Due Diligence is an essential element of an M&A transaction that a Buyer needs completed to help ensure a successful result. In a lot of cases, a full due diligence review of a target company is an onerous task and one that could come at a great expense to the Buyer. However, proper due diligence can uncover potential risks or liabilities that could far exceed the cost of performing a due diligence review. I like to compare buying a business to the similar challenges to buying a used car or a pre-owned house, just on a much larger scale.
Do you buy a used car without looking under the hood? Do you purchase a pre-owned house without getting the house inspected? For the majority of us, the answer to those questions is absolutely not. You never know what is hiding underneath the hood of that car, and you never know what is going on behind the walls of that house. You want to know those answers prior to making the purchase because you want to ensure that you are making a smart investment. Looking under the hood of a business is similarly important to protecting that presumably large investment you are about to make.
Three important aspects to proper due diligence
Proper due diligence on a target business starts with breaking down the business into 3 facets: business, legal, and financial. This will help organize the large task ahead of a buyer, and allow a buyer to tackle each facet individually. The next step in the due diligence phase of a transaction is to engage qualified and experienced help.
Just like when purchasing that used car where thorough buyers would seek the opinion of a qualified mechanic, or in the context of purchasing a preowned home, buyers would engage a licensed home inspector. In the context of a business acquisition, the considerations are very similar. You hire that mechanic because the mechanic knows what to look for in the engine and other aspects of the car to determine its condition.
Similarly, the licensed home inspector knows what he or she is looking for behind the walls, in the pipes and in the wiring looking for any hidden issues or problems. A buyer’s team of advisors will know what to look for in the target business to find those hidden problems, issues, or other matters that need to be addressed and resolved prior to a closing.
Knowledge of the market is necessary
When tacking “business” due diligence, the buyer typically has a handle on the market, the growth potential, current and perspective clients or customers, general product information, and the reputation of the target business in the industry. If the buyer does not know any of that type of information, they are usually knowledgeable enough themselves to be able to seek reports and input from the current executives of the target business in order to answer any questions or resolve any issues that arise during the course of performing their business due diligence.
Financial due diligence
A thorough “financial” due diligence review is also essential. Generally, a buyer will have the experience to review financial statements on their face, analyze the profitability of a company, but more times than not, engaging a certified public accountant (CPA) experienced in mergers and acquisitions will help to uncover any hidden elements of the financial statements.
Experienced CPAs do a thorough review of all aspects of the target business’s financial health including reviews of journal entries, accounts receivable, accounts payable, tax records, and any and all other financial aspects of the target business. The CPA will paint a clear picture for the Buyer of the positive elements of the finances, but will also point out areas of concern that require additional questions and document production from the target business.
Legal due diligence
“Legal” due diligence is another matter. Typically, a buyer will not know what to look for in the legal structure of the business, nor will a buyer know the correct questions to ask to get the answers they need. If a buyer has not yet engaged a qualified attorney who has experience in mergers and acquisitions, engaging one to perform the legal due diligence on a target company is essential.
Experienced mergers and acquisition attorneys will have exhaustive checklists to present to the target company in order to obtain relevant documentation, information, contracts, licenses, permits, certifications and all other legal aspects of the business. The attorney is looking to ensure that the target company has materially complied with applicable laws, is not in breach of any contracts or agreements, does not have any pending or threatened litigation. The attorney is also looking to ensure that the company assets are appropriately titled and in good condition, intellectual property is properly owned and has been protected, and to provide insight to any and all other similar legal issues that could arise.
The attorney, just like the mechanic and home inspector, looks at every legal aspect of the business and makes sure there are no surprises or issues that could arise after the closing, thus providing the buyer and attorney with a good understanding of how well the business was run by the attention the target business paid to the important legal considerations of its industry.
The importance of due diligence
Due diligence is important for two main reasons: (1) it helps ensure the buyer makes a wise investment; and (2) it can help uncover potential liabilities that could be a buyer’s responsibility once they own the business. Proper due diligence, and surrounding yourself with qualified advisors, can help you avoid a mistake in buying a house or car that can reach in the thousands of dollars, but thorough due diligence in an acquisition, and a good team advisors, can help a buyer mitigate risks that could reach into the millions of dollars.
Contact Cohen Pollock Merlin Turner, mergers and acquisitions attorneys in Atlanta, for help with your business decisions. We can help you through the entire M&A process so you will have the confidence and security you and your business need.
Legal Disclaimer: This blog post is for informational purposes only and is not intended to be, and should not be interpreted as, legal advice. Please contact an attorney with any questions pertaining to the information contained herein.