Why Conduct Due Diligence?

Many buyers ask, Why Conduct Due Diligence?

Due diligence is an audit of a potential M&A investment, which takes place prior to the closing of a transaction. Due diligence plays an important role in every M&A transaction. It is a discovery process that helps buyers understand the financial statements, potential synergies, cultural differences between the companies, and possible risks of a particular target.

Financial Diligence

It’s imperative for a buyer to conduct thorough due diligence on the target company’s financial records, particularly the income statement and balance sheet. A buyer needs to test the income statement to make sure that revenues are not inflated and that expenses are not understated. Similarly, the balance sheet items, or the value related to said items needs to be verified. In many cases, a buyer will test the inventory or even do a complete physical inventory to determine if it has been corrected stated on the balance sheet. In many cases, a buyer will also conduct a “quality of earnings” examination to determine if the earnings of the company match their understanding. Last, but not least, the buyer will want to make sure that they understand the cash flow of the business. This goes well beyond EBITDA!

Evaluating Potential Synergies

Synergies are the main motivators for many M&A transactions. Generating returns above and beyond what the two companies could achieve as separate entities is usually the goal of an acquirer. One of the most common pitfalls of M&A transactions is overestimating possible synergies. This results in buyers over paying for target companies and, in many cases, a failed acquisition. The due diligence process is a chance for buyers to do their “homework” on a target to see if these potential synergies can be realized. While potential synergies with a target company can be very appealing, it takes thorough due diligence to develop a roadmap to take these synergies from theory to reality.

Understanding Company Culture

Understanding a target’s company culture can be the difference between a successful acquisition and a failed one. In most cases, a company’s greatest asset is its employees as these are the people who manage the day to day operations and develop the strategies which define a company. The employees are a vital asset that is going to be acquired and a potential buyer should take the time during the due diligence phase to understand the culture. The culture in the workplace is one of the critical factors in determining the success of an acquisition. Differences in company culture are not always a negative as the two cultures can learn from one another; however, cultures that are radically different and cannot be managed properly will create a toxic work environment that destroys value. Due diligence gives the acquirer a chance to evaluate a target’s employees and will give the acquirer a better sense of whether these employees can be successfully integrated.

Discovering Potential Risks

Due diligence gives the buyer assurance that it is not assuming undue risk by acquiring a target company. Before signing a definitive agreement, every acquirer should have a full understanding of the risks that an acquisition poses. From a legal standpoint, the buyer will use due diligence to understand any potential litigation the target company could face in the future and if the acquirer could be liable for any damages resulting from that litigation. Due diligence also gives buyers insight into operational or financial risks of an acquisition. Debt covenants, supplier contacts, integration costs, possible off-balance sheet liabilities, etc. should all be thoroughly examined before committing valuable resources to purchasing a company.

Conclusion

Acquisitions are essential to almost every corporate strategy. They can be an effective way of building shareholder value and save companies time when trying to break into new geographies or product lines. Due diligence is an opportunity for acquirers to obtain a better understanding of the potential returns and risks of an acquisition. If utilized properly, due diligence can insure the completion of a successful acquisition.
While there are conflicts that prevent your M&A advisor from actually completing the due diligence, a good financial advisor should be able to advise their client on how to conduct the diligence process, what to expect from the process, and how to mitigate the risk of any negative findings by making adjustments to the Purchase and Sale Agreement. Versailles Group has over 25 years’ experience in advising both buyers and sellers in executing successful transactions.

We hope that this answers the question: Why Conduct Due Diligence?