Originally published by Forbes, featuring Frank Williamson.
We’re grateful to Forbes for the opportunity to contribute to this important conversation. Read the full article below.
When making any large purchase, be it a car, a house or a business, any smart buyer wants reassurance that there aren’t any hidden surprises waiting for them.
Just as a home inspection might uncover cracks in a foundation requiring repair, due diligence during the business M&A process is crucial because it can reveal vulnerabilities within a business that might not be readily apparent—and which, in fact, neither party may even be aware of. Given the amount of money often involved in mergers, acquisitions, financings and other business transactions, due diligence is a necessity to give a deal’s stakeholders an accurate picture before entering into a contract.
But make no mistake: Due diligence is long, tedious and a little daunting. It starts with broad questions and gets increasingly granular over a period of several months. If you’re a first-time buyer or seller and haven’t been through due diligence before, here’s a brief overview of what to expect.
The First Phase: Business Due Diligence
Due diligence takes place in two phases, one before the letter of intent and one after. The first and less comprehensive of these phases is referred to as business due diligence.
Because the buyer and seller are still getting acquainted with each other at this point and haven’t formalized their relationship, business due diligence is mostly about looking for obvious red flags and making sure that there’s a logical business strategy behind a potential deal.
This might involve looking at public financial data about a potential partner, reading annual reports, listening to earnings calls, reading industry chatter or studying competitors. There’s usually also some interaction between company CEOs, who ask each other big-picture questions to determine whether there’s a cultural fit between their businesses.
If all initial signs look good, the two parties begin establishing the hard numbers and market justification for a transaction, which is helpful for getting the buy-in of board members, investors, lenders and other stakeholders. At this point, both companies are assuming that all the information provided to them is factual. In the next phase of due diligence, they’ll determine with certainty what’s true and what’s not.
The Second Phase: Confirmatory Due Diligence
After signing the letter of intent, both parties begin confirmatory due diligence, where they carefully verify every one of their assumptions. During this phase, the parties ask each other hundreds of questions and request data and documents delving deep into the inner workings of their companies.
Confirmatory due diligence requires a core team of experts. One is an accountant who scrutinizes financial and tax documents to make sure those numbers are accurate and that standard accounting principles were applied. An attorney is also needed to examine other internal documents (such as customer contracts and employee and shareholder agreements) and check for any potential legal issues, such as infringement claims, regulatory investigations or compliance violations.
Finally, each party has an investment banker who funnels along data requests, escalates any concerns and helps maintain momentum toward a completed deal. If any details are uncovered that raise red flags, an investment banker advises their client on their options, which could involve modifying the deal terms or pulling out entirely.
Navigating Due Diligence The Right Way
It shouldn’t need to be said, but both parties in a transaction have the responsibility to be candid and truthful with one another. It’s rare for a party to intentionally withhold information from the other, but it does happen, and never ends well. It’s far more common for an accidental omission or misstatement to lead to a deterioration of trust, with both parties going their separate ways rather than taking the risk of further revelations.
While it’s essential for both buyer and seller to act with integrity through the process, there’s an appropriate way to share information with one another. We recommend responding to requests with only the data and documents required to validate specific assumptions from earlier in the process. This shouldn’t be viewed as withholding information; rather, it’s actually the considerate thing to do, since inundating the other party with unnecessary details can slow down an already lengthy process. When sharing information, try to frame it around a consistent narrative about your business, so the other party can see how these details lead back to a big-picture strategy about the deal.
It’s common for those in charge of managing due diligence to question how much is sufficient. There may be a gap between what they think is a reasonable amount of investigation and what the other party feels is overreach. But by following a standard list of questions and ensuring that each one is answered (even if the answer is “not applicable”), buyers and sellers can build enough trust to move forward, ultimately achieving a transaction both sides can feel confident about.