Mergers and acquisitions activity is significantly influenced by economic conditions. Factors such as gross domestic product growth, interest rates and market volatility create an undeniable influence on deal volume. When economic circumstances are favorable, it can seem easy to close transactions. Conversely, when the economy faces headwinds, buyers are more cautious and often kick more tires before initiating closing wires.
Given the current economic uncertainty, due diligence plays an increasingly critical role in the M&A process. Sellers and buyers alike need to implement a strategic approach to due diligence as they balance costs with the ability to provide a fully transparent process. Below is a brief list of the primary due diligence items a seller and buyer may want to consider as part of their transaction.
Legal Due Diligence
Legal due diligence involves a comprehensive review of a target’s corporate history and contractual agreements. During this process, the seller will be responsible for production of a range of documents related to the target’s business for buyer’s review, with the goal of assessing risks, making informed business decisions, and negotiating key deal terms that prepare the stage for post-transaction integration.
The process often begins with the buyer broad overview of the target by reviewing its corporate records. These documents may include the company’s organizational documents, stockholder and board meeting minutes, stockholder agreements and voting agreements that may contain restrictions on transfer of share rights. Other essential legal documents would include records regarding historical legal claims, real property leases or deeds and equipment leases essential to the underlying business operation, as well as employment and information technology agreements.
Of particular importance will be the target’s material contracts and obligations, which will vary from target to target. Buyers will review contracts integral to the target’s operational viability, such as supplier and customer contracts that drive revenue and expenses. Key issues to look for include whether these contracts contain restrictive covenants or provisions governing exclusivity, change of control, rights of first refusal, or otherwise require consent for assignment to the buyer. If consents are required to consummate the transaction, the parties will want to proactively discuss which will be required for closing as well as developing a contingency plan should they not be secured.
Often, in highly regulated industries, such as healthcare, finance or government contracts, legal due diligence also includes an examination of industry-specific regulations, potential liabilities related to governmental agencies and any ongoing investigations or audits. Technology-focused companies will often require a detailed analysis of intellectual property rights while companies with government contracts may require HSR and CFIUS approvals. Regardless of the industry, data-privacy has taken center stage and buyers are increasingly focused on the target’s procedures to collect, store and protect sensitive customer and personnel information in compliance with local and foreign data-privacy laws.
Financial and Tax Due Diligence
As its name would suggest, financial due diligence focuses on the historical financial performance of the target. Buyers should request the target’s financial statements for periods prior to the closing (including those periods during the executory period following the signing, if applicable) and assess whether the statements are prepared in accordance with standardized accounting principles, such as GAAP. To the extent material liabilities are discovered, the buyer may request a special indemnity to ensure no financial responsibility exists for claims arising from a pre-transaction timeframe. Additionally, if the accounting principles deviate from that of the buyer, the buyer will consider whether it will negatively impact its post-transaction financial outlook.
To get comfortable with the target’s financial status, the buyer will also generally commission a quality of earnings report to test the target’s the drivers of profitability. This process reviews the sustainability and reliability of the target’s primary sources of revenue and includes an assessment of the target’s recurring core-earnings generated from its primary operations against non-recurring or accounting adjustments.
With respect to tax due diligence, careful consideration should be given as to whether the target has any outstanding tax liabilities or obligations. Buyers will aim to identify existing or potential tax liabilities the target may have unknowingly accrued. For example, state tax obligations can vary widely and failure to file returns can result in back taxes, penalties and fines. Buyers will often examine whether the target has created a taxable presence in a state such that income tax or sales tax returns should have been filed. It is important to bring on a tax advisor early in the due diligence process to analyze these issues.
Operational Due Diligence
Operational due diligence is a forward-looking form of due diligence involving assessing the target’s ability to continue business operations smoothly post-transaction. The buyer will focus on the target’s long-term success by analyzing key customers, customer concentration risks, the target’s market position and competitiveness and if the buyer can create synergies with its existing business lines.
Buyers will also examine the management’s organizational chart and whether a change to personnel would disrupt the culture and stability. Given the importance of these employees to the business, a buyer may need to incentivize the retention of certain C-suite executives or employees via a post-transaction compensation and benefit plan. Ultimately, by thoroughly examining operational aspects, buyers can mitigate risks, make informed decisions and develop integration plans that ensure a successful transition.
Regardless of the economic climate, legal, financial and tax, and operational due diligence is essential to a successful M&A process. Paying attention to these pillars of due diligence will provide a sound foundation for a successful transaction for both buyers and sellers.