Due Diligence in merger and acquisitions (M&A)

What is Due Diligence in acquisitions?

Distilled down to the simplest terms, acquisition due diligence refers to an investigative audit of any business that another firm is thinking of taking over. It is done to confirm all facts and figures that may influence the buyer’s thought process while deciding whether to go forward with the deal. Obviously, the principles laid down for acquisition due diligence are generally valid for investor due diligence, when an investor or venture capitalist wants to take a stake in a start-up or more mature company. 

During the course of due diligence, thorough research and investigations are carried out to reveal all the financial and legal aspects of the business being investigated. This is an essential step that must be carried out before entering into any M&A transaction with the other party.

In the case of an acquisition of a business, due diligence must fully assess the company’s assets and liabilities, legal and financial obligations, and market standing. In short, the entire process is aimed at determining the feasibility of an M&A deal before going through with it.

Why is Acquisition Due Diligence important?

Secure your IT investment with due diligence

Acquisition due diligence doesn’t really aim to evaluate the valuation of a company. Rather it’s intended to gain a clear understanding of whether the deal would be profitable for both parties concerned.

Here it is important to tackle one common misconception that exists regarding due diligence, and that’s the notion that it only helps the buyer. This is simply not true, as due diligence is equally important for both parties in an M&A transaction. As much as a company’s balance sheet enables a company to have a snapshot of its financial situation, a full due diligence provides a picture of the whole workings of the company, highlighting strengths and weaknesses and allowing management to better plan for the future.

For the buyer, conducting proper due diligence gives them complete assurance that they are going forward with the correct deal. Also, it helps them obtain all the information required to learn more about the business’s customer-base, partnerships with existing associates, and to discover opportunities for greater synergies.

At the same time, due diligence also helps to confirm any assumptions that you may have made prior to moving forward with the deal. It can also reveal any financial or legal irregularities that may have an impact on the business in question further down the line. With cybersecurity, money-laundering, data protection and environmental sustainability carrying important financial, legal and reputational risks, investing in, acquiring or merging with a company has direct implications for the investor/acquiror in terms of their own standing in the market. 

Due diligence has sufficient importance and benefits for the seller as well. It allows the business seller to glean interesting insights about how it operates. It is a little like undergoing a medical check-up. It also prepares a business for seeking capital from investors or a potential acquiror. It helps the seller better understand the market value of the business and what would be a fair asking price to complete the deal.

What are the risks of skipping Due Diligence?

The crux of the matter is that without proper due diligence, no business deal can hope to succeed. A merger or acquisition without due diligence is like handing your money over to a stranger you just met on the street.

Financial loss

Without due diligence, the investor may overlook financial issues, for instance undisclosed liabilities, inflated revenues, or understated expenses. This could lead to significant financial losses post-acquisition.

Operational challenges

Without a thorough understanding of the target company's operations, the investor may struggle to integrate it effectively into their existing business, leading to operational inefficiencies and missed synergies.

Legal risks

Overlooking Due Diligence may result in unknowingly acquiring a company with legal or regulatory issues, for example pending lawsuits, compliance violations, or regulatory fines. These can have legal and financial repercussions for the investor.

Missed opportunities

The investor may miss out on identifying potential opportunities for growth, cost savings, or strategic advantages that could have been leveraged through the acquisition.

9 types of Acquisition Due Diligence

So, now we know what due diligence is and why it’s important for both buyers as well as sellers. However, it’s not as straightforward a process as one might be inclined to think at first glance. In fact, there are multiple perspectives from which acquisition due diligence can be carried out. Based on this, due diligence can be further subdivided into the following types.

1. Administrative Due Diligence

This is the aspect of due diligence revolving around administrative elements, such as occupancy rates, facilities management, and workstations required, to name a few. Here, the main purpose of carrying out the due diligence is to evaluate the facilities owned by the seller and also determining whether all aspects of the operational costs are reflected in the financial statements. It also provides a projection of the expected administrative cost the buyer must shoulder in case they decide to go forward with the merger.

2. Financial Due Diligence

This is perhaps the most important type of due diligence due to the fact that it helps decide whether the deal in question is going to be financially viable or not. It involves cross-checking whether financial details shared by the seller are accurate and above board. Through financial due diligence, the buyer aims to understand all aspects of the seller’s business financials, such as audit statements, unaudited financial documents, projected growth trajectory, inventory and expenditure plans, and its list of assets and liabilities.

During the process of financial due diligence, the buyer may also choose to examine accounts of major customers. They should also undertake a detailed analysis of variable and fixed costs, profit margins, and internal control procedures. Another part of financial due diligence involves examining the seller’s order books along with the sales pipeline in order to create pinpointed projections.

3. Asset Due Diligence

Traditionally, this is a part of financial due diligence but can also be classified under as a separate category. Asset due diligence works to create a list of fixed or variable assets of the seller as well as their locations. This includes but is not limited to machinery lease agreements, sales and purchase schedules of capital equipment, and real estate documents.

4. HR Due Diligence

For any business, the most important asset is the human resources associated with it. This is especially true of software and high tech companies. This means that before the buyer can decide whether to actually buy the business, they need to take stock of the HR assets. This includes analysis of employees and employment contracts, cost-to-company for salary and bonuses, and all HR policies such as sick leaves, annual leaves, and even dispute resolution in case of any arbitrary situation.

5. Environmental Due Diligence

In light of today’s climate change scenario, environmental due diligence is an essential part of any M&A deal in the 21st century. This is because if the company that is being bought violated or violates any local or global environmental regulations, litigation risks are heightened. Traditionally, environmental due diligence included careful scrutiny of environmental licenses and permits. It should also check all notices and communiqués from the local authorities concerned with environmental regulation. Nowadays, environmental due diligence goes much further. Indeed, with climate change, what is required of companies it to take positive steps to reduce their carbon footprint including requiring that their suppliers also adhere to sustainability goals. Environmental due diligence is part of a broader set of goals around sustainability. Companies must have policies and processes to ensure that their actions or omissions are sustainable by design. Sustainability includes social and environmental impacts.

6. IT Due Diligence

This one is rather self-explanatory and involves assessing all the IT assets of the seller’s business. This includes hardware as well as software systems, business-critical data, and the workforce interacting with it on a daily basis. It can also involve security risk assessments, vulnerability due diligence, and cybersecurity assessment. It helps create a software checklist that might come in handy in the future.

7. IP Due Diligence

All businesses have intellectual properties that are vital to their operations and profitability. Most of the time, these assets are intangible in nature and include patents, software algorithms, and even brand names, trademarks, and copyrights; IP due diligence aims to take stock of these items.

At the same time, this form of due diligence is also vital in determining whether the company is currently involved in any legal implications involving IP violations. So, this can also be thought of as a part of legal due diligence.

8. Technology Due Diligence

Nowadays many companies own technology and develop new products or services. Software companies in particular have as their main asset, their software and their talented developers. It is difficult to assess the value of a software program, especially with start-ups, because the source code for the program is kept secret to prevent others from copying it. As a result, it is often impossible for investors to really assess the product that they are investing in from a technology perspective. That's why Vaultinum has developed a series of tools that enable a technology due diligence, including a code scan, online questionnaires and interviews driven by tech experts.

9. Customer Due Diligence

The final type of acquisition due diligence that we’re going to take a look at involves the lifeline of any business: the customers. When you’re a buyer looking to take over a business, you invariably want to take a look at its existing and potential customer base. You’d also like to gain an understanding of the customer satisfaction levels of the business. This is exactly what customer due diligence can help achieve.

It must be mentioned here that the various types of due diligence discussed above aren’t the only ones available. Based on the business and how the buyer is looking at it, there can be many different types of acquisition due diligence.

M&A Due Diligence process: 6 key steps

As any reader can understand from reading up until this point, acquisition due diligence is a complex and complicated process that involves multiple layers. As such, every M&A process has different requirements, and different steps and methods should be followed to conduct due diligence that fulfills the particular requirements of the deal.

That said, there are some general steps that every business can follow to perform quality acquisition due diligence. In this section, we’re going to take a brief look at each of those steps.

1. Project Goal Evaluation

As with any project, the acquisition due diligence process also begins with evaluating what exactly you want to achieve from the exercise. Determining the corporate goals behind the process is essential to its success.

2. Financial Analysis

Once your goals are clear, the next step is to take up an analysis of the finances of the seller. This includes checking all financial documents such as balance sheets, tax records, and forecasts for business growth.

3. Detailed Inspection

This step usually takes the form of a detailed conversation between the parties involved in the M&A process. Here the buyer asks for all relevant documents for auditing, holds extensive talks with the seller, and may also perform on-site visits. In this step, it’s essential for the seller to be highly responsive in order to ensure that the deal goes through.

4. Analysis Of Business Plans And Models

Next, the buyer analyses the business plans and models used by the target company. This is important in order to understand whether the acquisition will be a good fit for the buyer’s business goals.

5. Risk Analysis

In this step, the buyer is required to carefully look at the target company from a holistic viewpoint and assess any risks that might be associated with the deal.

6. Creation Of The Final Offer

Lastly, the information from all of the above steps is combined and collated by the experts to understand the correct valuation of the target company. This is critical to creating an estimate of the final offer amount.

Conclusion

When it comes to mergers and acquisitions, due diligence is an important step that should not be overlooked. Due diligence for mergers and acquisitions helps ensure that the deal goes fairly for both the buyer and the seller and that possible pitfall can be avoided with ease.

In this respect, Vaultinum can be the perfect partner to help you out. We provide due diligence tools that address many risks. With proven expertise in the domain of acquisition due diligence, we can help your mergers and acquisitions go through without a hitch.

We even provide a full software audit tool that scans source code for issues and that can be used for performing due diligence audits. Using this tool, the due diligence process becomes more objective and helps decision-makers minimise risks and glean crucial information about the deal being made.

Now that you know all about Acquisition Due Diligence, check out our Due Diligence Checklist to get ready for your next investment.

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