M&A due diligence process: types, key steps, challenges, and solutions

Due diligence is an integral part of any M&A deal. With its help, the buyer gets a full understanding of the selling company’s potential and can then decide on the transaction.

Shockingly, about 60% of failed deals are attributed to inadequate due diligence. Hence, successfully navigating this process demands a well-organized approach and the ability to overcome challenges.

This article explores the essential steps of the due diligence process M&A and its significance. Additionally, we’ll provide effective strategies to tackle potential challenges, ensuring informed decision-making for all parties involved.

Highlights

• M&A due diligence is a comprehensive investigation and analysis conducted by the acquiring party to assess the target company’s financial, legal, operational, and commercial aspects.
• Due diligence is critical in ensuring the success of mergers and acquisitions, as it helps identify potential risks and synergies, aligns expectations, and facilitates informed decision-making.
• The duration of due diligence varies depending on the complexity of the deal, it typically takes several weeks to a few months to complete.
• There are various types of due diligence, including financial, legal, commercial, operational, environmental, human resources, intellectual property, tax, and IT due diligence.
• Due diligence challenges include limited access to information, time constraints, cost considerations, outdated methods, and the need for specialized expertise.

What is M&A due diligence?

The due diligence process in M&A is a comprehensive investigation and analysis conducted by the acquiring party to assess the target company’s financial, legal, operational, and commercial aspects.

• For a buyer, due diligence means obtaining the necessary information about the selling company’s performance to make an informed decision based on a thorough understanding of all risks and opportunities.
• For a seller, due diligence is a chance to convince the buyer that the potential acquisition would prove worthwhile.

How long does due diligence take?

The duration of the due diligence process in mergers and acquisitions varies depending on various factors. However, on average, due diligence takes anywhere from several weeks to a few months. Here are some key factors that influence the timeline:

1. Deal complexity. More complex business transactions involving multiple business units or regulatory matters may require an extended due diligence period.
2. Data availability. The availability and accessibility of relevant data and information from the target company can impact the speed of the process.
3. External factors. External factors such as regulatory approvals, third-party assessments, or market conditions also influence the duration.
4. Utilization of technology. The adoption of a due diligence data room speeds up the process, while traditional methods like physical document sharing and in-person meetings are more time-consuming and less efficient.

7 types of due diligence

Due diligence falls into the following categories:

1. Financial due diligence involves a comprehensive review of the financial statements, balance sheets, accounting practices, and other related financial metrics with future projections. The goal of M&A financial due diligence is to assess the financial performance, profitability, and potential risks. 
2. Legal due diligence looks into the legal aspects of a transaction, including contracts, franchise agreements, and loans. Buyers conduct due diligence to uncover potential liabilities, governmental proceedings, threatened litigation, or contractual obligations. The goal is to address legal issues and shield a potential buyer from lawsuits in the future.
3. Commercial due diligence considers the market in which a business operates and makes sure that the company’s business model and business plan will be able to withstand the challenges of the relevant market climate. 
4. Operational due diligence evaluates the company’s operations, such as manufacturing processes, supply chain, sales pipeline, IT systems, and organizational structure. The goal is to identify operational inefficiencies or integration challenges.
5. Human resources due diligence focuses on the workforce, key personnel, employment contracts, and HR policies.
6. Intellectual property due diligence involves reviewing a company’s patents, trademarks, copyrights, trade secrets, and other similar organizational documents. The goal is to ensure proper protection and identify any infringement risks.
7. Tax due diligence involves reviewing a company’s tax affairs and strategies to identify potential tax liabilities or opportunities.
8. Environmental due diligence assesses a company’s environmental permits, practices, and compliance with environmental regulations. It helps identify potential environmental issues.

Why is due diligence important?

Due diligence is crucial in the M&A process as it helps the buyers and sellers make informed decisions and mitigate potential risks. Companies that conduct proper due diligence are 2.8 times more likely to achieve their financial goals than those that don’t.

The table below illustrates the significance of due diligence from the buyer’s and seller’s perspectives.

Key steps in the due diligence process

Even though the due diligence process depends on many factors, there are common due diligence activities typical for every deal. 

1. Preparing for due diligence

To ensure comprehensive and focused due diligence review, it’s important to start with proper preparation, which includes:

• Identifying objectives and scope. Before starting the process, the acquiring party must define its objectives and the scope of the review. Understanding what they aim to achieve helps focus the investigation on the most critical aspects.
• Building the due diligence team. Creating a competent and diverse due diligence team is crucial. This team may consist of financial specialists, legal professionals, industry experts, and operational analysts.
• Creating a due diligence checklist. Developing a comprehensive checklist is essential to ensure that no critical aspect is overlooked during the due diligence process. The checklist acts as a guide for the team, keeping them on track and organized.

2. Conducting due diligence

The next step is due diligence itself. Here’s what it might include:

• Gathering and reviewing financial documents. The financial matters of the target company are vital for decision-making. Analyzing financial statements, material contracts, tax records, and other financial documents helps identify potential risks and opportunities.
• Analyzing legal and regulatory compliance. Legal professionals conduct a thorough examination of the target’s contracts, licenses, permits, litigation history, and compliance with regulations.
• Assessing operational processes. Understanding the target company’s operational efficiency and effectiveness is crucial. This involves evaluating supply chain management, production capabilities, and key performance indicators.
• Evaluating market position. Market analysts study the target’s market position, industry trends, customer base, and competitive landscape.

3. Identifying risks and opportunities

It’s critical that all parties to a proposed transaction completely understand the risks and opportunities associated with the deal:

• Specifying potential deal breakers or red flags. The step involves uncovering any significant issues that could jeopardize the transaction.
• Evaluating potential synergies. The aim is to reveal potential synergies and upside opportunities. 

4. Reporting and analysis

Here are a few more steps that contribute to the deal’s success:

• Documenting findings. Throughout the due diligence process, the team must thoroughly document their findings and provide actionable recommendations based on their assessments.
• Compiling a due diligence report. Creating a comprehensive due diligence report is crucial as it facilitates effective communication of critical information to key stakeholders, serving as a valuable reference for decision-making.
• Communicating with stakeholders. Regularly updating stakeholders, including senior management, board members, and security holders, helps align expectations and gather valuable insights.
• Preparing a final offer. Once the gathered information is analyzed, the acquiring party can prepare a final offer, initiating the negotiation and deal closure phase.

Structuring a successful due diligence program

It’s important to strike a balance between two kinds of due diligence operations: 

• Incomplete — leading to legal and financial issues further down the line
• Excessive due diligence — ending up more expensive than the acquisition itself

However, the process should not be viewed as simply as a necessary due diligence checklist so that an M&A deal can progress: it is about collecting the right information which allows the correct decisions to be made regarding the transaction.

The very nature of due diligence often causes disruptions to both parties and conveys mistrust to the seller. But even when the relationship between both groups is strong, there are several obstacles to consider:

• Confidentiality arrangements. Due to the potentially catastrophic consequences of any breaches of information, the selling party and their legal team are likely to make excessive demands in the area of confidentiality.
• Losing focus. The amount of data gained can make it difficult to separate key pieces of information from the rest of the pile. This is where having the judgment and expertise of advisers is helpful since maintaining a complete perspective is key to ensuring a quick and smooth program.
• Reliability of information. Sometimes, even without lying, respondents can be misleading. Therefore, it is essential to bear in mind the nature of the information — internal data is usually more reliable than external — and to keep an eye out for irregularities in the paperwork.
• Human bias. It is all very well acquiring the information, but the way in which it is interpreted is highly subjective. And when other influences come into play, such as friction between the two management teams and unwanted media attention, rash, and biased decisions can be made.
• Cross-border transactions. This obstacle is most prominent in legal considerations. In Europe, for instance, whereas French law seeks to protect the buyer, the British legal system favors the seller. This means that a French seller is obliged to release any information regarding the valuation of the acquisition, and such a thorough approach of British companies may seem over the top in a due diligence process.

5 possible due diligence challenges and their solutions

Due diligence is a critical process in mergers and acquisitions, but it comes with its own set of challenges.

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