Due diligence is a trust-building measure that benefits both sellers and buyers. In mergers and acquisitions (M&As), it’s an audit of the company, its financials, and its representation of market share that presents a clear picture of the deal on the table.
In the business world, M&A’s hit an all-time high in 2021. Global dealmakers were hungry for growth, revenue synergy, and diversification. Those numbers dropped in 2022 but still remained at a healthy pre-pandemic level. These trends also renewed the debate on due diligence, leaving some to wonder out loud if due diligence is worth the time and money.
As an investor, due diligence provides reassurance that your money is going towards a sound business model–or that you are aware of any bumps in the road. Let’s take a closer look at the pros and cons.
Due diligence: rewards and risks
The process of conducting due diligence takes time and money. Before you skip this step, keep in mind that both buyers and sellers have inherent bias.
Benefits of due diligence
Sellers tend to be optimistic about the value of the company, often basing growth forecasts on assumptions that may never materialize. Similarly, buyers tend to overestimate the speed with which they can acclimate and accelerate to growth.
The facts uncovered through due diligence serve as a grounding rod, providing both parties with more realistic expectations. As a result, there is a higher chance of success for the M&A to close.
There are many specific benefits of due diligence, including:
- Securing Financial Incentives for Key Parties
- Stronger Negotiating Power
- Identify and Proactively Manage Risks
- Benefit of Third-Party Insight
Risks involved with due diligence
When it comes to due diligence, most of the risks stem from skipping this important step in the M&A process. Of course, you could spend weeks of labor on due diligence only to have the deal fall apart. While that might not be the outcome you were hoping for, the due diligence process worked, saving you from closing a deal that would not benefit your long-term strategy.
Failure to invest in appropriate due diligence might result in the following:
- Overpaying Due to Inaccurate Financial Details & Inherent Bias
- Unnecessary/Preventable Risk Exposure
- Inability to Obtain Restitution
The bottom line is that due diligence benefits both parties. For sellers, it allows them to confidently negotiate a favorable deal while earning the trust of potential buyers. And for buyers, it provides transparency to support the final numbers at closing.
What is due diligence support?
The process of due diligence is detailed and requires varied expertise. It’s common to seek the help of qualified third parties to assist in this type of fact-finding mission. A due diligence support team can provide the necessary expertise. From start to finish, the whole process looks into the nitty-gritty details of financial statements, margins, working capital, expenditures, technology, revenue recognition, strategic positioning, workforce management, and much more.
Due diligence support includes legal counsel, consultants, accountants, bankers, and business strategists who know what they’re looking at. These individuals have enough experience to make appropriate value determinations based on a variety of factors, including current market conditions and industry-specific opportunities.
Investors typically build long-term professional relationships with key due diligence support team members independent of any specific project. As with any consultancy relationship, these individuals can provide ongoing professional advice before, during, and after an M&A. Unlike the employees of companies the investor owns or is acquiring, the due diligence support team can provide a unique third-party perspective which is helpful in maintaining objectivity.
Elements of due diligence support
Due diligence is a detailed process. It can take upwards of three to six months to look through every aspect of a company. Here is a look at what to expect.
Review of Company
At the highest level, the due diligence support team will look at the target company to see the big-picture overview and identify factors that are driving the sale. This step can provide some of the first clues as to whether or not the deal presented matches the buyers’ expectations.
The company review looks at:
- Reason for Sale
- Marketability of the Business
- Strategic Positioning of the Business
- Complexity of Business Structure
- Geographical Business Structure
Businesses sell for many reasons. Sometimes the current business is struggling to stay afloat, and the current owner is ready to call it quits. Other times, the business is healthy, but the owner is ready to part ways. Performing a due diligence review of the company can let you know if there have been previous attempts to sell a business and if there were deals that previously fell apart. Knowing this information can give you more power in negotiations.
In this stage, you’ll also gain a better understanding of what you’re really buying.
Next, your due diligence team will closely examine financial documents to ensure that claims of profitability and market share match up with historical data and reliable future projections. This is a key area for review because many sellers optimistically state the financial health of their companies.
Financial statements are reviewed for:
- Financial Trends (margins increasing or decreasing)
- Validity of Future Financial Projections
- Working Capital Figures
- Capital Expenditures or Investments
- Debt Balances
- Expected Revenue
The financial review aims to match money to data, proving that the seller can financially manage the sale and that there is full transparency in the financial health of the target business. Again, knowing that a company is struggling financially isn’t necessarily a roadblock to a sale. But it is an important precursor to understanding the reason for the sale.
Research and Development Review
At the heart of every business is a drive for innovation. This area of business is related to the main business but always focuses on some type of future growth. Typically, research and development (R&D) are where the real value lies in a business. This makes R&D an important focus in due diligence.
A review of intellectual property includes:
- Copyrighted Material
- Trade Secrets
With key stones unturned, the buyer can now begin looking at how the target business fits their overall strategy. Until this point in the due diligence process, the buyer has been operating on optimistic and often idealistic expectations.
There is really one important question to answer here: What opportunities, products, or services will the acquisition add to the buyers’ strategy?
Assuming there is a viable business reason to proceed with the M&A, the next big concern is customer integration. This is the point in due diligence where the fact-finding mission starts to look a little more like a strategizing session.
In terms of customer base, you want to know:
- Biggest Customers (with sales numbers and share of business)
- Consumer-Related Risks
- Warranty Servicing Needs
Access to a client base is one of the key motivating factors for some buyers. It makes sense that you would want to verify that those customers truly exist in the volume that is expected before closing the deal.
For example, when one manufacturing company bought out its competition to access key customer accounts, including several national grocery chains, the company discovered that the true cost of servicing those accounts was much higher than anticipated. Here, the purchasing decision was predicated on the assumption that it would have been proven false with thorough due diligence.
From a human resource perspective, the due diligence takes a look at the target company’s workforce. This is where a buyer can gain a better understanding of the human capital that may be accessible, along with obligations for wages and benefits. This information will inform additional discussions regarding cultural fit and, ultimately, what to do with the existing workforce once the company is acquired.
Another key accounting element that receives a lot of focus during due diligence is the tax structure of the organization. The team will look at both income and non-income financials like sales and use taxes, payroll taxes, and property taxes to gain an understanding of the true operational costs associated with the business.
This area becomes increasingly complex for global companies that manage workers under different taxing authorities. Your due diligence needs global expertise to understand the differences between triggering permanent establishment, business travel, and remote work policies to fully understand tax liability.
The legal concerns reviewed during due diligence include everything from employment contracts to product risks. This might include pending litigation or potential breach of contract triggered by the sale of the company. In many cases, the buyer assumes responsibility for all legal risk once the sale is final, so lawyers often comb through legal concerns with a fine-toothed comb, performing thorough risk assessments that sometimes stall the deal altogether.
The due diligence support process
The due diligence process is a significant resource commitment for both sides of the transaction. Both buyers and sellers hire reputable professionals in legal, accounting, and business strategy to review the facts and keep the deal moving in the right direction.
Here is a look at what to expect as your team goes to work:
1. Project Analysis: The team meets to set and discuss goals for the due diligence process aligned with the needs of either the seller or the buyer. This is an onboarding phase where the support team aims to get acquainted with the target business and the needs of the buyer or seller.
2. Pre-Analysis of Financials & Business Case: The team takes a high-level view of the target company’s financials and business strategy for context as they prepare to begin reviewing key business records.
3. Full Document Review: The team meticulously works through the review of key business documents, covering things like financials, operations, workforce, research and development, taxes, and legal concerns.
4. Detailed Financial Analysis: Equipped with more information, the team studies the financial records and business strategy side-by-side to determine the financial health of the business and associated risks.
5. Risk Analysis: Using the facts gathered during the document review, the team conducts a thorough risk assessment based on the context of the proposed deal.
6. Negotiations & Final Offer: The transparency provided through careful due diligence typically inspires an additional round of negotiations to reach a final deal. The support team who is most familiar with the deal is primed to facilitate these negotiations, make final offers, and monitor the transaction through closing.
The right due diligence support can make a big difference in your ability to negotiate a beneficial deal. As you think about your next goal, you’re probably already thinking of names you can throw in the hat to serve on your support team. Professional relationships can carry a lot of clout, but there is a difference in the interest alignment between your employees and your advisors. For some, the transparency provided by a third-party due diligence support team is invaluable.
The benefits of due diligence support
Hiring a third party to provide due diligence support can be a smart move. For one, they’re objective without any inherent bias towards either the buyer or the seller. A firm like Embarc Advisors, which offers due diligence support, can provide a ready-made team of experts in the field that have past experience in mergers and acquisitions.
This expertise becomes an invaluable safeguard, as M&As often involve several business and legal-savvy individuals, increasing the possibility of litigation. Imagine the possibility of acquiring a company, only to unwittingly trigger a breach of warranty.
In most cases, buyers are required to provide notice regarding warranty transfer to all customers with outstanding warranties. Again, most deals specify a deadline for this notice, typically within a matter of months of closing. However, in at least one case, the buyer was found to be in breach of contract after serving such notices that were later deemed to be non-compliant.
In another, much more high-profile case that is unlikely to be forgotten inside and outside of the business world, a number of fraudulent accounting practices led to the eventual collapse of the company. This was the 2001 collapse of Enron which would later reveal (2008) that several major financial institutions were implicated in the company’s demise. Enron alone is a case study for independent oversight.
Embarc’s approach to due diligence support
Embarc Advisors provides cost-effective, on-demand access to top-tier strategic finance talent. We understand what’s possible for businesses that have access to the best financial support teams, and we’re reimagining a different future that makes that support accessible to businesses of all sizes.
With a proven track record of success in startup fundraising, private equity investment analysis, and venture capital due diligence, Embarc Advisors is your A-list for top-quality financial support. We’re making exclusive, top-tier talent more accessible.
We’ve cultivated a team with the right talent, cherry-picked across the most prominent industries to provide a flexible, commitment-free opportunity for businesses that are ready to bring strategy and finance together to build legacies.
Embarc Advisors provides a team of qualified experts to handle your third-party due diligence process with ease. Learn more about why due diligence is the best thing you can do before closing a deal.