Due diligence is completed before a transaction closes to verify investigate and confirm all relevant information to the price and terms of an acquisition or capital investment.
‘Due diligence’ – two of the more daunting words in a business sale process. Boiled down, all this refers to is the process of answering questions from a potential buyer. These queries usually range from the easy and obvious to the pedantic and obscure.
What your acquirer needs – and why
Naturally, your likely acquirer wants to know what they are buying. In marketing yourself as an attractive acquisition, you will have presented your best profile and angle: now it’s time to check your claims. That’s why the DD initials behind ‘due diligence’ can also stand for ‘dig deeper’ or ‘deep dive’
Buyers and their M&A advisors plumb these depths to uncover a clearer, fuller and more complete picture of your organisation, revealing its true nature – past, present and future. In some cases, they also need a detailed due diligence report to support their funding applications and lender needs.
At best, their questions aim for transparency and knowledge. By covering every aspect of who you are, what you do and how you do it, the process aims to present the potential buyer with an understanding of the real you, reassuring them that they are protected from the unexpected.
At least, that’s the way it should work.
There is always a concern that the putative purchaser is also on a fishing trip, hoping to land a reason or two to reduce the price they will pay. Some corporate finance operatives seeking acquirer instructions are quite open about this, promoting their ability to find price-reducing skeletons in any seller’s cupboard.
If you see sharks in the water, there will be blood.
Far better to aim for fairness, in terms of process and pricing alike. An ethical advisor like CapEQ can spot the sharks and either avoid, subvert or manage their aggression on a seller’s behalf.
During DD we can steer a course, navigating buyer and seller through what is important, what is not and where to find it.
What you need for your due diligence checklist
Even small transactions generate reams of documentation. In days of yore (and still today, in some cases), physical documents would pile up in hotel rooms hired – often for a couple of weeks – for the purpose. Today the resource is far more likely to be built digitally and incrementally, held in a virtual data room curated by your advisor or lawyer.
But what falls under the DD umbrella? The short answer is anything that the buyer wants or needs to know. This is certain to include documented evidence of:
- Company status: certificates of incorporation and the names, addresses and shareholding of your individual shareholders
- Business structure: functions, reporting lines and operations
- Products and services: how defined, broken down and positioned in the market
- Customers and suppliers: T&Cs and other agreements
- Financials: accounts, reports, statements and contracts, tangible/intangible assets, operating costs, investment plans, etc
- Financial arrangements & liabilities: borrowings, debts, pensions, insurances and other obligations
- Intellectual property: patents, copyrights and innovations
- Litigation & compliance: disputes (current and potential), documentation, procedures and regulatory permissions
- IT systems: history, capability, investments, compatibility
- Employees/H&S: numbers, capabilities, productivity, culture, policies (D&I, disciplinary etc)
- Property/environmental: holdings, rentals, environmental liabilities
This is a partial list. In addition to these areas of universal interest, any seller is bound to be asked to provide information reflecting the status, current activities and existing policies of the particular enterprise. This may add a plethora of detail specific to the transaction, acquirer’s interests, industry developments and/or timely market issues.
For example, if you operate overseas, you are likely to be asked to show compliance with The Bribery Act 2010, and a full set of anti-corruption and fraud prevention measures.
Even a small business operating domestically still needs to prove that it is well-managed in this regard. If you run a construction business and your foreman bills for 10 skips, delivers five and pockets the balance, what procedures do you have in place to deter, detect and prevent such irregularities?
Sourcing information within your business
Every acquirer will have their own agenda, but all are likely to start DD by determining what they want to ask (most of which you will have anticipated), then assigning individuals to refining those queries and following up on your responses.
Ideally they will help you understand why they are asking the questions, and to what depth they expect you to answer. In reality, and in almost all cases, you will be left to infer such motivations and expectations.
People often compare DD to the disclosures you give to the other side’s conveyancers when selling your house. Such comparisons break down immediately on the grounds of complexity and depth of detail. A house buyer wants to know what’s in the seller’s kitchen and which bits are included in the sale (such as the cooker). A business buyer needs to know who supplies your groceries, how often you cook, what your utensils are worth and how qualified you are to prepare a meal.
Organise your company records now
Consequently the level of detailed reporting is far deeper and much more time-consuming than you might expect. In the vast majority of cases, some information exists, but is outdated, in an unshareable format, or is archived away. A lot of the required facts, understanding and statistics do not exist at all.
The sooner you start compiling, creating and shaping this resource, the better. You will soon spot gaps that need filling – the staff handbook that hasn’t been revised for a decade or the latest incomplete financial update. Not only will preparatory work save time overall, it also demonstrates competence. Any buyer receiving clear and accurate answers rapidly is going to be impressed by the way you (seem to!) run your affairs.
The word ‘accurate’ is key. You are liable for what you disclose (and fail to disclose). This information feeds into the guarantees and promises you give the buyer and provides a snapshot image of your business at the moment it is transferred.
All the information you have compiled in response to buyer questions is passed to the buyer on completion, showing them precisely what they have bought. This has legal status: if any of that content proves inaccurate in the months and years to come, any economy with the truth could come back to haunt you.
What is a dataroom and why do you need it?
At CapEQ we anticipate purchaser questions by populating a data room as early as possible. This is a virtual repository, containing content which is version-controlled, encrypted, protected and segregated – ie accessible for sharing, but only as authorised.
The compilation process starts with a questionnaire for you, our client. Then we guide the individuals you have assigned to complete the DD tasks/process through the weeks and months spent gathering information. By managing responses to enquiries, we can protect clients from sinking beneath a relentless onslaught of questions.
How to handle M&A information anomalies
In an M&A transaction valued under £1m, DD may be relatively straightforward, involving just one or two people on each side.
However, when the deal moves into eight figures you could have 20 or 30 people on the buyer’s DD team, spread across departments and jurisdictions. Inevitably different people end up asking the same questions, making a fraught process even more difficult. The best way to ensure a meeting of minds is to agree that both sides will channel DD communications via a single accountable lead.
There is a tendency among buyers to demand information about everything you do, at the deepest level of detail. Multiple representatives will ask for much the same information, unaware of their colleagues’ requests, or the bigger picture. The best form of mitigation is to have the information to hand in advance, properly filed and curated, so that it can be presented immediately to the buyer, in a metaphorical box, with a bow on it.
Any partial or delayed response is likely to encourage suspicion (‘what are they hiding?’), further digging and detailed requests, risking death by a thousand cutting queries.
By contrast, clear and rapid responses convey a lack of obfuscation. They maintain a focus on value and the deal, without getting bogged down in unnecessary detail. It is easy to lose focus and trust in the face of DD questions from people who want to know the cost of everything yet understand the value of nothing.
We always recommend getting extra help and hands on deck, so that you can prepare and manage the data room effectively and enable such speedy efficiency. Tapping into our ‘been there, done that’ expertise can also derail problems before they arise. For example, as questions arrive from potential buyers, we explain the terminology and clarify what is needed, often going back to the suitor to explain why a question is irrelevant or needs adapting.
It is not uncommon to be sent form lists created when acquiring a manufacturing business, for instance, which have no relevance to a proposed consultancy business acquisition.
How to avoid due diligence
Sorry – you can’t. Yes, it’s a hassle but also a vital part of any M&A transaction.
DD is the toughest, most frustrating, relentless and time-consuming part of the deal. You cannot subcontract most of the work: only you and your team know where the information can be found.
However, a good advisor can take some of the weight off you, helping to target, clarify and prioritise what is really needed, and fending off the less relevant enquiries.
Done properly, this results in a priceless repository of information, which justifies a fair and mutually satisfactory deal. It can reduce earnout risk, or the need for an earnout element in the first place. A good DD process facilitates a fair deal. The resource created can also be reused, should the sale fall through.
So, yes, DD is tough. But handing the facts to your M&A advisors helps defend you from price-chipping and protects you from being saddled with all the liabilities.