Due diligence refers to the process of verifying, investigating, and/or auditing a prospective transaction target or investment option to confirm all pertinent information and financial details, as well as to spot-check any last-minute issues that arose over the course of the deal or investment timeline. Due diligence is conducted prior to the closing stage to give the buyer a certain degree of assurance as to what they are agreeing to purchase or invest in.
Transactions that utilize a due diligence period are statistically proven to have a far greater chance of being successful in the long-term. Due diligence enables buyers to make informed decisions by providing them with quality data on which to premise their decisions.
The following due diligence checklist is a non-exhaustive, generalized list of factors a buyer should take into account as part of its acquisition analysis. Note that additional questions need to be incorporated for industry-specific diligence.
Target Company Analysis
- Motivation for Selling: There must be a key reason prompting the business owner(s) to sell the company. These can range from generating capital for an estate tax payment to monetizing a lifetime’s work to less than ideal situations such as the anticipation of adverse litigation or a projected decrease in market performance—which could prompt the acquirer to reevaluate their decision to take over the target company.
- Corporate Structure: Just how complex is the business? If the target company is comprised of several disparate subsidiaries that are involved in diverse industries, it may be too challenging for the buyer to oversee such a multitude of interests or scale it in the future. On the other end of the spectrum, target companies with straightforward product lines or services are ideal acquisition targets.
- Industry Analysis: Take a close look at the leading players in the specific marketplaces the target company is involved in. Identify the competitive niches occupied by these entities, and how their business models may compare with that of the target corporation. Will you be competitive with them? Is the target company ideally positioned to take advantage of any industry-specific developments or trends?
Target Company Employee Analysis
- Employee Types: Gather data on the number of employees in all operational departments of the company to include production, materials, human resources, etc.—take note of all key personnel with leadership and/or revenue-generating responsibilities.
- Client Associations: Identify any employees of the target company that have close relationships with key clients. This is a key consideration as a buyer will want to incentivize those employees to remain with the company so as to not influence key accounts to leave upon completion of the acquisition.
- Compensation: Calculate the aggregate cost of the essential personnel of the target company, including base salary, commissions, bonuses, stock options and payroll taxes as well as any applicable benefits and/or reimbursements.
- Union Information: Be aware if any employees are represented by unions. If so, obtain a copy of the collective bargaining agreement and take note of scheduled wage rate increases, caps on working hours, guaranteed benefits and other potential issues that impact the operational costs of the target business and restrain management changes you may wish to make.
Target Company Financial Analysis
- Financial Statements: Gather the financial statements for at least the past five years, which can then be translated into a trend-line comparative study to identify any potential business/operational concerns.
- Cash Flow: A major component of financial statements is the cash flow entry. This section indicates the main sources and utilization of revenue. Be mindful to keep the cash flow data in mind when reviewing the income statement, as the target company may report significant profitability while they are in all actuality exhausting their cash reserves. On a similar note, pay attention to expenses categorized as non-operational—the target business may shift its expenses into this category in an attempt to make its operations appear more robust than they actually are.
- Management Correspondence: Following any audits the target company has undergone. Auditors typically compile a list of recommendations in a management letter, which is then distributed to the CEO and audit committee. These letters are worth examining during due diligence as they underscore any deficiencies in the target organization’s business practices.
Intellectual Property Analysis
- Patents: Is the target company the owner of any patents? It is challenging for a due diligence team to acquire the requisite technical proficiency to sift through complex patents owned by the target organization in order to determine which ones are most valuable. Doing so may require hiring a third-party expert, which could increase the due diligence timeline/budget.
- Trademarks: Has the target business completed the registration process for any trademarks? Are they adequately protected? Determine if any competitors are infringing them.
- Licensing Cost: Target companies sometimes have obtained a license to use a crucial piece of intellectual property from a third-party entity. If this is the case, determine the time remaining on the licensing agreement as well as the rights of the licensor to retract usage permission if the target organization is bought or sold.
- Accounts Payable: Take a close look at the current aged accounts payable report in order to determine if there are any outstanding or past-due payables. If there are, find out the reason why they have not been paid off.
- Leases: Determine if any equipment or facilities have leases and obtain copies of the applicable agreements for each. If any equipment has bargain purchase clauses that may enable your company to obtain permanent ownership of either space or materials at a discount. On the other hand, if leases are not assignable or transferable, you may be without significant assets upon purchase.
- Debt: Conduct a thorough review of the debt instruments existing and determine if there is any contractual language that could potentially accelerate outstanding payments in the event the business ownership changes hands. Additionally, there may be personal guarantees on debt that have to be renegotiated prior to the present owners of the target company being able to sell their business.
- Legal Issues: If there are any ongoing lawsuits the target company is a party to, gain an understanding of the status and likely outcome, as well as any costs associated with the case. It is also a good idea to be aware of any past lawsuits within the last five years or so and to get copies of any settlement agreements associated with them—the target company could have financial or regulatory obligations resulting from prior litigation.
This is a general overview of some of the pertinent issues associated with M&A due diligence protocol. A properly conducted due diligence program mitigates many potential risks and affords the acquiring company a degree of protection against any unanticipated financial or regulatory issues and associated costs. This is why we tell clients: Never purchase or invest in a business with conducting due diligence.
Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM, PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.