What is Due Diligence in a Business Acquisition? | Hilton Smythe

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What is Due Diligence in a Business Acquisition?

The due diligence process is so important to protect you. This guide discusses the importance of due diligence and why it must be done as part of any merger or acquisition deal.

Acquiring a business is exciting as your organisation begins a new chapter, but the due diligence process is so important to protect you and the seller by confirming that all facts are accurate.

This guide discusses the importance of due diligence and why it must be done as part of any merger or acquisition deal.

What is due diligence?

Due diligence is an investigative process launched by the buyer to confirm that all facts given about the company are true. In mergers and acquisitions, due diligence involves investigating the target company before committing to a sale.

Several areas of interest will feature as part of professional due diligence, including:

  • Financial statements
  • Legal documents
  • Senior management
  • Employees
  • Target market
  • Industry

Of the 2,099 M&A deals involving UK companies in 2022, every deal differed in size and complexity. These factors influence what level of due diligence will be required for your M&A deal.

Disclosure vs. due diligence

M&A transactions also have the concept of disclosure. It’s a process closely related to due diligence and will factor into exploring a target company.

In brief, disclosure is the process whereby the seller provides relevant information and documentation about the company. According to UK law, if a seller fails to disclose relevant information, they could be sued.

This is where due diligence comes in. Essentially, you are verifying each disclosure to confirm its accuracy and completeness.

Who is responsible for due diligence in an acquisition?

The buyer is always responsible for carrying out their due diligence in an acquisition. If the seller has disclosed all relevant information accurately and the buyer fails to investigate it, the legal concept of caveat emptor, or let the buyer beware, will likely come to the fore.

No buyer is legally required to conduct due diligence, but it would be foolish not to. Without due diligence, you rely on the seller’s disclosures at face value.

Typically, a buyer will form a team to lead the due diligence process. This may involve consulting with a due diligence firm specialising in M&A deals.

Why is due diligence important in business acquisitions

Due diligence is always crucial in any M&A deal for buyers and sellers alike.

Firstly, the buyer must be aware of the caveat emptor concept. If you decided to buy a second-hand car without inspecting it, you would find it challenging to get your money back if it had problems. Why? Despite the seller providing disclosures, you didn’t do your due diligence.

The same goes for businesses but on a much larger scale. Get it wrong, and it could derail your business acquisition plans and cost your firm valuable time and money. Moreover, if issues do appear during your due diligence, you have several options, including:

  • Asking for a discount on the initial purchase price.
  • Demanding an indemnity within the final purchasing agreement.
  • Walking away from the deal.

Sellers also benefit from due diligence. It enables them to keep their paperwork organised for the disclosure process, which takes place after the various purchasing agreement warranties have been drafted. Buyers who have already done their due diligence will typically see a speedier purchase.

Naturally, sellers also benefit from the protection of due diligence. If a purchaser tries to reverse the deal or sue later because of an issue you disclosed, they will find it difficult to succeed if they don’t do their due diligence.

In short, due diligence ensures that everyone is on the same page and can enter a transaction with confidence.

Types of due diligence in acquisitions

Acquisitions are often held up because of the due diligence process. The amount of paperwork and legwork involved can mean that M&A deals take six months to several years, depending on the deal.

If you don’t know where to begin, here are some of the most common areas due diligence will focus on:

  • Accounting
  • Corporate information
  • Tax issues
  • Employment
  • Health and safety
  • Litigation
  • Contracts
  • Property
  • Intellectual property
  • IT
  • Environmental concerns
  • Insurance
  • Finance, including bank accounts
  • Data protection infrastructure
  • Asset ownership
  • Licences
  • Pensions
  • Competition

Note that not all of these areas may be relevant to your specific deal. Moreover, some industries may have additional areas of due diligence they need to initiate.

For example, your due diligence into IT issues will be far more detailed if you’re in the technology industry. Likewise, hiring an environmental consultant may be necessary if you are attempting to acquire a manufacturing business.

What is the due diligence process?

Due diligence forms a part of the overall acquisition deal. In most cases, due diligence will form the longest part of the process, other than sourcing target companies. 

Let’s examine how it fits into the broader acquisition process from the purchaser’s perspective.

Step One – Sign a letter of intent. In some M&A deals, you may also need to sign a Non-Disclosure Agreement (NDA).

Step Two – Send a due diligence questionnaire to the seller’s legal team. This is your opportunity to specify anything you may be concerned about or aspects you want to know about.

Step Three – Await a reply to your questionnaire. You can also reply with follow-up queries.

Step Four – Allow your legal advisors to work with any third-party professionals you have called to investigate different aspects of the target firm. What comes out of this step will influence the various indemnities and warranties that go into the final purchasing agreement.

Step Five – Once complete, your team will complete a formal due diligence report covering the most important issues. Note that if the seller has been truthful, the information contained within this report should not be anything new. However, if there are any areas of concern, they may warrant a renegotiation of the deal.

Step Six – If the purchaser is satisfied with the outcome of their due diligence, they will move to finalise the transaction documents.

Once again, a hassle-free due diligence process should repeat the information you already know. If anything differs from what you expect, this could indicate a problem that requires altering the final deal or even walking away from the acquisition entirely.

How long does the due diligence process take?

Unfortunately, there is no straightforward answer to determine how long your due diligence process will take. Various factors decide your timeline, including:

Complexity – Complicated deals, especially those involving international companies or multiple business units, can delay the due diligence process.

Data – How easy is it to obtain relevant information? If getting that information is like pulling teeth, your deal could find itself in the doldrums.

Depth – The amount of scrutiny required can also impact your timeline. Some buyers may order more in-depth investigations, which will always take longer.

External Factors – Factors outside of your control could also cause problems. For example, Pfizer’s proposed $118 billion takeover of British-Swedish pharmaceutical company AstraZeneca was heavily delayed due to regulatory and political concerns. The American multinational would walk away from the deal in May 2014.

Resource Allocation – Resource availability can also become a factor. Your due diligence could become plodding if you’re stretched thin and cannot bring in extra resources.

Generally, your timeline depends on the factors above. Typically, small business takeovers can take a few weeks, but acquisitions involving multinationals could last for months – or even years.

What happens if due diligence isn’t done when acquiring a company?

Long timelines and relentless paperwork can tempt entrepreneurs to gloss over the due diligence process or even skip it entirely; but, this is always a mistake because you cannot afford to take what someone else says at face value.

Some of the possible issues could include:

  • Overvaluing the target company.
  • Uncovering hidden financial issues after completing the deal, such as outstanding liabilities.
  • Overlooking legal problems like pending lawsuits or regulatory violations.
  • Problems with integrating the company into your operations include mismatched cultures, incompatible business processes and structural issues.
  • Reputation damage if post-acquisition problems emerge.
  • Losing your competitive advantage by not gaining a thorough understanding of the target company’s position in the market.
  • Unexpected employee resistance, which could cause an exodus.

Sellers are required to disclose relevant information about their company. On the other hand, they cannot answer pertinent questions, like: “Will acquiring this company provide me with the market leg-up I’m looking for?”

Disclosure only goes so far. Due diligence is the only way to ask these questions and confirm the validity and accuracy of what you have been provided. Otherwise, you risk finding yourself in a “Let the buyer beware” situation.

Key to any due diligence process as part of an M&A deal is assembling the right team around you. At Hilton Smythe, we can support your company as it embarks upon acquiring a target company.

Contact our team now to learn more about carrying out in-depth due diligence and advice on the best way to leave no stone unturned.

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