What is Due Diligence?
M&A due diligence is a buyer’s investigation of the target company to determine whether to acquire it or drop it. It also involves determining what needs to be discussed and resolved in negotiations if the deal continues.
Due diligence is typically conducted after sourcing the target and before negotiating a deal.
DD includes the following:
- First, you must understand the target company’s business and assets in their entirety.
- Second, you need to figure out how much to pay by calculating the enterprise value of the target company.
- Thirdly, you should discover as many possible risks you may face after acquiring it from a legal, financial and commercial standpoint.
- Finally, it is necessary to gain insight into what synergies and how much growth you could create when the target company is integrated.
DD should not only involve investigating the data room of the target company but also conducting on-site surveys, discovering key personnel, interviewing relevant executives and employees, and obtaining vital information to improve the target’s performance.
That’s why DD consumes much time, effort, and money.
Therefore, a buyer needs to select a potential target they can invest in and then perform DD on that target.
Types of Due Diligence
We can generally divide due diligence into three main types: financial, legal, and commercial DD.
- Financial DD is one of the most basic, yet important, in M&A due diligence.
The purpose of this is to ultimately calculate and validate the target company’s value.
To do this, it is necessary to analyse future performance along with historical financial data of the target company.
Financial DD may include the investigation of tax, insurance, pension, and tangible assets as sub-categories.
- Legal DD is identifying all issues to be addressed in the final investment contract between two parties.
It is essential to minimise conflicts between the two before the deal is done. In turn, you should investigate all the contracts, from internal ones between the company and its employees to external agreements with suppliers, clients, or other third parties.
Additional DD related to legal includes anti-trust, intellectual property investigation, and environmental impact assessment.
- Commercial DD is ultimately intended to establish whether the target company is suitable for the acquirer in business and whether it is worth acquiring.
Therefore, you should understand the target company’s industry, its consumer trends, and the target’s position and strengths in the market.
This requires consequentially measuring the potential for future growth and the synergies the two companies would create.
Additionally, you would investigate the previous management’s operation and how it worked, identify key personnel, and conduct technical and operational investigations.
The Importance of Due Diligence
M&A due diligence is not a legal requirement, but it is a critical process for increasing acquisition returns.
It involves evaluating a company’s reasonable value, identifying risks, and analysing how to improve its value after acquisition.
The importance of M&A DD can be summarised as follows:
- First, it is necessary to determine the company’s value.
The due diligence process enables the analysis of a business, estimation of future cash flows, and identification of market prices for assets and all liabilities, which helps determine how to reach the price of the target company.
- Second, DD enables the identification of all risks related to the acquisition, including potential liabilities, lawsuits, or regulatory issues.
This allows the acquiring company to evaluate whether the potential benefits of the acquisition outweigh its potential risks.
If the acquirer decides to acquire the target company, the buyer can discuss all those issues with the seller to mitigate the identified risks.
- Lastly, DD enables the creation of a PMI (Post-Merger Integration plan).
If you don’t set up the PMI plan during due diligence, you would have a risk of delayed integration, which may cause key employees of the target company to leave.
To achieve successful integration, you should analyse operational, organisational, and cultural differences.
Additionally, the PMI planning allows you to set up how to increase future cash flows through its M&A opportunity. That is the value-up strategy, which is critical in the M&A process.
Case Study for Due Diligence
Hewlett-Packard‘s acquisition of the software company, Autonomy is detailed in the table above. Looking at this table, we can see just how important the existence of due diligence is.
Looking to leak into the software industry, HP acquired Autonomy in October 2011 for around 11 billion dollars.
However, during their financial DD, HP and their advisors overlooked Autonomy’s accounting errors for up to a year. Because of this inaccuracy, in 2012, HP reported an 8.8-billion-dollar impairment charge relating to the goodwill and intangible assets of Autonomy Corporation in its annual report.
Shareholders were, quite rightly, furious with HP’s errors, suing them in federal court for their negligence for a sum of 1 billion dollars.
Eventually, in June 2015, the case was settled, and HP had to pay out 100 million dollars to shareholders who bought shares between the takeover announcement date and when HP came clean about their errors.
If HP had been more thorough in their financial due diligence, they would have easily prevented paying this settlement.
Due Diligence Process
Let’s break down the acquisition process into four steps.
- The first step is establishing an M&A strategy for its growth and exploring target companies.
- In the second step, once the buyer selects a target company, they form a Task Force team to conduct due diligence. The DD process may vary depending on whether the target is listed or private, or whether the deal is a public sale or private sale.
- Third step, the buyer will negotiate with the seller on the company value and critical issues found in DD and then reflects all of them in the sales and purchase agreement. Then, the deal will be completed.
- And finally, the buyer executes corporate value-up and post-merger integration strategies discovered and planned during DD.
From a document standpoint, due diligence is performed after the letter of intent is submitted. And it is completed before the acquisition contract is signed.
Due Diligence Process in Further Detail.
There is no formal process for due diligence, but we can roughly go through the following six steps.
- First, the buyer should decide which areas of due diligence they give priority in consideration of the characteristics of the target company. It is because the important areas vary depending on the sector or business.
- Second, the buyer asks the other party for a data room to review. Generally, a data room can be subdivided into operational, financial, administrative, human resources and legal aspects.
- Third, the due diligence team estimates the future sales and profits of the target company and then calculates the deal value through a financial assessment. This process may include market and competitor research.
- Fourth, the due diligence team should also conduct on-site inspections and interviews with the management team to check the target company’s operational aspects. If the acquirer found able management in the target company during their due diligence, they might keep them even after buying the company.
- Fifth, it is necessary to clearly identify all legal issues that must be specified in the final investment contract by checking risk factors during due diligence.
Once this is all done, the due diligence team needs to put it all together and be ready to negotiate with the seller.
Sources and Further Reading
If you have found information on Due Diligence insightful, head over to the M&A Institute, log in and start our online courses now. Or go to our Youtube Channel for further watching!
Other M&A Due Diligence categories are as follows:
Sources:
