When you’re closing in on an M&A deal, the topic of due diligence is sure to come up. This is a vital step in the process, so understanding how it works, and why it’s important, is crucial.
Before you fully commit to a merger or acquisition, due diligence allows you to pick through all the financial details with a fine-toothed comb. With so much on the line, M&A due diligence should not be taken lightly.
What Is Due Diligence?
Due diligence is the process of conducting an audit to determine the legal and financial risks involved in a business deal. Once an M&A Letter of Intent is signed, you will enter the due diligence phase.
It’s important to understand that there is no “right” or “wrong” level of risk when conducting your due diligence—it’s entirely up to you and your team to prioritize risk and find the balance between the acquisition target and your own financial health and stability.
The Importance of Due Diligence
When conducting your due diligence process, you want to identify both the strengths and weaknesses of the acquisition target.
Due diligence is important for many reasons, as it can help you:
- Identify hidden risks
- Mitigate any risks
- Assess whether the acquisition is a good investment, or whether you should look for a different acquisition target
- Determine how well the acquisition fits within your company’s strategy and financials
When doing your due diligence, you should aim to get as much information as possible about the target company. This includes financial records, detailed information about the business plan and projections, employees and management, and more.
Hard vs. Soft Due Diligence
Due diligence can be broken into two distinct categories: “hard” and “soft.” These are differentiated by the types of things you are reviewing.
- Hard due diligence: Focuses on the financials to help you get a full, clear picture of the company’s financial situation. This way, you can make projections for the future financial stability of the company.
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- Items reviewed under this type of due diligence include:
- Organizational documents
- Annual reports
- Financial statements
- Tax returns
- Items reviewed under this type of due diligence include:
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- Soft due diligence: Focuses on the qualitative side of the company, looking into aspects such as the employee base, the customer profiles, and management.
The purpose of doing both hard and soft due diligence is to ensure a complete and total understanding of the target company. This includes financial records, benefit systems, employee satisfaction, management structure, and more. All of these may contribute to the company’s profitability.
Understand the Company’s Processes, Products, and Priorities
To fully comprehend the strategic initiatives and overall priorities for the target company, review the following:
- Product line
- Lines of service
- Customer Acquisition Cost (CAC)
- Customer Lifetime Value (CLTV)
- Supply chain, sales channels, and customer relationships
- Internal team structure(s) and management styles
- Historical marketing strategies
- Specific business niche
Doing this will also help you identify key benefits and potential drawbacks of the company. If you’d like some extra help conducting your own M&A due diligence, we recommend consulting with an experienced M&A lawyer.
What if I’m the Seller in an M&A Contract?
If you’re on the other end of the deal during the due diligence phase, you’ve got some work to do as well. As the seller, you should:
- Make sure you’re caught up on bookkeeping
- Ensure accounting is up to date and GAAP-compliant
- Review your internal teams and processes for efficiency
- Build a team to help you oversee the process
Pro Tip: Buyers will expect airtight financial records; be prepared for them to dig deep into the details of your balance sheet and financial projections. Ideally, you should fix your financial records before even seeking a buyer to ensure you get the best price. Our sister company, Gordon Tax, can help you get due diligence-ready!
How Long is the Due Diligence Phase?
Due diligence is a process that involves a lot of research—both online and offline—to gather relevant information about the target company. The information your attorneys and accountants gather during this process will help you identify potential risks and determine if the acquisition target is a good investment for your company.
There are many ways to conduct due diligence, but the most common method is to evaluate the records, then conduct a “walk-through” with the key executives of the company you’re evaluating.
During the walk-through, you’ll be able to:
- Ask specific questions about the business
- Evaluate their response
- Decide if the partnership would be profitable.
With so much complex information involved, the due diligence process can take a few weeks or several months.
Documents Requested During Due Diligence
Your due diligence team should include an experienced M&A lawyer, accountants, and other consultants who will prepare a detailed checklist of all the documents and information you should review.
Typically, the following documents will be requested:
- Corporate records
- IP agreements and other current contracts
- Litigation history
- Stockholder information
- Tax returns
- Balance sheets
- P&Ls
- Financial projections
Additional documents may also be required depending on the type and size of the target company. Mergers and acquisitions can be complex and require a lot of communication between the buyer and seller. This step, although tedious, may be one of the key differences between a successful and failed deal.
Gordon Law is Here to Help
Whether you’re just starting ideation around a merger or acquisition, or you’ve laid the groundwork and it’s time for due diligence to begin, you can trust the team at Gordon Law to help you navigate what’s ahead. Our business law attorneys will ensure you check every box during this crucial process.
