The Due Diligence Process

Conducting due diligence requires the buyer to understand both the whole of your business and its individual parts. Because buyers often employ a variety of experts to handle due diligence on their behalf, they might struggle to understand a business in its entirety. This highlights one of the biggest challenges for buyers – focus. Many buyers have a difficult time maintaining their focus when conducting diligence. It’s easy for a buyer to become lost in the details and to simply “check off the boxes” without appreciating how the various parts comprise the whole and how they work together.

For the buyer, due diligence can make the difference between success and failure. What may initially look like an attractive acquisition may later prove to be unattractive after the due diligence review is completed. Acquirers use due diligence in conjunction with other activities such as strategic planning and valuation to determine whether to proceed with the transaction. At a high level, the buyer is assessing whether the acquisition is a strategic fit – assuming the buyer is a strategic buyer – and the risks and opportunities your company presents. 

How thoroughly the buyer performs due diligence may depend on the following factors:

• Degree and Likelihood of Potential Risk: The buyer will conduct more thorough due diligence if the sale is structured as a stock purchase or if they expect to assume pending litigation with a sizable potential outcome. The buyer is expected to do everything reasonable, not just possible, to assess the transaction’s level of risk. The performance of due diligence shouldn’t require an unusual amount of effort, just a reasonable effort given the level of risk that the transaction represents. Buyers should never expect to uncover every possible risk in a business. 
• Time and Money Available: The extent of due diligence also depends on how much time and money the buyer is willing to spend on the process. The amount of resources invested in performing due diligence often depends on the degree of risk present in the transaction, the size of the transaction, the form of the transaction, and the buyer’s familiarity with the target business’s industry. It’s worth noting that a higher percentage of the purchase price is spent conducting due diligence for smaller transactions.
• Operations of the Business: Operations include how many years the business has been in existence, whether the financial statements have been audited, the degree of turnover among the staff and management, customer turnover, and any other factors that may affect the stability and perceived level of risk in the business. The more complex the operations, the more thorough due diligence usually is.
• Complexity of the Business: More complex businesses with multiple product lines and locations that operate in multiple international jurisdictions and across several industry sectors require a greater degree of diligence than a simple business with one product line in one location that operates in an unregulated industry.
• Public vs. Private Companies: Publicly held companies are subjected to a greater degree of scrutiny by the underwriters, the advisors servicing those firms, and the investor base both during the initial diligence in the underwriting process and throughout ongoing due diligence. They also have ongoing disclosure obligations that help reduce risk for the buyer. Public firms generally have more thorough controls in place, and purchasers often expect public firms to present less risk than private firms. On the other hand, the acquisition of public companies doesn’t often include thorough representations and warranties because pursuing indemnification from such a dispersed shareholder base would be difficult. 
• Scope of Reps and Warranties: The degree of protection you’re willing to offer the buyer in the purchase agreement can also affect the level of diligence performed. In theory, the more protections you’re willing to offer, the less thorough diligence can be. But, in practice, few buyers are willing to forego conducting a reasonable level of due diligence, even if you’re willing to offer a thorough set of reps and warranties, unless there’s an external reason for doing so, such as the need to close by December 31 for tax reasons.
• Form of Transaction: Whether the transaction is structured as an asset or stock transaction will also impact the level of diligence required. An asset purchase may require the buyer to perform less thorough diligence than if the transaction were structured as a stock purchase. That’s because the buyer would generally not assume liabilities unless they expressly agree to do so – the major exception being successor liability. The successor is generally not liable for the debts and legal obligations of the predecessor unless they contractually agree to assume such liability.
• Third-Party Financing: Additional diligence may be required by the buyer’s financing sources. An example of this would be environmental risks, when, in some cases, the lender may assume successor liability related to environmental contamination.
• Ability to Verify: Buyers prefer not to rely on your oral representations if the information can be reasonably verified. The more information that can be verified through documentation, as opposed to management interviews, the more documents will be requested. This allows buyers to see your business for themselves, understand that you’re telling the truth, and view your business as less risky. 
• Red Flags: The more red flags the buyer perceives as due diligence unfolds, the more likely they’ll conduct more thorough diligence.
• Controls in the Business: The more controls present in your business, such as financial controls and management reports, the more trust the buyer will have in your company, and the less thoroughly they’ll perform diligence.

How Due Diligence Fits Into the Overall Process

Due diligence is normally driven by the head of M&A or corporate development, or the legal counsel of the buyer. Here’s a summary of how due diligence fits into the sales process:

• Letter of Intent: The parties negotiate and accept the LOI.
• Due Diligence: The due diligence period begins immediately after the LOI is accepted by the parties. 
• Purchase Agreement: Due diligence is usually conducted simultaneously with the drafting of the purchase agreement. Whatever findings arise from due diligence are incorporated into the purchase agreement or listed as exclusions in the disclosure schedules.
• Contingencies That Survive Due Diligence: Often, contingencies survive due diligence, such as bank financing, lease assignment, or license transfers. These contingencies are resolved between the conclusion of due diligence and the closing. The buyer may cancel the transaction if these contingencies aren’t resolved.
• Closing: Once the contingencies are resolved, the closing may occur. In most cases, the purchase agreement is signed at closing, but it may be signed prior to closing in a minority of cases.

The Appropriate Level of Diligence

Traditional due diligence checklists imply that the selling company is a landmine of potential problems. The implication is “buyer beware.” But the level of diligence required should be proportional to the size and complexity of the transaction. Ronald Reagan put it best when he said, “Trust but verify.” 

The goal of the buyer is to first predict potential risks and then find a way to mitigate those risks. But even the best strategy for due diligence can only be so comprehensive.

Reasons for Being Diligent

If the buyer is a public company, making the wrong move can tarnish its reputation and negatively impact the value of its share price. In a study of over 1,200 transactions conducted by Mark Sirower, co-author of The Synergy Solution (Harvard Business Review Press, 2022), whom I had the pleasure of interviewing on my M&A Talk podcast, Sirower determined that the market’s initial reaction to an acquisition is surprisingly accurate. Yes, the market is smarter than you think and has little patience for anything less than due diligence. If you would like to learn more, check out the M&A Talk episode Why Half of Acquisitions Fail with Mark Sirower at morganandwestfield.com/resources/podcast. 

Mistakes can put a company out of business nearly overnight, whether the company is public or private. In other cases, the participants can be held personally liable for failing to exercise “due” diligence. Congress has also passed numerous pieces of legislation that have required companies to exercise an even greater degree of due diligence. The problem is compounded by the limited time available to conduct it.

How careful do buyers need to be? Do they need to consider every imaginable risk, those that are most likely, or only those that can have the greatest impact? 

The level of due diligence ultimately required is subjective.

Let’s break down the meaning of “due diligence.” Here’s the definition according to the Merriam-Webster Dictionary:

• Due: Required or expected in the prescribed, normal, or logical course of events.
• Diligence: Steady, earnest, and energetic effort: devoted and painstaking work and application to accomplish an undertaking. The attention and care legally expected or required of a person, such as a party to a contract.

Common sense and judgment are required when exercising diligence. In most cases, you can easily see what went wrong in retrospect. The trite adage holds true – hindsight is 20/20. But predicting a specific problem within a company that may potentially have hundreds of problems is difficult. 

To illustrate the complexities of due diligence, consider the failures of “Big Five” accounting firm Arthur Andersen in 2002 and the energy company Enron in 2007. They underscore the fact that judgment can’t simply be delegated to a third party – all parties involved in the diligence process must exercise care and perseverance. Both of these catastrophic collapses were due to a lack of diligence. These are the stakes of the due diligence process. In fact, participants may expose themselves to personal liability even if they had no intent to defraud but simply failed to exercise due diligence. The scandals that enveloped the corporate world even before Arthur Andersen and Enron in the 1990s and 2000s changed the way business is conducted. The result was increased legislation requiring anyone involved in the due diligence process to ensure that diligence – for lack of a better word – is conducted diligently. 

The best acquirers now integrate due diligence into the entire acquisition process – from early valuation modeling to integration planning. Integration is no longer an afterthought but a critical component of the process for every acquirer.

The level of diligence required should be proportional to the transaction. 

Due Diligence and Small Private Enterprises

It’s becoming more likely, even for small, privately held companies, that the buyer of your company will be an institutional investor, such as a private equity firm or a strategic acquirer. Institutional investors have multiple stakeholders to please, and a failure to exercise diligence can expose them to liability.

What does this mean for you, the seller?

It’s simple – expect that diligence will be conducted diligently.

Any skeletons in the closet will likely be discovered. A thorough diligence process also highlights the importance of preparing for due diligence in advance by identifying and eliminating as many problems as you can. 

Assessing Problems Before a Sale

While preparing for due diligence, you may come across problems that can’t be feasibly solved before the sale. How should you go about addressing them? Here are my rules of thumb. 

Degree vs. Likelihood

When assessing risk, you should consider both the potential impact and the likelihood of the risk. A hurricane can be deadly, for instance, whereas an alien invasion is unlikely. For another example, in a retail business, theft is likely but not material. In a manufacturing business, liability may be unlikely but could be significant. 

By weighing both the likelihood of the problem occurring and the degree to which it may impact your business, you can decide how to move forward. Should you mitigate the problem so you can convince the buyer it isn’t important, or should you simply be upfront about the problem in an effort to build goodwill? The answer, of course, depends on the specifics of the problem itself, but using these two variables can help you decide which action to take. 

Due Diligence and Timing

Due diligence may be conducted sequentially or iteratively. If sequential, it’s common for the most accessible information to be reviewed first, such as financial statements, or to first review those areas that present the most risk. In most cases, due diligence is performed in an iterative fashion that’s driven by the pace of information you provide to the purchaser.

In addition, due diligence doesn’t have a definite start and end date. Diligence often begins when the buyer first receives information on the target company and doesn’t end until sometime after the closing date. Diligence may extend beyond the closing because the purchaser is afforded protections through the reps and warranties provided in the purchase agreement. Due diligence is an imperfect process that’s highly iterative, subjective, and dependent on the unique circumstances of the transaction.

Typically, due diligence takes 30 to 45 days, but the time frame is heavily dependent on how thoroughly you’ve prepared. The more prepared you are, the quicker the time frame can be. The converse is also true – the less prepared you are, the longer the process will take.

The length of due diligence should be based on the following:

• Availability of Information: If you respond promptly to the buyer’s document requests, the due diligence period can be shorter.
• Turnaround Time: By providing concise, organized, and clear information, you make it easier for the buyer to review the information quickly, speeding up the process.
• Communication: If you’re more available to the buyer, this may also shorten the due diligence period.

Due diligence is an imperfect process that is highly iterative, subjective, and dependent on the unique circumstances of the transaction.

Mutual Due Diligence

As the seller, you may also conduct due diligence on the buyer if:

• You’ll play an ongoing role in the business.
• You’ll carry a note or finance a portion of the purchase price.
• The buyer holds back a portion of the purchase price outside of escrow.
• You’re receiving stock in the purchaser’s entity as a form of consideration.
• The buyer is seeking third-party financing, and you aren’t sure of their financial qualifications.
• You own the real property and will be leasing the property to the buyer.

What Can Go Wrong

When determining what can go wrong, you can look to the providers of reps and warranties insurance. In an episode of my podcast, M&A Talk, I interviewed TJ Noonan, Managing Director of M&A Transaction Solutions Practice with Hyland. He provided the following statistics based on the number of claims under reps and warranties insurance policies for M&A transactions regarding these common problems: 

• Financial statement accuracy: 20%
• Tax liabilities, such as income and payroll taxes: 18%
• Compliance with laws, such as minimum wage laws: 15%
• Material contracts, such as all customer contracts being in good standing: 13%
• Miscellaneous, such as IP, litigation, operations, environmental, and more: 34%

Learn More

To listen to the full interview, check out the M&A Talk episode Reps and Warranties Insurance with TJ Noonan at morganandwestfield.com/resources/podcast. 

List of Documents and When They’re Shared

Every transaction is different, but here are my general guidelines.

Here’s what to share before you accept an LOI:

• Confidential information memorandum (CIM)
• Profit and loss statements (P&Ls)
• Balance sheets
• Summary or abstract of your lease
• List of assets included in the purchase price
• Sales literature and brochures

Before accepting an offer, you should be cautious regarding what information you disclose to a buyer. You should come across as motivated and cooperative, but you shouldn’t comply with every request they make. At some point, you should politely and tactfully ask the buyer to make an offer.

Here’s a partial list of what to share after you accept an LOI:

• Federal income tax returns
• Bank statements
• Invoices and receipts
• Full copy of the lease for the premises
• Equipment leases
• Third-party contracts, such as supplier or vendor contracts
• Sales and use tax reports
• Staffing and payroll-related documents, including job descriptions and employment contracts
• Insurance-related documents like workers’ compensation, as well as health and liability insurance
• Equipment inspection reports
• Licenses and permits
• Marketing, advertising, and promotional documents
• Environmental documents and inspections

The list above isn’t typical for every business. Each business will have a unique due diligence structure. Most due diligence requests are more extensive than the list above, but this gives you a general idea of what documents are shared before and after you accept a letter of intent.

Handling Buyers Who Request Too Much Information

How should you handle a buyer who’s requesting too much information, such as bank statements and tax returns, before submitting an offer? 

While this is uncommon with seasoned buyers, you may experience these types of requests from smaller corporate buyers or from those who may have ill intentions. If so, explain to the buyer that a thorough investigation can only be conducted after you accept an offer. Tactfully point out that once an offer is accepted, they’ll have plenty of time to perform their due diligence and verify the accuracy of your representations. Let the buyer know that you’re making representations that will be verified during due diligence. 

The Importance of “Representations” and “Warranties”

Due diligence is never perfect – it can never uncover every potential problem with a business. The buyer can never be absolutely assured that your business is without problems. In fact, there’s no such thing as a “perfect” business. 

If a buyer can’t ensure your business is problem-free by performing due diligence, what can they do?

Reps and warranties are statements and guarantees by you, the seller, relating to the assets, liabilities, and other elements of the business you’re selling. You’ll be required to make factual statements in the purchase agreement regarding the condition of your business, covering nearly all aspects of your company. 

Essentially, you’re assuring the buyer that your representations are true, and if proven to be otherwise, the buyer will be entitled to seek legal remedies, which could result in you having to reimburse the buyer for damages. Reps and warranties collectively serve to mitigate the risk of any material defects that weren’t discovered, or disclosed during due diligence.

• A representation is a statement of fact. If a representation is untrue, it’s “inaccurate.”
  • As the seller, you may represent that the assets of your business are in good repair, that all inventory is salable, that there are no hazardous substances used in the business, that it’s operated in compliance with all laws, or that you have the legal capacity to sign the purchase agreement. 
• A warranty is an assurance. If a warranty is untrue, it’s “breached.”
  • You may warrant that you’ll operate the business in a regular and normal manner and will comply with all laws until closing, or you’ll pay all payroll taxes that will come due from past operations up to the time of closing. 

Reps and warranties in the purchase agreement assure the buyer that legal remedies will be available if you fail to disclose any material facts regarding your business that aren’t subsequently discovered during due diligence. Reps and warranties assure potential acquirers that additional protection is available if you aren’t fully forthcoming during due diligence. It covers any gaps that are naturally present within any due diligence process.

Due diligence is never perfect – it can never uncover every potential problem with a business.