The Best Practices for M&A Due Diligence

27 February, 2020

under the hood

Due diligence is a critical part of acquiring or selling an asset or stock. It’s the process of “kicking the tires” and “looking under the hood” in an effort to thoroughly evaluate the underlying financial and material risks, liabilities, and other unknown attributes that lie under the surface. It's the responsibility of a business to assess that it is what it says it is, both financially and in all other aspects. Yet many business buyers fail to conduct due diligence properly—and end up paying for it after they've signed on the dotted line.

The failure rate for mergers and acquisitions, or M&A, is extremely high when you consider the impact that a failed deal can have on the brand and political capital of an organization. Solely this past decade, we’ve seen countless failures. Most recently, we witnessed software pioneer Microsoft write off 96% of their $7.9 billion investment in Nokia, while Google lost a near $3 billion on their 2012 venture into Motorola. Those are combined losses of over $10 billion just naming two deals.

In fact, despite the hunger to diversify, broaden product lines, and increase market share, a majority of M&A ventures fail. The Harvard Business Review reports that according to a number of recent studies, “M&A is a mug’s game, in which typically between 70 and 90 percent are abysmal failures.” Many times, the reason for these failures is that the due diligence process is not broad enough.

Acquirers often focus myopically on the financial aspects of the target. They assemble expert teams to construct elaborate economic models in an attempt to predict the future and adjust for risk, but they fail to focus as thoroughly on other vital aspects of the business, such as legal and regulatory scrutiny, whether or not key employees will be retained, and whether cultures will be synergistic, or clash.

It’s important to note that “failure” doesn’t necessarily mean that the new company goes completely down the tubes and dissolves. One KPMG study found that a whopping 83 percent of M&A deals did not boost shareholder returns, while a separate study by A.T. Kearney concluded that total returns on M&A were in fact negative. The reports suggest that this is due to mismanagement of risk, price, strategy, cultures or management capacity.

Due diligence requires collecting all the intelligence on the target, and that daunting process requires meticulous effort. For this reason we recently partnered with Dorset Capital and EisnerAmper, to host a web panel discussion focused on best practices, common pitfalls, and ways to optimize value prior to entering due diligence.

The one-hour session explores many of the nightmares often experienced during due diligence and how to avoid them, including:

Failure to Come Dressed for the Party

During due diligence, preparation—on both sides of the transaction—is key. Naturally, buyers need to dig deep into the target business, evaluating finances, risk, the team, the culture, the customer base and the business plan in order to ensure they’re getting what they’re paying for. But sellers have an equal responsibility to do due diligence on the buyer.

They should seek answers to several questions: Why are you acquiring me? What are your plans for the future? What will my role be and for how long? Are you going to take care of my employees? Parties on both sides of the negotiation should have realistic expectations about what they hope to achieve from the transaction. If these expectations are not at least somewhat aligned, it may be a sign that the party should be called off.

Rushing to the Party

You’ve probably heard that “time is money” or “time is risk.” The reality is that the longer the due diligence process plays out, the greater chance there will be price adjustments—usually negatively impacting the seller. Sometimes it’s essential to expedite the transfer of a company from one owner to the next (that’s in the seller’s best interest). But if that means the buyer is rushing the due diligence process they could be at risk. It’s never appropriate to hurry through due diligence just to hit a closing deadline. Take whatever time is necessary to cover all the bases.

Incomplete Due Diligence

Due diligence should always be a comprehensive process that looks at all aspects of the business (and the intentions of the buyer). Unfortunately, a lot of business buyers (and sellers) aren’t familiar with all the issues that due diligence should address.

As a result, things are missed. To ensure the due diligence process is as comprehensive as possible, buyers (or their bankers) often supply the seller with a due diligence checklist. These materials are then organized in a virtual data room that the buyer (or many buyers) is given access to. The benefits of a virtual data room include that due diligence materials are secure and available 24/7 from anywhere in the world, access to documents can be staged as the due diligence process evolves and more access is warranted, that access can be instantly revoked if the need arises, even for documents that have already been downloaded.

Having all due diligence materials organized in a virtual data room before the diligence process starts is part of being prepared and expediting the diligence process. It makes sellers look professional and it’s what buyers expect.

Too Much Reliance on Outside Counsel

As a business buyer, you’re not necessarily an expert in due diligence or the nuances of the industry you’re entering. It’s important to understand your limitations and to know when it’s necessary to call in outside resources. Bankers, attorneys and brokers have the expertise to help you navigate the due diligence process properly. However, bankers, attorneys and brokers are often very transactional, meaning when the transaction is complete, their role is complete. They’re not concerned with the next 100 days as critical synergies are formed and new processes are ironed out. People in the trenches, who will stick around after the transaction is completed, should always have a role in the diligence process.

Overly aggressive due diligence

Sellers expect buyers to conduct thorough due diligence. But sometimes buyers can go a little overboard and become overly aggressive in their due diligence pursuits, which can result in seller fatigue, defensiveness and resentment while a potential investor might scrutinize a specific asset or component of a business, perhaps demanding access to documents before the seriousness of their intent warrants it. The result is that sellers become antagonized, or wary, and less likely to cooperate with the buyer’s effort to move the deal forward, thus impeding the process rather than expediting it.

Wrap Up

In this article, we presented some of the best practices for M&A due diligence. If you missed this informative discussion where our panel of business experts dove into the nuances of M&A due diligence, and shared their extensive experience you can request the recording below.