The Importance of Due Diligence in Mergers and Acquisitions

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According to a study conducted by M&A consultants Alan Lewis and Dan McKone, out of 2,500 M&A deals analyzed, more than 60 percent resulted in lost shareholder value. Most research indicates that only about half of M&A activity meets its objectives, making it essentially a coin toss.

Due diligence is the lifeblood of any financial or legal dealing, as it forms the bedrock for informed decision-making and risk management. A comprehensive due diligence process uncovers hidden pitfalls and potential growth opportunities to explore.

Among the hundreds and thousands of financial transactions that fail yearly, including M&As, an oversight in due diligence is responsible for a significant percentage.

What Exactly is Due Diligence?

Due diligence in the context of mergers and acquisitions (M&A) is the thorough investigation and analysis the acquirers conduct to assess the target company's operations, financials, legal compliance, and other relevant aspects.

It's a comprehensive review or audit of documents, records, and information to verify their accuracy, identify potential risks or liabilities, and evaluate the value and viability of the transaction.

Financial, legal, operational, and other specific forms of due diligence help you gain a deep understanding of the target company's IT systems, financial health, legal obligations, operational capabilities, and potential integration challenges.

What are the Different Types of Due Diligence in M&A?

While operational, commercial, legal, and financial are the main types of due diligence that foster a successful merger or acquisition deal, there are several other types of due diligence when it comes to M&A and they include:

1. Financial Due Diligence

This focuses on evaluating the target company's financial statements, accounting practices, cash flow, assets, liabilities, tax compliance, and overall financial performance and condition. It aims to verify the accuracy of financial information and assess the target company's financial health.

2. Legal Due Diligence

Legal due diligence digs into the legal issues the target company is battling with. It's an in-depth review of the target company's legal documents, contracts, licenses, permits, litigation history, regulatory compliance, intellectual property rights, and legal or regulatory risks to mitigate any potential legal issues that may arise.

3. Commercial Due Diligence

Commercial due diligence assesses the target company's market position, competitive landscape, customer base, sales and marketing strategies, products or services, industry trends, and growth potential. It aims to evaluate the target company's market opportunities, competitive advantages, and prospects.

4. Operational Due Diligence

Operational due diligence analyzes the target company's operational capabilities, production processes, supply chain management, IT systems, facilities, and potential operational risks. It aims to assess the efficiency, scalability, and integration challenges of the target company's operations.

5. Technical Due Diligence

Technology or technical due diligence evaluates the target company's technology infrastructure, software systems, intellectual property related to technology, cybersecurity measures, data privacy compliance, and technological risks.

6. Environmental Due Diligence

Environmental due diligence investigations examine the target company's compliance with environmental regulations, potential environmental liabilities, contamination risks, and sustainability practices. It aims to identify any environmental issues that may impact the transaction or pose long-term risks.

7. Human Resources Due Diligence

This focuses on the workforce, employee contracts, compensation and benefits programs, HR policies, culture, and potential HR-related risks. It helps evaluate the compatibility of the workforce and identifies any potential integration challenges.

These types of due diligence provide a comprehensive assessment of different aspects of the target company, enabling the potential buyer to make informed decisions, identify potential risks, and plan for a successful synergy.

What is the Importance and Role of Due Diligence in Mergers and Acquisitions?

The crucial role of due diligence in mergers and acquisitions (M&A) cuts across the entire transaction process, and includes the following:

1. Assessing Risks and Opportunities

Comprehensive due diligence helps you to identify and examine potential risks associated with the company you're buying. It allows for a comprehensive study of the company's financial resources and operational, commercial, and legal aspects to uncover liabilities, litigation, compliance issues, or other potential obstacles.

Simultaneously, due diligence also helps identify opportunities for growth, synergies, and operational improvements that can enhance the value of the transaction.

2. Informing Decision-Making

The things you discover in your M&A due diligence will provide you with essential information to make informed decisions about whether to proceed with the transaction, negotiate terms, or even withdraw from the deal.

Thorough due diligence of the company's financials, operations, and legal standing provides a comprehensive understanding of the risks, opportunities, and value proposition of the transaction.

3. Valuation and Pricing

Due diligence may help you determine the actual price of the company you want to acquire. Due diligence is a critical tool that helps you assess the fair market value and negotiate the purchase price accordingly. It also allows for an evaluation of any contingent liabilities or risks that could affect the valuation.

4. Mitigating Post-Acquisition Risks

Due diligence allows the buyer to anticipate and mitigate potential risks and challenges that may arise after the acquisition. This thorough understanding of the target company's operations can help both buyer and seller plan for a smoother integration process.

5. Facilitating Negotiations and Deal Structure

The insights gained through due diligence provide the acquiring party with a solid basis for negotiating the terms and structure of the deal. It helps identify areas where adjustments, warranties, or indemnities may be necessary to account for potential risks or contingencies discovered during the due diligence process.

6. Regulatory and Legal Compliance

Due diligence ensures that both parties, especially in a merger, are aware of any legal or regulatory compliance issues associated with the target company. It helps identify potential violations, permits, licenses, and pending litigation or regulatory investigations.

The process of due diligence in any M&A transaction is one of the most crucial as it can save both parties a whole lot of time and resources. That's why it's advisable to consider collaborating with both legal and financial experts to conduct due diligence before entering the M&A process.

Comprehensive Due Diligence Checklist in M&A?

Before engaging in an acquisition or merger, you must first thoroughly examine the following aspects of the financial, legal, and other aspects, as these are what determine whether the deal will haunt you in the future or not.

Below is a comprehensive guide to due diligence whether you're the seller or the buyer:

1. Financial Due Diligence:

  • Audited financial statements
  • Annual reports and SEC filings
  • Tax returns and related tax matters
  • Revenue and expense analysis
  • Cash flow analysis
  • Debt and liabilities review
  • Capital structure and financing arrangements
  • Contingent liabilities and commitments

2. Legal Due Diligence:

  • Corporate documents (e.g., articles of incorporation, bylaws)
  • Contracts and agreements (e.g., customer contracts, vendor agreements)
  • Intellectual property (e.g., patents, trademarks, copyrights)
  • Regulatory compliance (e.g., permits, licenses, certifications)
  • Litigation and legal proceedings
  • Employment and labor matters (e.g., employment contracts, employee benefits)
  • Environmental compliance and liabilities
  • Insurance coverage and claims history

3. Operational Due Diligence:

  • Organizational structure and key personnel
  • Operations and production processes
  • Supply chain management and vendor relationships
  • IT systems and infrastructure
  • Customer and sales analysis
  • Inventory management and analysis
  • Quality control and product/service warranties
  • Real estate and facilities assessment

4. Commercial Due Diligence:

  • Market analysis and industry trends
  • Competitor analysis and market positioning
  • Customer base and customer contracts
  • Sales and marketing strategies
  • Distribution channels and partnerships
  • Pricing and revenue models
  • Product or service differentiation

You'll also have to consider the following:

  • IT systems and infrastructure
  • Software applications and licenses
  • Data security and privacy measures
  • Intellectual property related to technology
  • Research and development capabilities
  • Technology integration and compatibility assessment
  • Employee contracts and personnel records
  • Employee benefits and compensation plans
  • Workforce composition and turnover rates
  • Employment policies and compliance
  • Labor union agreements
  • Key employee retention plans
  • Environmental impact assessments
  • Compliance with environmental regulations
  • Permits, licenses, and certifications
  • Health and safety policies and records
  • Regulatory compliance in relevant industries

Understand that all these processes may not be necessary depending on the specific circumstance, industry, or nature of the deal.

You Don't Have to Do It Alone!

Mergers and acquisitions are daunting. The financial and legal technicalities and potential pitfalls along the way require careful navigation and expert guidance. That's where Calkins Law Firm comes in.

At Calkins Law Firm, we believe in the power of collaboration. We will work closely with you as your trusted advisors throughout the due diligence process. We'll analyze the details, uncover hidden opportunities, and identify potential risks while ensuring your best interests.

Request a free consultation today to discuss how we can help you.

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Benjamin Calkins

Benjamin Calkins

Ben Calkins is a well-educated, top-rated, and highly experienced business law attorney.

Ben Calkins is an honors graduate of Harvard College and the University of Michigan Law School. After law school, he clerked for a Federal Judge before joining one of the World’s largest law firms, Squire, Sanders & Dempsey. Mr. Calkins has also worked at, and been a partner in, several of the most prominent “old style law firms” in the World.