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The Scope of Due Diligence in Mergers and Acquisitions

The Scope of Due Diligence in Mergers and Acquisitions

The buyer of a business wants to ensure that no major material issue will arise after merger transaction takes place. Therefore the buyer will insist on a thorough due diligence process in order to know about any such issues and to negotiate with the seller on better terms before completing any merger or acquisition. Due diligence process is conducted to determine the value of the target company, structure the deal, and identify any problems. The target’s business operations, financials, and legal documentation should be thoroughly examined.

Due Diligence - Team

The Due Diligence Team should include external advisers (financial advisers, accountants, lawyers) and representatives from the buyer’s management and legal staff. The head of the team should supervise the due diligence process to ensure efficient team work. Team members should be aware of any changes in deal structure so that they could adjust their work during the due diligence review accordingly.

Due Diligence - Request List

The buyer submits a due diligence request list in order to conduct a detailed review of the seller. The due diligence request list covers the review of the seller’s operations, financial information, and legal matters. The due diligence process should be well organized so that no duplicate requests from multiple sources occur.

Due Diligence - Data Room

A data room is an important part of the due diligence process in merger transaction. In general, corporate advisers for the Seller begin the procedure of collecting the data room, by defining the required information to be included which the Seller then provides.

Due Diligence - Confidentiality

A confidentiality agreement between the buyer and the seller is important in an M&A transaction. Everyone involved should be aware of all legal obligations under the confidentiality agreement.

Due Diligence - Areas for Review

  1. Financial due diligence
  2. Legal due diligence
  3. Commercial due diligence
  4. Technical due diligence
  5. Cultural due diligence
  6. Environmental due diligence
  7. Management due diligence

Financial Due Diligence as a Part of M&A Process

The key goal of financial due diligence in merger process is to verify, confirm, question or change the financial data and assumptions made with regard to the business and its operations.

The main components of the financial due diligence are the following:

  1. Historic financial statements for over a three-year period. The main areas of analysis are the sustainability of net revenues and profits, drivers of growth, profit margins, working capital and cash flows.
  2. Business operations are reviewed to understand the Target’s customer base, sales and production processes, products, suppliers and marketing methods.
  3. Financial management review and identification of key employees who possess expertise in key areas such as marketing finance or significant relationships with the Target’s customers and suppliers.
  4. Accounting procedures and accounting policies are reviewed to assess the reliability and sufficiency of the financial information so that the Buyer could accurately assess the performance of the business.
  5. Tax due diligence which includes an analysis of the consequences for the buyer in case of acquiring the company from a tax perspective.

The key goal of financial due diligence in merger process is to verify, confirm, question or change the financial data and assumptions made with regard to the business and its operations.

Financial due diligence tries to understand the important risks in generating revenue in future by questioning the forecasts and the assumptions behind them, and by performing sensitivity analysis applied to the financial model in order to assess the influence of particular circumstances on revenue and cash flows.

Legal Due Diligence as a Part of M&A Process

The fundamental objective of legal due diligence in merger process is to enable investors to understand and asses any legal risks related to the target company and to the completing the transaction itself . Basically, it is a legal audit of each significant area of the target’s business. The legal due diligence report is produced emphasizing any issues or areas of possible risks that may arise as a result of disagreements or non-compliance with laws, which may or may not be substantial. By its nature, legal due diligence requires the participation of numerous specialists, and as a result it is a time consuming process.

However, a wisely managed and timely legal due diligence process will not only assist in the merger transaction, but also add value to buyers. A buyer generally leads the legal due diligence process in mergers and acquisitions. The buyer’s advisers provide a questionnaire containing the comprehensive list of required legal information, the answers to which will form the foundation of the merger due diligence report. The quality of legal due diligence highly depends on the truthfulness and completeness of the answers provided, while the buyer typically reserves the right to ask additional questions in order to clarify contradictory information.

The scope of the legal due diligence should be agreed with the client, since certain matters which are substantial for an automotive business will not be at all applicable to a financial services business, and vice versa. Therefore, careful thought should be given to the areas of most significance to one business or another.

During the legal due diligence process legal advisers review the following materials and information:

  1. Information about all existing shareholders, directors and officers
  2. Customer and supplier agreements that are material to the business
  3. Licenses that are required for the company to continue to operate
  4. The company’s title to all tangible assets, including leasehold properties
  5. The existing employment terms of senior staff and other employees, including pension scheme
  6. Details about any recent or ongoing litigation or disputes
  7. Information about registered and unregistered intellectual property

As a conclusion, M&A due diligence reports should contain an executive summary highlighting the crucia lissues and concerns and recommendations on the ways to deal with those problems. If an issue is significant and may be a deal-breaker then it should be raised immediately before the full, final report is completed

Other Due Diligence Procedures in M&A Process

  1. Marketing due diligence - an assessment of the market and strategies set out by the Target company.
  2. IT systems due diligence - a detailed review of the Target company’s IT capabilities and infrastructure.
  3. Environmental due diligence – an assessment of the environmental risks related to the business properties (offices or commercial properties) which may include a site visit and the taking of ground samples.
  4. Management due diligence - a completion of psychometric tests, followed by an interview with specialist HR consultancies.As a result the strengths and weaknesses of each individual in the team are assessed in order to make recommendations for their development.

Due Diligence – Report

Due diligence report can be either detailed report or a summary of the main issues, or both. Regular updates on any potential problems with the target identified during early stages of the due diligence process should be provided as soon as possible to the buyer. The results of the due diligence investigation can significantly affect the final terms of the deal.

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