One of the most important and time-consuming parts of a merger and acquisition agreement is due diligence. The due diligence process is a thing or set of acts that a buyer does to confirm the accuracy of the seller’s claim. A potential merger and acquisition deal involves a few kinds of due diligence. However, many still don’t understand due diligence. To gain better knowledge regarding the due diligence process, let’s see the following article!
What is due diligence?
Due diligence is an investigation, audit, or review carried out carefully by a legal consultant on a company or object to obtain information or facts regarding the condition of the company or object. The purpose is to reduce the risk of the investment decision.
In the finance world, due diligence requires the examination of financial records before entering into a proposed transaction with another party. An individual investor can perform due diligence on any stock using publicly available information. The same due diligence strategy will work on other types of investments. The due diligence involves examining the company’s numbers and comparing them with the trend over time and with those of its competitors. Due diligence can be used in different ways, such as by looking into a potential employee’s background or reviewing a product.
Also read: How to Get Investment from Venture Capital?
The Types of Due Diligence
What is due diligence? (source: Freepik).
Due diligence (DD) is a long process that the buyer goes through to evaluate the business, assets, skills, and financial performance of the company they want to buy. The main types of due diligence include:
1. Administrative Due Diligence
Administrative due diligence is an aspect of due diligence that involves verifying administration-related items such as facilities, occupancy rates, the number of workstations, etc. The idea of doing due diligence is to verify various facilities owned or occupied by the seller and determine whether the financial plan includes all the operating costs. Administrative due diligence also gives buyers a better idea of the kinds of operational costs they will likely have to pay if they want to grow the company they want to buy.
2. Financial Due Diligence
One of the most important types of due diligence is financial, which investigates the financial accuracy presented in the confidential information memorandum (CIM). Financial due diligence aims to give a complete picture of the company’s finances. It looks at things like the audited financial statements from the last three years, the current unaudited financial statements, a similar report from the year before, projections, the reasons behind the projections, capital expenditure plans, inventory schedules, debtors and creditors, and other things.
The financial due diligence process also involves an analysis of key customer accounts and fixed and variable costs, an analysis of profit margins, and an examination of internal control procedures. The company’s order book and sales pipeline are also looked at as part of financial due diligence. This helps improve a projection and makes it more accurate. Many companies that buy other companies have a separate part of their financial analysis that looks at how much debt the target company has. The analysis might include evaluating the company’s short- and long-term debt and prevailing interest rates. The company’s ability to pay off its debt and secure more funds if needed, along with inspections and evaluations of its overall capital structure.
Also read: Early Startup Funding Stages: Explained From Seed to IPO
3. Asset Due Diligence
Asset due diligence is another type of due diligence performed. Usually, an asset due diligence report has a detailed list of the property and where it is (if possible, it should be checked in person), the lease agreements for equipment, a schedule of sales and purchases of major capital equipment in the last three to five years, real estate deeds, mortgages, title policies, and permission to use
4. Human Resources Due Diligence
Human resources due diligence is vastly broad. The following may include several of them:
- – The analysis of total employees, including the current positions, vacancies, maturity for retirement, and notice of service
- – The analysis of current salary, bonuses paid over the last three years, and years of service
- – The employment contracts, with confidentiality, non-request and non-competitive agreement between the company and its employees. If there are any discrepancies regarding the general contract, any questions or concerns need to be clarified.
- – The HR policies regarding annual leave, sick leave, and other forms of leave are subject to be reviewed.
- – The analysis of employee issues, such as alleged wrongful termination, harassment, discrimination, and any pending legal cases with current or former employees
- – The potential financial impact of current labor disputes, requests for arbitration, or pending complaints procedures
- – List and description of the employee health benefits and welfare insurance policies or other self-funded arrangements
- – ESOP and grant schedule
5. Environmental Due Diligence
Due diligence related to environmental regulations is significant because if the company violates the main rules, local authorities can exercise their right to punish the company to the extent of shutting down its operations. Therefore, environmental auditing of any property owned or leased by the company is regarded as one of the main types of due diligence. In the assets due diligence process, the following should be carefully reviewed:
- – The list of environmental permits and licenses with the same validation
- – The copies of the correspondence and notices from local agencies of environmental protection
- – The verification of the conformity of the company’s waste disposal methods with current regulations and guidelines
- – The examination of contingent environmental liabilities or ongoing redress obligations
6. Taxes Due Diligence
Due diligence in relation to tax obligations includes reviewing the taxes owed by the company and ensuring the calculations are correct, without intending to report the underpaid taxes. As well as verifying the status of pending tax-related cases with the tax authorities. The documentation of tax compliance and potential issues typically includes verification and review of the following:
- – The copies of the tax returns, including income tax, withholding, and sales tax, for the last three to five years
- – The information related to past or pending corporate tax audits
- – The documentation related to ZERO (net operating loss) or remaining credit from tax deductions or credits
- – The important and unusual correspondence with tax agents
7. Intellectual Property Due Diligence
What is due diligence? (source: Freepik).
An established company has intellectual property assets that can be used to monetize the business. This intangible asset differentiates the company’s products and services from the competitors. The company may often comprise some of the most assets. Some notable things to consider in the due diligence review are:
- – The schedule of patents and patent applications
- – The schedule of copyrights, trademarks, and brand names
- – The pending documents of the patent permit
- – Any pending claims by or against the company in connection with intellectual property infringement
8. Legal Due Diligence
Legal due diligence is fundamental and usually includes examining and reviewing the following elements:
- – The copies of the Memorandum and Articles of Association
- – The notes from Board Meetings in the past three years
- – The copies of shareholders’ meetings and actions over the last three years
- – The copies of share certificates issued to The Key Management Personnel
- – The copies of warranties to which the company, as the other party
- – The material contracts, including any joint venture or partnership agreements; limited liability company or operating agreement
- – License or franchise agreement
- – The copies of all loan agreements, bank financing agreements, and lines of credit to which the company is a party
Also read: What Are Acquisitions in Business? Here’s What It Means
9. Customer Due Diligence
Since the customers or clients are the lifeblood of business, this type of due diligence always involves close observation of the target company’s customer base, with the following examination and analysis:
- – The company’s top customers: those who make the largest total purchases from as well as the customers who own the largest total assets, and all the customers regardless of their current level of spending
- – The appropriate insurance coverage and service agreements
- – The current credit policy; run and review outstanding sales day (DSO) metrics to assess the receivables efficiency
- – The customer satisfaction score and related reports for the last three years
- – A complete list and its explanations of lost customers in the last three to five years
10. Strategic Fit
The acquirers are generally meticulous in conducting due diligence, especially when evaluating the target company’s conformity with the buyer’s strategic business plan. For instance, a private equity firm considering a new acquisition would ask how well the proposed target would complement the company’s existing portfolio. A big company that is eyeing a possible merger and acquisition deal would consider the success rate in the acquisition of the target company into the total organization of the buyer’s company.
The following are some key issues that the acquirer looks at and evaluates:
- – Does the target have key technologies, products, or market access that the acquirer does not have and needs or could profitably make use of?
- – Does the target have key personnel representing a substantial human resource gain?
- – The assessment of the operational and financial synergies that can be expected from the target integration and the acquirer
- – If the target company will be merged with another company that the acquirer also owns, examine the merger plan and project the duration of the merger process, as well as estimate the actual cost of executing the process.
- – Determine the best personnel from both parties to manage the merger process
Other due diligence research areas include IT networking, stock or bond issuance, research and development (R&D), and sales and marketing. Performing thorough due diligence is essential to any successful acquisition. Without comprehensive knowledge of the target company, making well-defined decisions regarding the merger and acquisition is impossible.
