Due diligence
KEY TAKEAWAYS
- Understand what due diligence is
- Learn how much due diligence costs
- Understand the challenges of a “merger of equals”
What is due diligence?
Due diligence serves two principal functions. First, it is the process by which a buyer evaluates a seller’s business to confirm the buyer’s assumptions about the business. Second, due diligence is used to set up the integration of the seller’s business following the closing of the transaction.
In a typical transaction, a buyer and seller begin exploring a potential transaction and the seller will share limited information with the buyer (hopefully under a non-disclosure agreement) so that the buyer can begin to formulate an offer for the seller’s business. After some back and forth, the buyer and seller will negotiate a more formal letter of intent that will include the purchase price for the company, the structure of the purchase, and other pertinent terms of the deal.
Included in the letter of intent will be a provision that the buyer (and sometimes its financing sources and lenders) must be satisfied with its due diligence in order to close the transaction.
To get to the letter of intent, the buyer will have made
specific assumptions about the business, its operations, and its ability to
generate future revenue and cash flows. Due diligence is the process that the
buyer uses to confirm (or deny) these assumptions.
What is due diligence in venture capital?
Due diligence for venture capital investors is similar to due diligence for private equity investment or buyers, but is more focused on the team and its capabilities, the addressable market for the company’s products or services, and the company’s business plan. Because there will be less operating history for the business, these three elements are particularly important in determining whether a venture capital firm will make the decision to invest.
What is the due diligence process?
Most due diligence processes start with an extensive due diligence request list from the buyer.
A due diligence request list is a 10-20 page document that lists hundreds of documents and reports the buyer (or its advisors) will want to review.
It will include a request to see financial records, contracts, internal reports, legal records, details about personal and real property, documents related to intellectual property, employment and HR records, insurance policies, tax records, litigation summaries, and other documents and records.
The buyer will deliver its due diligence request list at the time of the letter of intent. The seller then collects and organizes (typically in an electronic data room) its responses to each of the different requests (many answers will simply be “not applicable”). Some questions might require the seller to prepare some additional analysis of its financials, for example, while other requests are to see the underlying contracts or documents.
The buyer and its advisors will review all of the due diligence materials and then schedule calls to ask follow-up questions to the seller (and its advisors, as appropriate) to clarify questions and dive deeper into areas where the buyer might see problems.
For example, one request buyers make is to see your accounts receivable aging. Once the buyer reviews your A/R aging, they will have questions about specific accounts that might be over 60 days. The buyer is trying to determine if those amounts are indeed collectible, or whether they will eventually have to be written off.
This process of document review, question and answer calls, and follow-up requests for additional information can go on for a while. Sometimes maddeningly long for a seller.
Most sellers get pretty frustrated by the end of the due diligence process because the buyer and its advisors will have asked the same question multiple times, the buyer’s team might not be talking with one another so there are even more duplicative requests, and as the buyer drills into problem areas, the seller will start to get frustrated (and potentially worried the buyer is going to ask to reduce the purchase price as a result).
The buyer will use all of the information it has received to prepare its own due diligence report, which it will be required to provide to lenders who might be providing debt financing for the acquisition and to its own internal investment committee or other group responsible for approving the transaction. The due diligence report will list all the findings of the buyer and its advisors, including any potentially problematic areas.
As you might expect, people working for the buyer do not want to miss anything in due diligence which could show up after closing as an issue.
Missing due diligence issues is “career-limiting,” as we say, so most buyer personnel and advisors will be exhaustive in their due diligence.
We have been through hundreds of transactions, and in every case, our client has been surprised at how extensive the due diligence process is. Their common refrain is, “I had no idea how involved, time-consuming, and complex this process would be.”
Questions and topics for due diligence
Some of the most common topics in the due diligence process will include questions about:
- Company background and history
- Strategy
- Marketing and positioning
- Team
- Financials
- Products and services
- Customers
- IP & IT assets
- Legal issues
- Facilities and equipment
What are the types of due diligence?
There are several areas buyers will explore in due diligence: financial, operational, legal, information technology (IT), intellectual property (IP), human resources (HR), benefits, environmental, insurance, cultural, regulatory, background checks, facilities and equipment, and interviews with customers, market studies, employees and partners. Let’s briefly explore these.
Financial due diligence
Financial due diligence has three primary purposes: first, to confirm the historical financial results as previously presented by the seller to the buyer prior to signing the letter of intent; second, to determine whether the projections provided by the seller for future financial performance are supportable; and third, to determine if the company’s financial records and systems are adequate to support future growth.
How to conduct financial due diligence
- Examine annual and quarterly financial information
- Review sales and gross profits
- Review the accounts receivable
- Review past projections and results
- Look at future projections
- Get a history of pricing policies and past increases
- Ask for all business tax details
- Review summary of debts and their terms
- Get a summary of all current investors
- Get a summary of all shareholders
Quality of earnings review
In most transactions over, say, $15 million in transaction value, the buyer will employ the services of an outside accounting or “quality of earnings” firm to perform its financial due diligence. Internally, we refer to a quality of earnings review as an “audit cubed.” A financial audit looks at historical financials to confirm their accuracy and completeness, whereas a quality of earnings review not only seeks to validate historical financials, it also examines whether the business can continue to grow and generate increasing amounts of cash flow.
A quality of earnings review is extensive and will examine every aspect of a seller’s financials and forecasts.
Operational due diligence
A buyer might employ an outside firm or complete an operational review itself. Operational due diligence examines a company’s lead-to-cash processes, manufacturing processes (if applicable), hiring practices, depth of team, operational scalability, systems, and other relevant areas to confirm that the seller’s business is run well and can scale to support future growth requirements.
Legal due diligence
Legal issues might range from potential litigation exposure to regulatory issues to contracts that require the consent of the other party prior to completing an acquisition to be lawfully assigned to the buyer.
How to conduct legal due diligence
A buyer will usually hire an outside law firm to perform legal due diligence. Legal due diligence is a review of a seller’s contracts, regulatory requirements (and compliance therewith), prior and current litigation, and business practices to determine whether there are any specific legal issues or risks that could potentially be an issue post-closing.
IT due diligence
Businesses increasingly depend on their own IT infrastructure to manage operations. As a result, buyers are keenly interested in confirming that the seller’s IT systems can support current and future operational requirements. In addition, buyers will scrutinize the security measures taken by the seller to protect user and customer data given the significant of data privacy regulatory requirements. Buyers will also look at current accounting and enterprise resource planning (ERP) systems to determine if they can accommodate future growth or whether they will need to be replaced (which will be risky and expensive for the buyer). IT due diligence has taken on greater and greater significance in transactions.
IP due diligence
For companies which rely on proprietary software, patents, trademarks or other proprietary information, buyers perform IP due diligence to confirm: a) the company owns all relevant intellectual property rights to conduct its business and sustain its competitive advantage, and b) the company is not infringing on others’ intellectual property rights in a way that could visit liability or disruption on the buyer post-closing. This type of diligence is usually performed by a combination of specialist attorneys and outside firms who perform IP and software code audits.
Sample IP due diligence questions
- Is the company aware of any information that can make them unpatentable or invalid?
- Has the company received a notice from a third-party, or obtained a formal or informal opinion from counsel in the past?
- Has the company been involved in any IP-related disputes?
- Does the company anticipate any IP-related disputes?
HR due diligence
Buyers will evaluate a seller’s HR policies, practices and procedures to ensure compliance with applicable law and to determine if there is any risk of future liability from pre-closing employment practices (such as a wrongful termination or discrimination claim).
This diligence can be performed by the buyer itself, an outside law firm, or a specialist in HR due diligence for mergers and acquisitions. The buyer will also seek to understand if there are any particularly unique employment policies which could create an issue for the buyer (for example, if the seller has an “unlimited” vacation policy but the buyer has a more traditional vacation policy, the buyer might upset seller employees with a more traditional vacation policy).
Employee benefits due diligence
ERISA is a federal law that governs how companies provide benefits to employees, and has hundreds of complex requirements companies must meet. Many companies are unaware of potential ERISA issues they might have, and due diligence is often the first time they become aware of a potential issue. Sophisticated buyers understand the liabilities ERISA can create for the unwary, and will use due diligence to minimize these risks going forward.
Environmental due diligence
For any company that owns real estate and handles any hazardous materials, the buyer will likely perform environmental due diligence. This usually first starts with a Phase I assessment of the property, and if issues are identified, then a Phase II might be required. Given the potential significance of environmental liabilities and the fact that the buyer will in many cases assume those liabilities, buyers pay close attention to these issues.
Insurance due diligence
Buyers will typically use an outside insurance broker to evaluate the insurance policies and prior claim history of a seller. Insurance due diligence covers liability insurance, director and officer insurance, property and casualty insurance, health insurance, and other insurance coverages. The buyer wants to understand the costs of these policies and whether they would be more or less under buyer ownership, and the buyer wants to understand what type of coverage will remain for acts committed prior to closing. Insurance is a complex field requiring specialized knowledge to properly evaluate during due diligence.
Cultural due diligence
Buyers—whether private equity or strategic —have a unique culture. Particularly in the case of a strategic buyer, if the culture of the seller’s company is at odds with the culture of the buyer’s company, there will likely be operating and other challenges post-closing which could adversely impact the performance of the business. As a result, buyers will usually want to talk with several members of a seller’s team to evaluate whether the seller’s culture will be a great fit for the buyer. If there are conflicts, buyers might walk from the deal or work with the seller to develop an integration plan that would address these cultural differences.
Regulatory due diligence
For companies that must comply with specific regulatory requirements, buyers will hire an expert to evaluate the seller’s compliance with the applicable regulations. There are dozens of state and federal regulatory agencies with hundreds of thousands of regulatory requirements – buyers do not want to walk into a situation where the seller has not been in compliance and where the buyer might be subject to fines or worse following closing.
Background checks
It is sometimes a surprise to sellers that the buyer will do background checks on all key management personnel of the seller.
Sellers should always perform their own background checks on their critical team members (particularly those involved in the financials or cash management of the business), and buyers will do the same.
If you are aware of any specific issues that might come up in a background check of your key personnel, let the buyer know ahead of time so the buyer does not think you are hiding anything.
Facilities and equipment diligence
Particularly in businesses that are equipment-intensive, buyers will examine the equipment and facilities of the seller to understand their condition and expected useful life. Buying a company with equipment that is on its last legs means the buyer will have to invest yet more dollars in either repairing or replacing such equipment. In addition, if the facilities are not large enough to accommodate future growth, or the company is currently bursting at the seams because the seller did not invest in additional space, the buyer will need to account for those investments post-closing to get the company into a condition where it is ready for growth.
Customer interviews
In transactions we manage, we usually wait until the last week before closing the transaction to allow the buyer to interview customers.
It is understandable why buyers want to talk with a seller’s customers (they want to know if customers are satisfied, or if there are issues that will come back to haunt them post-closing), it can also be extremely disruptive if the transaction does not close for whatever reason. We also usually ask buyers to not identify themselves as a buyer, but act as a survey company doing a customer satisfaction survey (or better yet, ask the buyer to actually hiring the surveying company do the customer checks).
Market studies
Market studies are performed by third parties to evaluate the overall state of the market for a seller’s company, potentially including how the seller’s company is perceived in the market by competitors and customers. Most strategic buyers will already know this information because of their presence in the market, so they will usually not commission a study of this type. But private equity firms often hire a market research firm to include this information in their due diligence report, and to look at the seller’s pricing to see if there might be opportunities to increase pricing following closing.
Employee interviews
Similar to customer interviews, buyers want to assess a seller’s team, particularly its management team and its capabilities for growth going forward. For managers who are aware of and participating in the transaction, these interviews can happen any time during due diligence. For managers who are not aware of the transaction, it is best to defer these interviews until the very last steps before closing. The buyer will also attempt to discern how dependent the business is on the seller, given the seller’s motivations will change once the transaction is closed and they might not be as active in the business going forward.
How to prepare for due diligence as a seller
If you are an owner of a company looking to either raise money or sell all or a part of your company, you will need to prepare for due diligence.
One of the biggest mistakes we see owners make is entering into negotiations with a buyer without first having put their own diligence materials together.
This subjects the seller to endless rounds of back and forth, significant disruption to them and their team during the diligence process, and potentially a decrease in purchase price as the buyer uncovers issues that impact the value of the company.
6 steps to prepare for due diligence
Step 1 – Get a sample diligence request checklist
In Appendix B of our book, Harvest, we provide a sample diligence request list, but you can also find them online or from your attorney or investment banker.
Step 2 – Collect and organize your due diligence materials
Starting with the most important materials (your investment banker can help you prioritize your list), collect and organize all of your diligence materials (preferably in an electronic data room) using the diligence request list as a guide.
Step 3 – Get help to review your materials
Ask your corporate or M&A attorney to review your diligence materials to determine if there are any specific problems or issues that you need to address prior to presenting these materials to a buyer.
Step 4 – Hire an outside firm to perform a quality of earnings review
For any transaction that is expected to be over $15 million, buyers are going to perform an extensive quality of earnings review of your financials.
You do not want to wait for a buyer to identify specific problems in your financials – these can create opportunities for a buyer to renegotiate the purchase price, especially if you are not prepared to address the issues they identify head-on.
Having a seller-prepared quality of earnings review not only alerts you to issues (and opportunities) ahead of time, it also tells buyers you are a serious seller and allows you to control the agenda for the financial review.
Step 5 – Address specific diligence issues ahead of time
For any issues you or your advisors identify, if you have enough time, be sure to address and hopefully resolve the issue prior to buyer due diligence. If you do not have enough time, make sure to explain and position the issue prior to signing your letter of intent when your negotiating leverage is at its maximum. Our CoPilot application can help you both identify and address specific risks in your business before ever talking with buyers.
Step 6 – Control the agenda
Too many sellers allow buyers to run roughshod over them during the diligence process. Properly prepared sellers can set the agenda for the diligence process with timelines, milestones, weekly check-ins, and other steps to make sure the process is as smooth at can be.
An investment banker can also help you with this step by acting as an intermediary to control the process and insulate you and your team from buyer demands and requests (which will be many).
How to conduct due diligence on a company
If you are planning to buy a business, you will need to be equally disciplined about your due diligence process lest you waste valuable time, money and energy on a deal that will never happen.
7 steps to prepare for due diligence as a buyer
Step 1 – Identify your list of “dispositive negatives”
If you are not clear on exactly what issues would prevent you from doing a deal and what specific attributes must be present for you to be interested in a seller’s business, you will waste a lot of time talking with companies that are not going to be a fit for you.
Identify those “dispositive negatives” and required attributes first so that you can dive into them quickly.
Step 2 – Compile your list of questions and document requests
Once you have your list from Step 1, for each item, develop a list of questions and document requests that will help you determine as fast as possible whether the company meets your requirements. Getting these questions answered early can help you avoid a lot of wasted time on companies that don’t meet your criteria.
Step 3 – Develop your prioritized due diligence request list
At our firm, we have two different lists we use – one for initial discussions with buyers, and one we use for full due diligence. As a buyer, develop your own prioritized list of items. First priority items are those that can help you quickly understand the business, its financials, and future prospects. Second priority items might be specific risks that would materially impact valuation, and third priority items might be everything else on a typical diligence list. Prioritizing your list will help you manage the seller’s time as well – there is no bigger deterrent to a seller engaging in negotiations than to have a buyer with an unreasonably long initial diligence checklist.
Step 4 – Make your go/no-go decision
Once you have completed Step 2 and have received your high-priority diligence items, determine if you are ready to proceed with an offer and a transaction. Assuming you are able to come to terms with a seller, then you are ready to proceed to Step 5.
Step 5 – Hire your team
For any transaction, it is unlikely you as a buyer (especially if you have not purchased a business before) will have all of the technical areas of expertise required to complete a full diligence review of the seller’s company. At a minimum, get outside legal counsel and a quality of earnings review firm. If your target company is asset-intensive, consider an asset appraisal firm. If your target company relies heavily on IP, consider an outside firm to do a code evaluation. You get the picture – your diligence team needs to focus on the areas most critical to a successful acquisition.
Step 6 – Manage the process
Sellers get frustrated when buyers are disorganized or do not coordinate all their teams. Sellers hate answering questions multiple times and this frustration will lead to deal fatigue eventually which will not be productive for either party.
As a buyer, organize your efforts, adhere to milestones, and do your best to make the process as easy as you can for sellers or else you risk losing their interest after you have spent time, money and effort.
Step 7 – Identify, quantify and prioritize your list of diligence issues
For most sellers, this is their first time through a diligence process, so a long list of things that are wrong with their business will turn them off. Run through your list – which items will impact valuation? Focus on those in your discussions with the seller if you intend to renegotiate the purchase price or terms. If you are not planning to renegotiate the purchase price, better to let these items sit or else the seller will be less excited about you as a buyer for just criticizing their business. If you have issues that need to be address during post-closing integration, get them prioritized as well so you can talk with the target company’s team about them following closing.
How long should due diligence take?
If the seller is reasonably prepared and the buyer is experienced, due diligence should take 30-60 days. If the seller is not organized, or the buyer is inexperienced and not coordinated, it can extend to 90-120 days or longer.
Having someone manage the process in the middle like an investment banker can shave time off the process, but the best way to ensure a shorter diligence period is to come fully prepared.
How does due diligence relate to an “exclusivity period”?
As we discussed, due diligence happens after buyer and seller have signed their letter of intent. In almost all letters of intent, buyer and seller will agree to an “exclusivity period.”
The exclusivity period is the time period (usually 30-90 days) during which the seller agrees that in exchange for the buyer investing a bunch of time and money in its diligence process, the seller will agree not to talk with any other potential buyers.
Assuming diligence and the deal negotiations are proceeding apace, buyer and seller might agree to an extension of this period, or if the seller believes the buyer is wasting too much time, the seller might insist on no extensions.
Can a buyer back out of a deal during due diligence?
In short, yes. In practicality, no buyer goes into a due diligence period expecting to back out. A buyer is going to invest a lot of money and time and does not want all their efforts to result in a busted deal. However, almost all letters of intent are based on the buyer’s assumptions about the seller’s business, and if those assumptions turn out not to be true and the buyer and seller cannot agree to different terms or a reduced price, then the buyer is able to walk away from the deal. Letters of intent are not binding on either party with respect to price and specific terms, so either party is able to walk from the table.
Who is involved in performing due diligence?
As referenced above, there are usually multiple parties involved from both buyer and seller in completing the due diligence process. Both buyer and seller need to determine who from their own organizations will participate, and then determine whether they need help from outside parties. Ideally, buyer personnel are experienced and can be efficient with their requests, and ideally the seller’s managers who are involved have done enough pre-planning that the process is not overly distracting to them. In almost all cases, the seller is going to need to involve their head of finance as many of the diligence items will be financial in nature.
What is third party due diligence?
Third party due diligence is the diligence performed by outside advisors to a buyer. These outside advisors include attorneys, accountants, consultants, insurance providers, environmental assessment firms, benefits consultants, code auditing firms, and other consulting firms who specialize in evaluating businesses.
Often in a letter of intent, a buyer will refer to “third party due diligence” that must be completed. If you are a seller, insist on the buyer identifying the outside firms they will be using and insist that the buyer has a way of coordinating their requests. Your investment banker can help you with this process.
How much does due diligence cost?
Costs for due diligence can range widely. We have worked on deals where the costs ran into 7 figures, and other deals where they were less than $100,000.
Not including the costs for both the buyer’s and seller’s team, attorneys costs for due diligence might range from $5-50,000, quality of earnings reviews can range from $30-300,000, a market study will range from $150-350,000, and consulting firms will have costs on top of these. In short, completing due diligence is expensive and time consuming. This is why buyers don’t want to go through due diligence and have a busted deal.
What is a due diligence or break-up fee?
Some buyers will negotiate for a break-up fee to cover their due diligence expenses in the event a seller walks away from the deal that was agreed to in the letter of intent. We recommend against sellers agreeing to a provision of this type because the seller should also be performing due diligence on the buyer at the same time. If the seller concludes that the buyer is not going to be a good fit or meet the seller’s expectations, then the seller should be able to also walk from the deal.
In some cases, all of a buyer’s third-party expenses would be included in this break-up fee, or it might be pre-set in the letter of intent at a specific dollar figure.
M&A due diligence consulting
Due diligence is an important exercise in a transaction between buyer and seller and serves an important function in planning post-closing integration. Both buyer and seller should expect to invest significant time and energy in the process and both benefit from having a well-organized, prioritized diligence process.
If you are considering buying or selling a company and have questions about the process or how an investment bank might be able to assist, please feel free to contact us or reach out to chris@classvipartners.com personally and we will discuss your goals and objectives and the tools we have to assist you.
If you’d like to learn more about how prepared your business currently is for a sale, click the red banner above to take our CoPilot Assessment. CoPilot will help you identify what specific risks your business has that decrease company value and reduce your certainty of close. The assessment identifies over 90 different types of potential risks your company could have that will make your business less valuable in the eyes of an investor. Get the test ahead of time and build value today with CoPilot.