do you believe in the company, their strategy, and mission? Is this something you see as truly being successful?

Conduct Due Diligence Process the Right Way

Conducting proper due diligence is an important, yet tedious process. Here are a few helpful tips:

  1. Use a Diligence Management Software - Diligence management software combines the features of a traditional virtual data room with project management capabilities. This allows users to not only securely store data, but effectively manage and share files as well.
  2. Start Early - The diligence process can be extremely time-consuming. It’s best to get started early in an organized manner. When teams utilize a tool like DealRoom, they can start the process within minutes.
  3. Utilize Checklists - When teams use a diligence management software, they can easily create organized checklists. For example, rooms can be broken down into different stages of diligence. Users can efficiently check items off as they are completed.
  4. Address Potential Risks Throughout the Process - If potential bottlenecks and risks arise during diligence, teams should address them promptly.
  5. Employ Experts - Hiring M&A professionals such as investment banks and consultants make the due diligence process more efficient. Deal teams have experience with conducting diligence and know the necessary steps to take.

Easy Due Diligence Process with DealRoom

Traditionally, due diligence process is completed using a virtual data room, Excel trackers, and one-off emails.

Unfortunately, this leaves room for inefficiencies such as version control worries, miscommunication, duplicate work, and information silos.

With DealRoom, all diligence can be managed within the platform.

Teams no longer have to switch between multiple platforms and this allows diligence to be completed up to 40% faster. They can effortlessly share information and collaborate internally, as well as externally with clients.

Final Thoughts

The due diligence process is never easy, but that doesn’t mean it has to be inefficient and disorganized. With the proper software and workflows in place, diligence can be straightforward and productive.

After all, the information that is discovered during diligence is critical to a deal’s success.

Due Diligence Software like DealRoom, equips teams with the proper tools to be thorough, yet efficient, and to close deals faster.

due diligence software

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