The Methodology of Due Diligence

When looking to buy or sell a business, a preliminary review of offers will lead a seller to select the buyer he or she wants to negotiate with. At this stage, the buyer’s nonbinding letter of intent (LOI) informs the seller of how the buyer wishes to proceed and what the general terms of the offer will be.

Turning the nonbinding agreement into a formal contract to acquire is what due diligence, the next stage of the process, enables both parties to do. Following this is a final once-over that we call “circling back” to confirm the deal is ready to close. Upon the successful execution of these steps, the formal agreement is signed, ownership changes hands, and the transaction is complete.

As a task belonging to the buyer, due diligence in an exercise in “trust, but verify” that examines and reconfirms everything the seller has asserted about the condition the business is in.

In most cases, due diligence takes place within 90 days of the execution of the LOI. During this period, the buyer has the option to withdraw the offer, and the seller the right to walk away. Assuming neither of these things happens, the buyer’s attorneys are then free to draw up a purchase agreement for the parties to sign.

‘Deep Dive’ for Answers

Due diligence is a deep dive into the fundamentals and the fine points of the seller’s company. Its main thrust will be financial as the buyer scrutinizes sales, profitability, cash flow, liabilities and indebtedness, and anything else related to top- and bottom-line performance.

The buyer’s accountant probably will take the lead here, relying on the seller to provide business records as required. Needless to say, historical information should be readily available to all of the buyer’s representatives whenever they ask for it.

The vetting process will also examine the company’s organizational structure, the nature of its customer base (including account concentration), the composition of its workforce, and its plans for achieving future growth. Pending litigation against the company (if there is any) will be reviewed; so will real estate issues and whatever environmental and/or health and safety concerns it may be addressing.

Quite a Queue of Queries

Just how granular can the investigation be? In one transaction we know of, the buyer’s preliminary due diligence request ran to 23 pages. It specified scores of items to be reported under 14 separate headings over a five-year time frame. In this case, the seller clearly had some homework to do. Not every due diligence examination will be this rigorous, but they are all alike in their insistence on detailed and reliable documentation.

It should go without saying that the seller must be as transparent and forthcoming as possible while due diligence is under way. We urge our selling clients to disclose everything that could bear on closing the deal, even if the details aren’t flattering.

In a properly conducted due diligence, everything comes to light sooner or later. It’s better to be up front about problem areas now than risk having them scuttle the deal by blindsiding the buyer at a later stage.

This is why we encourage our selling clients to perform “reverse due diligence” — a critical self-examination of the company in preparation for being acquired. Looking at the situation through the buyer’s eyes helps the seller anticipate questions and potential objections, and prepare convincing answers for them.

From the buyer’s perspective, the goal is to arrive at a level of comfort that revalidates the original decision to make the offer to purchase. Only with the clarity provided by due diligence can the buyer be certain the acquisition continues to makes sense.

Being Blunt Is Best Approach

This is why sellers should anticipate blunt inquiries about the company’s merits as an acquisition target. Even a company with an attractive P&L and a strong balance sheet may have underlying flaws that the buyer would inherit upon closing the sale. If they exist, due diligence exposes them for both parties to confront and resolve.

Buyers also should be alert to the seller’s reputation in the marketplace. Thanks to the Internet, social media channels, and industry networks such as trade associations, it isn’t hard to get a sense of how the seller is perceived by its vendors, employees, and peers. Because harmonizing company cultures is so essential to the success of M&As, this softer aspect of due diligence shouldn’t be overlooked.

If due diligence was thorough, there should no longer be any gaps in the big picture of the transaction that is now about to take place. But because the acquisition process as a whole probably has spanned months, it’s wise at this stage to review the main elements of the deal and verify they are the same now as they were when the process began.

Does It Still Feel Right?

Buyers do this by pausing and circling back to what attracted them to the opportunity in the first place. Again, thanks to due diligence, there should be no major surprises. But, taking a final look at issues such as customer retention and the continued participation of key employees helps the buyer to remain certain that the transaction still makes sense.

Circling back in this way removes any remaining ambiguities and puts the buyer in the right frame of mind for what comes next: seeing to it that the acquisition works not just on paper but in actual practice. Now the buyer can proceed with confidence to signing — and to the bigger challenge of making the whole of the merger exceed the sum of its parts.