In mergers and acquisitions (M&A), due diligence is the process of obtaining and disclosing key information to ensure that the transaction proceeds smoothly, and that all parties are open and honest in their claims.
The process is typically carried out by an independent third party and requires careful scrutiny of financial and business records, as well as checking contracts and final agreements.
It is considered one of the most important stages in a business acquisition. Even relatively simple due diligence can be one of the most time-consuming processes in an M&A deal.
According to the type of deal and the area of business, one or more of the following types of due diligence will be required:
Administrative – Admin-related items of a business include the facilities and everything in them. This area ensures that operational and administrative costs are covered in the financial deal. This can also help identify any potential costs for expanding or downsizing the operation following the acquisition.
Financial – This is arguably the most important type of due diligence. It checks whether the information included in the Confidentiality Information Memorandum (CIM) is accurate.
The process of ensuring that every financial element of the business is covered is long and painstaking. The auditor will check at least the last three years of financial statements. They will also look at the most recent unaudited financial records, consider projections and forecasts, and will look at expenditure and income, as well as any debtors or creditors that the business has.
Financial due diligence even looks at the order books as well as pending and projected sales, and the auditor will typically create their own financial forecast for the business.
Assets – All assets should be considered as part of any merger or acquisition. The auditor needs (ideally) to complete a physical check of those assets where possible.
Auditors will also look at lease deals, outstanding payments and even the condition of assets, as well as documenting the current value of them. Assets not only include real estate but any machinery, plant equipment, vehicles and other items that are owned or used by the business.
HR – It is said that the greatest asset of any business is its people. Human resources due diligence can be as extensive as financial diligence, although it will depend on the size of the workforce and the complexity of their contracts.
The auditor will look at the total number of employees, salaries and bonuses paid in the past three years, and all contracts between the business and its employees. They will analyse employee grievances and problems, any disputes that are ongoing, and the annual sick and holiday leave of employees.
Importantly, this type of due diligence not only looks at existing contracts but considers the future impact of any outstanding action between the business and its workforce.
Taxes – Auditors will check tax records, taxes filed and whether there are any outstanding tax matters that need to be dealt with. They will consider whether any tax audits are outstanding, check tax liabilities and take into account any potential rebates or refunds that might be due.
Tax discrepancies can be extremely problematic and expensive for a business. Responsibility for meeting tax requirements will fall on the new owner following a merger or acquisition, so these checks are vital.
Intellectual property – Intellectual property is a collection of intangible assets. While these cannot necessarily be seen, they can be very important to the business and its profits.
Intellectual property diligence looks at existing patents and their value, as well as when those patents lapse. It also considers schedules of copyrights and brand name trademarks, as well as any claims made against the company for violations of intellectual property.
Legal – Many aspects of business are bound by legal requirements; a failure to comply with any area of business law can land an organisation in regulatory trouble. Due diligence looks at everything from Articles of Association to licensing and franchise agreements, and even the agreements that are in place with suppliers and business partners.
The auditor will need to ensure that all records are in place, including minutes from all shareholder meetings, and they will use a lot of this information to assist in other key areas of due diligence.
Customer – Customers are the essence of a company. Analysts will check the top customers of the business, as well as flagship customers that might be important despite not being the biggest or most profitable.
This area will also look at credit policies, agreements with customers, and customer satisfaction levels for the past three years.
Finally, the auditor will look into a list of reasons why clients have left the company within the past three years. It can prove very difficult to turn a relationship around with existing clients – even if the business is under new management – so ensuring that clients are satisfied is important.
The exact process of due diligence will vary according to the complexity of the deal, the industry that both businesses serve and many other variables, but a broad outline is covered below.
First, the auditor will begin by collecting all relevant information, including company records, financial records and any supporting evidence. They will also need to gather documents such as shareholder meeting minutes, and tax records that have been submitted to HMRC.
For most mergers and acquisitions, financial records are key. The auditor will check the financial records of the business in question to attempt to answer the following questions:
Is cash flow positive?
Is there a decent amount of cash coming into the business every month to cover outgoings?
What are the company's biggest areas for expenditure?
Are profits up or down compared to the last three years?
Are forecasts based on previous years, or do they appear inflated or deflated, and what is the reason for any discrepancies in these figures?
Have all tax records been filed properly and on time?
The auditor will need access to as much paperwork and documented evidence as possible, to assess the financial state of the business and any other areas that need to be investigated.
The findings will then be disclosed to the buyer/investor in full.
Effective due diligence relies on factual and documented evidence rather than words and promises, so the company must be willing and ready to provide the paperwork necessary.
However, it is rare that auditors receive everything they need in one go.
The most common career path in this field is that of due diligence analyst.
A due diligence analyst works for independent auditors and gathers all paperwork and evidence, compares this to the information included in a merger or acquisition proposal, and reports their findings to the buying party.
Due diligence is especially important in those deals that require structured and outside funding. Many investors will not invest unless there has been documented and reliable due diligence performed.
Banks will not loan money without this information, and there are strict deadlines that must be met throughout the process.
The job can be complicated, will require a lot of research and is highly detail-oriented. The candidate will be expected to have certain key skills:
The candidate must be proficient with numbers and be able to analyse large data sets reliably and accurately.
The prospective analyst must be driven, because of the long hours and painstaking work.
You must have excellent accountancy skills. You will be dealing with financial records for the business that is being acquired as well as financial records for customers, suppliers, employees and others. You should be proficient in tax accountancy too.
Communication is vital. While you should receive a lot of the paperwork and information required at the start of the process, there will be some missing information that needs to be sought. You are likely to have many questions throughout the various steps of due diligence. Being able to communicate effectively will help ensure that you get access to the required information when you need it.
The ideal candidate will have strong attention to detail. The due diligence process is painstaking and it deals with large quantities of information and data pertaining to various different areas of business. Mistakes can prove incredibly costly for the business and, ultimately, for the analyst.
The due diligence analyst will find that they are required to work long hours, especially when a deal is close to completion, to ensure that everything is ready for the merger or acquisition to go ahead by the deadline.
On average, an analyst can expect to earn between £30,000 and £35,000 per annum, although this can increase with experience and when dealing with high-profile deals.
Due diligence is a painstaking and laborious process filled with administrative work, analytical requirements and tight deadlines.
If you are good with numbers, detail-oriented and willing to work long hours, a career as a due diligence analyst could be for you.