An In-depth Guide to Due Diligence in M&A Transactions

Over 790,000 M&A transactions have been completed worldwide with a value of about $57 trillion. They brought growth and capital increase for many companies. 

A successful M&A transaction is always preceded by thorough due diligence — a process of audit and verification of a potential deal. Due diligence in M&A transactions can be overwhelming for both the buyer and the seller as these deals involve the preparation and review of a significant volume of financial, legal, and operational documents.

Yes, the process is tedious and time-consuming, yet essential as it reveals potential benefits as well as red flags of the transaction.  

The guide below aims to give comprehensive information on why the process of due diligence in M&A is so important and how to conduct it fast, effectively, and with minimum effort. There’s also an M&A due diligence checklist to follow and advice on what tools to use for secure file storage and distribution.

 Due diligence in M&A transactions

What is due diligence in M&A deals?

Due diligence in M&A is the process of collecting and verifying relevant information like the economic, legal, fiscal, and financial aspects of a business. It helps an ordering party to make informed decisions about a transaction. The ordering party can be either selling or acquiring company, as the due diligence phase is significant for all parties involved in the deal. 

The findings of the due diligence are outlined in a due diligence report. The final version of each report may vary depending on the complexity of the transaction. For example, it can be high-level reporting or an in-depth audit of the business.

What is the role of due diligence in M&A deals? 

The importance of due diligence in M&A transactions shouldn’t be underestimated. Let’s see what role it plays from the perspective of both the buyer and the seller.

Importance of due diligence for a buyer 

As the selling company is under no duty to inform the purchaser of any defects and liabilities of the business, the buyer has to conduct their own investigation, known as due diligence. The process helps:

  1. Determine potential deal breakers at an early stage
  2. Mitigate potential risks
  3. Protect yourself from Foreign Corrupt Practices Act (FCPA) compliance violations
  4. Ensure everyone has clear and realistic expectations about the upcoming transaction
  5. Negotiate what measures should the seller take regarding the risks and liabilities, like reducing the price or giving warranties.

Importance of due diligence for a seller 

There are two main benefits a seller gets from due diligence:

  1. The fair market value identification. A thorough due diligence and financial investigation often reveal that the fair market value of the selling company is higher than what was initially defined. Therefore, it’s common for sellers to prepare due diligence reports themselves prior to potential transactions.
  1. Protection from warranty claims. All company data given to the buyer during due diligence is compiled to produce a disclosure letter, which gives the seller an opportunity to make disclosures against the warranties listed in the sale agreement.

Types of due diligence in M&A

There are four major due diligence types in mergers and acquisitions.

1. Financial due diligence

Financial due diligence is an analysis of the financial performance of a target company. Its purpose is to  ensure that the numbers stated in the financial documents are true and accurate.

Thus, financial due diligence implies investigating assets, debts, cash flow, projections, financial statements, and related financial metrics. 

2. Legal due diligence

Legal due diligence is the process of gathering and assessing the legal risks associated with the acquisition of another company.

Legal aspects that are usually assessed during this type of due diligence include licenses, regulatory issues, contracts, and any legal liabilities that may be pending. 

3. Tax due diligence

Tax due diligence is an analysis of all the taxes that a company will have to pay in case of a financial transaction. It helps to avoid mistakes and oversights, which usually lead to huge fines.

It also helps to evaluate the company’s total tax liability and the level of regulatory compliance with tax laws.

4. Operational due diligence

Operational due diligence aims to investigate a selling company’s main operations and processes. 

With it, an acquiring company can assess if operational improvements could create additional value during the transaction. It also helps to identify operational risks and consider the best ways to deal with them.

5. Intellectual property due diligence

Intellectual property due diligence is an analysis of a target company’s intellectual property assets. Such assets monetize a business and are often an important contributor to the company’s overall value.

During this type of due diligence, patents, copyrights, and trademarks are assessed.

4 steps to take to complete due diligence

Here is an approximate due diligence plan to follow, in order, to complete the process quickly and effectively.

1. Gather the due diligence team

As there are several types of due diligence in M&A and the process is long and complex, it involves many participants. Among them are:

  • M&A analysts
  • Fund managers
  • Broker-dealers
  • Investment bankers
  • Individual investors
  • Accountants
  • Attorneys 
  • Intellectual property (IP) lawyers

Each expert or a group of experts will have their own due diligence checklist to follow, depending on the area they specialize in. The professionals most actively involved in the M&A transaction are usually accountants and lawyers.

2. Prepare and share documents

During the due diligence investigation, potential buyers or investors carefully learn and analyze every aspect of the target company. That’s why the relevant information should be prepared in a timely manner and shared with all parties that require it.

Organize and structure the necessary files from at least two previous financial periods. The minimum set of documents usually include:

  • Legal documents 
  • Intellectual property documents
  • Agreements
  • List of current shareholders, officers, and directors
  • List of customers
  • Supplier documents 
  • HR documents 
  • Finances and taxes
  • Current management reporting and business plan

After reviewing the documents, potential bidders should have a full understanding of what company they’re going to acquire. For that reason, make sure there aren’t any gaps in the documentation.

Use the due diligence data room checklist to find out a full list of what documents to prepare.

3. Consider using a virtual data room

Virtual data rooms for due diligence are secure cloud repositories used for the storage and distribution of confidential information between different parties involved in corporate transactions. 

Virtual data rooms have great advantages:

  • Sorting security. Companies undergoing M&A transactions often face the challenge of how to secure sensitive documents. Virtual data rooms are a perfect solution for that problem as they have numerous security features like two-factor authentication, encryption, and watermarking.
  • Effortless collaboration. Features like chats, comments, notifications, and reminders allow all participants of the due diligence process to communicate easily and stay up-to-date. 
  • User activity tracking. Reporting tools notify you of the most active bidders and the documents mostly viewed by users. It helps to identify who’s the most engaged in the transaction and what information is the most interesting to them.  
  • 24/7 availability. Users can access virtual data rooms from anywhere and anytime. Besides, they can use several devices for that, including mobile phones, tablets, or laptops. 

Virtual data room pricing options vary depending on the tools and services vendors offer. You can read virtual data room providers reviews to find what’s the best for your needs.

4. Compile the final report 

Once all due diligence activities have been completed, the team meets to compile a report — a document that contains a detailed summary of the due diligence process.

More precisely, it should include:

  • Management summary
  • Corporate structure and ownership
  • Financial summary
  • Business plan
  • Sales and marketing
  • Assets
  • Management and staff
  • Operations
  • Legal summary
  • Risks
  • Other observations
  • Recommendations

Usually, the recommendation can be one of the following:

  1. The acquisition is a proper investment and the deal should be continued.
  2. The deal needs to be modified based on the findings of the due diligence team.
  3. The deal should be canceled because of the team’s findings.

Due diligence activities in M&A transactions

Here are the questions to ask yourself during each due diligence stage.

1. Target company overviewWhy does the owner want to sell their business?
Were there attempts to sell the business in the past?
What business plan does the company have?
How complex is the company (in terms of products, services, subsidiaries)?
Has the company recently acquired or merged with other companies?
2. FinancialsWhat’s the financial performance of the company?
Are margins for the company increasing or decreasing?
What amount of working capital is required to run the company?
What are the current capital expenditures and investments?
Does the company have enough financial resources to cover the cost of transaction expenses for the deal?
3. Target baseWho are the company’s top customers?
What consumer risks are apparent for the company?
What is the customer backlog?
4.  Legal IssuesWhat claims, if any, are there against the company?
Are there any governmental proceedings against the company?
5. Information TechnologyHow much does it cost to maintain the company’s IT infrastructure?
Are there any outsourcing agreements?
Does the company have a disaster recovery plan in case of  cybercrime or natural disaster?
6. Corporate matters and organizational documentsWho are the security holders of the company?
Are there subsidiaries of the company?
Are there any recapitalization or restructuring documents?
7. Environmental issues Does the company have environmental permits?
Are there any environmental claims or investigations related to the company?Are there contractual obligations relating to environmental issues?
8.  Marketing strategiesAre there any franchise agreements?
What are the current marketing strategies?
Are there any sales representative or agency agreements?

M&A due diligence checklist to follow

Here’s a due diligence checklist you can use to ensure you provide all necessary information for a successful transaction. 

CategoryDescriptionDocuments
Corporate structure and general mattersThe due diligence process starts with the review of the company’s corporate structure and general corporate records in order to make sure there won’t be any issues with the M&A transaction.1. Incorporation documents
2. Corporate by laws
3. Organizational chart
4. Lists of all securities holders
5. Stock option agreements and plans
6. Stockholder and voting agreements
7. Warranties
8. Stock appreciation rights plans and related grants
9. Recapitalization or restructuring documents
10. Minutes from all board, shareholder, or executive committee meetings
11. Agreements related to any sales or purchases of businesses
Financial recordsOne of the most important steps during due diligence is to review financial information and analyze the financial performance of a target company. 1. Unaudited financial statements
2. Audited financial statements (for at least the last three years)
3. Financial evaluations from external sources
4. Profit and loss statement
5. Cash flow projections and strategic plans
6. Pro forma statements for the next year
7. Balance sheets
8. Documents on previous fundraising transactions
9. Loans and credit agreements
10. Company investments 
11. Details of stockholders (percentage holdings, voting rights, etc.)
12. List of collateral for debt
TaxesLawyers and accountants should conduct tax diligence to confirm that taxes are current in all jurisdictions and that there won’t be any unexpected tax problems during the transaction.1. Tax returns for the last two years
2. Schedule of completed tax audits for the last five years
3. List of jurisdictions where a target company pays taxes and files tax returns
4. Information on tax policies
Legal due diligence documents Legal diligence implies the review of all legal aspects of the company, including general information, previous transactions, etc.1. Shareholder certificate documents
2. Local, state, and federal business licenses
3. Occupational license
4. Building permits documents
5. Zonal and land use permits
6. Tax registration documents
7. Power of attorney documents
8. Previous or outstanding legal cases
9. List of jurisdictions where a target company is licensed 
Intellectual property documentsIP documents include the details about the target company’s intangible assets.1. Trademarks, brand names, slogans, logos, etc.
2. Copyrights
3. Domain names
4. Product documentation and manuals for the target company’s software 
5. Patents
6. IP claims and litigation
7. Industrial designs
HR documentsHuman resources due diligence is required to make sure the company doesn’t have any human capital problems.1. A list of current employees and independent contractors
2. Health and safety policies
3. Details about training programs
4. Benefits policies
5. Employee resumes
6. Details of employees’ positions and wages
7. Policies regarding sick days, overtimes, and paid holidays
8. Employee rules of conduct handbook and safety policies
9. Appraisal policies

Key takeaways

M&A and due diligence go side by side. A buyer can’t have a successful financial transaction without a proper investigation of the company they want to acquire. That’s why knowing how to effectively conduct, due diligence, is essential. 

Here are the key takeaways from the guide:

  1. Due diligence in M&A is the process of verification of a potential deal with the purpose to confirm all relevant facts and financial information.
  1. Due diligence is required for risk mitigation and ensuring all deal participants have clear and realistic expectations about the upcoming transaction.
  1. Four major types of due diligence in M&A are legal, financial, operational, and tax.
  1. Four main steps to take during due diligence are to gather the due diligence team, prepare documents, use a virtual data room for secure document storage and sharing, and compile the final report.

The most important documents to prepare for due diligence are corporate structure, general matters, legal, financial, intellectual property, and taxes.

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