Buy Side M&A Blog Series - Vol 6 - Due Diligence

As investment bankers, RKJ Partners possesses a breadth of knowledge and experience in advising buyers on business acquisitions.  In our latest blog installment, we define and outline the key elements involved in the due diligence process from a buyer’s perspective.

What is due diligence?

Simply stated, due diligence, in the context of a business acquisition, is the process undertaken by a buyer to confirm the consistency and material accuracy of representations made by the seller.  Buyers seek to satisfy themselves and their stakeholders as to the current state and condition of the business for sale, thus reducing the chance of any post closing surprises.  Due diligence plays a pivotal role in the buy side M&A process as it is critical in helping to uncover potential risks and items deemed to be “deal-breakers”.  The due diligence process can also assist in finding hidden values and synergies via a thorough review of all pertinent data including assets and financials to customers and products/service offerings. The emphasis of due diligence can vary depending on the industry/market sector, company type (publicly or privately-held), business phase (start-up, growth, expansion, mature) and transaction size.

What are the phases of due diligence?

Due diligence occurs in two distinct phases: preliminary due diligence and formal due diligence.  Preliminary due diligence is defined as the first phase of the due diligence process and is focused on the buyer identifying “deal-breaking” issues before an excessive commitment of time, resources and expenses are incurred. Examples of issues that can immediately cause abandonment of a potential business acquisition are: material misstatements of financial statements, employee/personnel issues, customer retention concerns, and pending legal litigation/potential lawsuits. A buyer should have a reasonable level of comfort that the business for sale fits its acquisition criteria and the deal has a favorable chance of closing.  During the preliminary phase of the due diligence process, it is important to note that sellers are often hesitant to provide in-depth, detailed financial statements and operational information early on in the process without first feeling comfortable that the buyer can successfully close a transaction.  A buyer may be forced to settle for information and data in summary form at this stage in the process. 

Formal due diligence is the second phase of the due diligence process and occurs after the signing of a letter of intent (LOI) between the buyer and seller.  The timing of formal due diligence is designed to ensure that the seller can avoid disclosing private and confidential company information to unqualified buyers and wasting resources on unnecessary preparation.  Upon delivery of an executed LOI, the buyer has  the opportunity to investigate the business for sale in a detailed, in-depth manner and given access to financial statements, operating reports, and other private and confidential company documents (financial and non-financial).  It is critical that the buyer retains experienced professionals on the deal team to assist in facilitation of the formal due-diligence process, including a trusted, experienced investment banker, attorney and accountant.

What are the key elements of due diligence?

The due diligence process is designed to ultimately position the buyer and his deal team to be able to answer five key questions: Should buyer make this acquisition? How much should buyer pay for the business? How should the acquisition be structured? How should buyer deal with any post-acquisition operating, accounting, and legal issues?  To arrive at answers to these key questions, the buyer’s due diligence efforts are typically divided into functional areas and disciplines.  The following are examples of key categories of focus along with some corresponding questions teams are typically tasked with answering:

• Business/Operations: What are the products/services offered? What types of customers are there? Is the customer list diversified? Is the post-acquisition strategy in-line with the current customer base?
• Finance / Accounting: How accurate are the financials? What are the major internal and external factors impacting financial results?  Has anything not been accounted for? Is everything current?
• Legal/Regulatory: Will there be any legal issues in the post closing process? Will employment contracts be impacted? What potential legal threats are in the business? What governance/regulatory issues exist?
• Organizational: Will there be a “culture clash”?  Should certain/all management remain in their current positions? What is the plan for retaining key employees? What is the plan for a successful integration after the closing?

From the buyer’s perspective, it is important to be strategic and thoughtful in outlining goals of the due diligence process as it is a very involved undertaking.  A common mistake for first-time buyers pursuing acquisitions is rushing into the due diligence process without the proper assistance and support of trusted professionals (investment bankers, attorneys, accountants).  A buyer supported by an experienced and skilled due diligence team goes a long way in making a seller feel comfortable that the buyer can successfully close the transaction, especially in a competitive situation with multiple buyers pursuing the business for sale.