The Importance of Due Diligence in M&A Transactions
Tuesday, August 29, 2023
Due Diligence in M&A Transactions

In any merger or acquisition, the due diligence stage is one of the most critical steps. It allows the acquiring company to identify dealbreakers, assess risks, make informed decisions, negotiate effectively, ensure compliance, plan for integration, and set the stage for a successful and value-enhancing merger or acquisition. 

The acquiring company, with its legal, tax, and financial advisors and other advisors, must carefully examine several areas of the target organization in great detail to identify any issues with their financial, operational, technological, regulatory, tax, and other departments. Below, we look at the areas of examination necessary for a comprehensive due diligence process.

Financial, Accounting, and Tax Due Diligence

Financial due diligence involves analyzing the target company's financial statements to fully understand its finances and internal controls on how they are prepared. Acquirers should review revenue streams and cost efficiency to better reveal the economic landscape. Acquirers should pay particular attention to any difference in accounting standards adopted by themselves and the target companies and whether any material liabilities are not reflected in the financial statements.

Examining revenue, cost drivers, profitability, and financial patterns will help uncover influencing factors, and focusing on earnings quality and reporting accuracy can assure data dependability. Looking at cash in and cash out will identify essential patterns and sequences, seasonality, and credit risks. 

Buyers should consider the qualities of the financial statements and balance them against the corporate lifecycles of the target companies and the closing processes. For example, early-stage or closely-held target companies may not have prepared audited financial reports, and acquirers should consider supplementing these financial statements with additional representations, for example, absence of undisclosed liabilities representation, accounts receivable collectability representation, etc.

Tax diligence is another critical aspect. From a structural point of view, particularly in a scenario where at least a portion of the consideration is payable in stock, acquirers and targets must understand whether a transaction could qualify as a tax-deferred reorganization. If not, it is up for negotiation whether a portion of the consideration payable to equity holders should be in the form of cash to enable these holders to make their tax payments. From an operational point of view, acquirers will want to understand matters such as whether the target has paid sales tax to each of the states and other jurisdictions where tax could be imposed, whether the target has employees in a state where it does not pay sales taxes;   has the target business taken advantage of potential research and development tax credits and other government incentives; transfer pricing allocating revenues and costs among the different group entities, etc. 

Legal Due Diligence

Legal due diligence entails an in-depth investigation of the target company's current and historical legal status. It involves evaluating legal structures, ownership, securities laws compliance, stockholder agreements, management, and its authorities to enter into the transaction. Material contracts, agreements, and obligations should go through a thorough due diligence process to identify any potential liabilities. To the end, at Foley, we have licensed an AI tool called "Kira," which aids and greatly reduces the time attorneys need to review them.

Examinations of intellectual property status, commercial rights, and any pending litigation are crucial in determining legal hygiene. These evaluations include portfolios of patents, trademarks, copyrights, and trade secrets. Verifying the acquiring company's licenses and permits also ensures the business operates legally. 

Suppose existing customer contracts are an integral part of the transaction. In that case, acquirers will want to diligence the material customer contracts constituting a significant percentage of its revenue to determine the terms of the contracts and whether the counterparties have a right to terminate by convenience, whether these agreements contain any restrictive covenants, whether consents from these counterparties are required, as well as other commercial arrangements with the customers.

If the target engages in a regulated business, special attention should be given to regulatory compliance diligence. Acquirers should also work with target companies from the outset to determine the HSR (antitrust) or CFIUS (foreign investment) implications of the transaction. 

While we call this area of due diligence “legal,” it uncovers key inputs to target enterprise value just as critical as the numbers.

Operational Due Diligence

When conducting operational due diligence, buyers must examine how a company or business runs on a day-to-day basis. Understanding how the industry works, including systems, processes, and infrastructures, helps unearth strengths, flaws, and possible risks. It may help if the acquirer is engaged in a similar business to the target company so that the acquirer understands the industry's landscape well. The goal is to understand daily business operations, determine efficiency, and find practical problems.

Possible operational risks, such as weak points in the supply chain, problems with production, and capacity limits, are identified to understand their effects on general operations. The company's customer base, market position, and competitive landscape are assessed to learn more about its impact on the market and how well it competes. Conducting operational due can also help identify any issues with future integration and improve operations for long-term success.

An essential benefit of operational due diligence includes identifying revenue synergies. For example, are there overlapping customer relationships that can be amplified by multiplication rather than addition? Can costs be saved by a factor of division rather than subtraction? Can contract revenues be extended? Can customer retention be improved? Are there opportunities for customer upsell?

Technical Due Diligence

Technical due diligence thoroughly analyzes the target company's technical components, including examining hardware, software, cybersecurity, data privacy, open source adoption, scalability, innovation potential, dangers, and networks comprising its technology infrastructure. The system's versatility, dependability, and security are investigated meticulously.

Technical due diligence helps stakeholders make well-informed choices about the company's technological readiness and compatibility for successful integration.

Customer Due Diligence

A thoughtful customer due diligence investigation will identify growth opportunities and solicit feedback on increasing market share after the transaction closes. Acquirers typically will want to be connected to target companies' customers. Still, target companies would typically request that acquirers develop a communication plan with them to preserve confidentiality before closing and maintain customer relationships.

Team Due Diligence

Employment or team due diligence involves checking that all contributors are correctly classified as employees or independent consultants and that these individuals have executed assignment agreements assigning their rights to IP to the target companies. Acquirers would want to ensure that the target companies have complied with employment laws and that they understand the implications that the acquisition will have (i.e. whether such will be accelerated) on employee equity grants. For integration purposes, titles, compensations, and responsibilities of target companies' employees should be mapped against those of the acquirers to make competitive offers to the individuals. If there are any critical employees on which the operation of the target's business depends, the acquirer should consider requiring their execution of offer letters and contractor agreements as closing conditions.  

Conclusion

These are only some areas that a thoughtful due diligence investigation will cover. Doing your due diligence is a key factor in the success of any acquisition, before and after the closing, and for many years to come.

 

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