Our colleague Mimi Hunter recently summarized the basic aspects of due diligence in the context of a venture capital investment (What is due diligence?). In this series of posts, I will highlight considerations for due diligence in the context of a merger and acquisition (M&A) transaction.
M&A due diligence generally
The term “due diligence” describes the process each of the parties undertakes to investigate the other before a final decision is made whether to proceed with the transaction.
Due diligence is important because it provides a company insight into what they are purchasing. Essentially, it is like a home inspection prior to purchasing a house, in both understanding the inner-workings of the house in addition to determining whether you want to purchase the house and for how much. And much like a real estate transaction, a buyer loses their leverage to attain critical operating information when the deal closes. Well executed due diligence can alter the course of a deal and can protect a company from making bad investment decisions. Company executives rely on due diligence and the related analysis by their attorneys to make crucial business decisions.
While it may seem that due diligence is primarily the concern of the acquiring company, a seller should be equally concerned about the buyer, especially if the deal consideration is securities of the buyer or there is some strategic combination contemplated.
What are the objectives of due diligence in an M&A transaction?
The objectives of M&A due diligence vary depending upon:
- whether a party is the buyer or the seller;
- the buyer’s business purpose for the transaction (i.e., does the buyer plan to integrate operations following the closing, or will it strip down the seller’s operations to assets); and
- the proposed deal terms, including the type of consideration that the seller would receive.
For the buyer (or seller if the transaction contemplates a stock-for-stock exchange, “merger of equals,” or strategic combination), the objectives of due diligence may include the following, among others:
- accumulating sufficient information to validate the proposed valuation and to justify the business reasons for consummating the deal;
- learning more about the seller’s business and operations and collecting information that may be critical to operating the seller’s business post-transaction or extracting institutional knowledge seeded in seller’s personnel that may not continue on with the surviving entity;
- uncovering and identifying the current and potential issues, problems, risks and liabilities posed by the transaction;
- determining whether the seller’s business can effectively be integrated into that of the buyer; and
- identifying unused capacity and determining how such capacity can be effectively utilized to produce synergies.
For a seller receiving cash consideration in the transaction, its focus during due diligence will be on (i) what stockholder or third-party consents are required to consummate the transaction; (ii) corporate, business records, or contract clean-up issues; (iii) compensation, severance, or personnel matters; and (iv) arrangements where the consummation of the transaction would cause an undesirable effect on the seller, such as an event of default, a right of a third party to terminate a material obligation of the seller, or a trigger of a source code escrow obligation.
We will be adding subsequent posts that explore other aspects of M&A due diligence, such as the process, who is or should be involved, scope of review and what do you do with the results of due diligence review.