Due diligence is a key phase in the M&A process where the buyer reviews pertinent information about the seller to get a detailed picture of the seller's company, including any potential risks in buying or merging with the company. During due diligence, every important aspect of the seller's company, such as contracts, finances, and customers, is reviewed. It's as though the seller's company is put under a microscope. Any seller who has gone through due diligence knows how focused, time consuming, and complex it can be. But it's a necessary exercise, one that can make or break a deal.
Due diligence also means dealing with teams of professionals hired by the buyer. In today's M&A environment, PE firms, as the leading buyers in volume, set best practices for conducting due diligence. And those practices typically involve hiring professional services firms who bring in multiple teams to meticulously investigate the seller's business. For example, in a recent transaction involving a Corum client, the prospective buyer, a PE firm, hired six outside firms to conduct due diligence, including a legal team, an accounting/audit team, a tax team, a team to assess the seller's business model, and an organizational development team to assess the seller's strengths and weaknesses. As a seller, having to deal with all these teams on the buyer's side can be intimidating if you only have a small team on your side.
So, be prepared for due diligence. Know how to get around some of its potential hazards—its "landmines"—and know that you will likely be dealing with teams of professionals on the buyer's side. If you're not prepared, you won't survive due diligence.
Here are 12 tips to help you avoid some of these landmines.
1. Understand the buyer's due diligence checklist. A due diligence checklist is a document that lists all the things the buyer will examine about your company before agreeing to a sale or merger. The checklist is typically comprehensive and is usually arranged in a basic format, covering everything from your products and services to information about your customers, your employees and benefits, contracts, tax records, licenses, assets, and legal issues. It's important that you prioritize the information you'll need to provide to the buyer in a strategic way. Know what you will need to provide and when and how to share it. Keep in mind that divulging highly sensitive information to the prospective buyer could be damaging to your company if the deal doesn't go through. Have a plan in place for how to protect the confidentiality of that highly sensitive information.
2. Prepare your data room in advance. A data room is a secure physical or virtual location that the seller uses to store essential documents required during the M&A process. Put all your critical documentation in the data room and give appropriately managed access to the room to the people on the buyer's staff or to the buyer's representatives who are important to the transaction. Professional services firms such as Deloitte and KPMG are often hired to perform due diligence for the buyer in an M&A, and they often bring in teams of lawyers, accountants, and consultants to do the work. Expect these teams to examine the documents in the data room thoroughly and ask incisive questions about that information. Also, expect them to verify your responses. You need to be able to reply to inquiries truthfully and professionally. Done right, your provision of the data room and your responses to questions reinforces trust and increases your chances of successfully closing a deal.
3. Deal with accounting problems ahead of time. Accounting problems can snag a deal. Often problems occur because there is a mismatch in the way the seller and the buyer account for income. For example, the seller books income on a cash basis, that is, at the time it is received, while most tech M&A buyers prefer an accrual basis where income is recorded over the period it is earned, in accordance with GAAP, IFRS or other international accounting standards. Buyers also strongly prefer that software development costs are expensed on an income statement rather than capitalized on a balance sheet. Expensed software development costs give buyers a truer understanding of the company's P&L. So, think through your accounting statements carefully and get them up to global standards if they aren't already there.
4. Control the timing of disclosures. If you know there are issues that can potentially arise during due diligence, get them out early while you've got the most leverage and you're still building trust. Try to work through those issues in the discovery phase before the Letter of Intent (LOI) is signed. It will give you the most leverage while negotiating the LOI. Understand that issues that emerge late can damage trust and kill deals.
5. Run due diligence and the final agreement process in parallel. After the prospective buyer signs the LOI and the due diligence phase begins, you should start drafting the definitive agreement of the transaction, which may be a merger agreement, acquisition agreement, stock purchase agreement, or some other agreement. It's important that you run the due diligence and final agreement processes in parallel because the information discovered about your company during due diligence can affect the definitive agreement. For example, it could impact the treatment of escrows, liabilities, reps and warranties, and other adjustments to price or deal structure. Drafting the final agreement while due diligence is proceeding gives you the flexibility to amend it in a timely and stress-free way.
6. Get a draft agreement in place within two weeks of beginning due diligence. This is another reason to start drafting a final agreement when due diligence begins. The buyer and their lawyers almost always draft a definitive purchase agreement as quickly as possible. It's important for you to know what is in the draft purchase agreement because it indicates what additional documents, addendums, and schedules the buyer is going to require. When these requirements are stated late in the process, it creates stress, delays, extra expense, and difficulties in closing. So, understand and comply with these requirements as early as possible. Good document preparation can ease this critical aspect of the M&A process. In addition to the purchase agreement, the attachments, disclosures, and schedules can provide an equally big lift to completing the deal.
7. Appoint a dedicated due diligence coordinator. Ensuring that due diligence is performed correctly and efficiently is crucial. In particular, you want all the necessary documents in place and stored in your data room. It is tempting for a CEO to personally control production of all the documents, but this can quickly become overwhelming. Instead, you need to appoint a trusted, responsible coordinator—someone who is well organized and has project management experience. In addition, the person in this role is often responsible for creating a single comprehensive list of questions and document requests to hand over to the seller. Sellers appreciate receiving all the questions to the questions together. As due diligence progresses, you also need to keep the company on track to avoid missing key financial targets. In other words, you've got to focus on hitting your targeted numbers, so consider appointing a chief financial person such as a CFO as the due diligence coordinator. This type of person often works well in this role.
8. Inform key employees only. As mentioned previously, during due diligence you may have to share sensitive information about your company. To maintain confidentiality, it's important to limit the spread of that information. Even within your company, you should restrict sharing of that information to only those employees who need to know. These are people who you designate to be involved in the due diligence process, such as the CFO, CTO, or high-level product managers. Exposing sensitive information to a wider group of employees during due diligence, when details still remain to be ironed out, can cause those employees to be worried and concerned. Employees tend to get fixated on their own future, what they get out of the deal, and everyone gets distracted from actually completing the due diligence.
9. Watch working capital. Working capital is the operating liquidity available to your business, more specifically, the value of your company's current assets minus its current liabilities. Buyers want operating liquidity. They don't want your debt, but they do want the cash that's on your balance sheet and all your receivables. It helps them pay for the investment in and operation of your company without the need for additional capital. In fact, buyers often require a minimum amount of working capital on the balance sheet when the deal closes to ensure there are no immediate liquidity issues. So, issues like the quality of receivables, the amount of your payables, collection rates, bad debt, bonuses, vacation accruals, and taxes all need to be examined to understand what the actual working capital of the business will be at close. Remember that working capital is a moving target, so keep a close eye on it as you move through the due diligence process to closing. A clear understanding of this can avoid a lot of last minute drama.
10. Use your accountants effectively. Having accounting and financial expertise available early in the M&A process is extremely important. An adept accountant can help in a variety of areas such as preliminary valuation of your company, tax advice, ensuring that accounting standards have been followed, and evaluating risk. Ideally, you should deploy your accountants and other financial experts before the due diligence process begins. If there are policy concerns, revenue recognition issues, quality of revenue items, you need to be ready to respond before you get into due diligence with the buyer. Your accountants and other financial experts need to be prepared, so that they can respond to buyer requests quickly and avoid creating unnecessary delays.
11. Use your lawyers effectively. It's important to have good legal advice during the M&A process. A good lawyer can help negotiate agreements that are advantageous to you and legally sound. It's important to hire a lawyer that has the experience and skills to provide good legal representation during the M&A process. Don't hire the guy you went to school with, or your neighbor, or the guy that helped you when you bought your house. You need a lawyer who specializes in tech M&A, one who has plenty of deal experience, especially with IP and complex corporate issues—the kind of things you're going to see with sophisticated buyers. The toughest, most stressful negotiations are about post-transaction liabilities specific to your business. These come in the last mile of due diligence. Drafting the definitive contract can be very stressful if you don't have an experienced legal professional on your side trying to manage and mitigate these exposures.
12. Use your intermediaries effectively. An intermediary is someone who can assist and advise you through the M&A process. The intermediary you choose to guide you through what is likely the most important transaction of your life is crucial. You want someone who can do the proper preparation, positioning, buyer research, and document production that allows you to focus on running your business and hitting your target numbers. A good intermediary knows the buyers, what they want, and how to value, structure, and negotiate with them to create an environment that generates an optimal outcome for you. Just as important, a good intermediary knows how to get you through due diligence and negotiate a definitive contract ‒ a point in the process where too many deals die. And a good intermediary knows the tactics buyers use during due diligence and contract negotiation to re-trade deals, lower value, and get better terms for themselves. This is where an experienced intermediary really makes a difference.
Due diligence is a critical and increasingly complicated phase of the tech M&A process. You'll typically need to deal with teams of professionals on the buyer's side analyzing every nook and cranny of your business. You don't want to go into due diligence unprepared and on your own. You want an experienced advisor who understands the possible landmines that can arise during the process ‒ someone in your corner who has the experience and know-how to guide you through these due diligence challenges.
Remember, selling your company is one of the most important transactions of your life. So be careful. Be prepared. Be ready.