I have spent a good part of this year doing due diligence on acquisitions for clients and today I began my fourth project. The client sent me a copy of their proposed due diligence information request and asked for my comments. After reading the client's attempt at such a list, I decided it might be useful to my valued readers to discuss due diligence.
In the way that I approach due diligence for an acquisition, there are five parts:
Many people would probably limit the scope of their due diligence to 1-3. While discovering undisclosed liabilities, shareholding discrepancies and misstated financial statements in parts 1-3 obviously is important, the real value added part of due diligence is not in parts 1-3. When you buy a company there are three questions that should always be on your mind:
- Are there any operating risks which if they were to occur would severely catastrophically affect the business, e.g. loss of a customer, distributor, license, etc., and thereby lead to a re-examination of valuation or to walking away from the deal
- How are we going to integrate this acquisition into our existing operations and what will it cost
- What will be the cost in capital and management time to execute the post acquisition strategy (while you should have addressed this issue when you did the original valuation, in due diligence you are confirming the accuracy of the hypothesis)
While parts 1-3 of due diligence may identify some of the operating risks in a business (customer concentration from an AR aging), they do little to address integration or the capital requirements of the go forward strategy. Therefore, an equal or greater part of due diligence should address operations and IT. It is a big mistake to limit due diligence in these areas because you know the industry, had extensive pre-LOI (letter of intent) discussions or the existing management has a continuing financial interest post acquisition.. The real opportunity to understand in depth the acquisition target's operations and IT begins during due diligence.
To clarify what I mean by "operations", we are basically talking about understanding the market and the industry. In other words, sales, marketing, distribution, pricing, new technology and competition. Looks very similar to the analysis of the growth drivers in the business, but in due diligence one should be equally focused on the upside and the downside risks.
The focus of the investigation in IT is typically on integration--how easy will it be to integrate the automated systems, procedures and accounting of the acquired company into the acquiror. Understanding the importance of any proprietary software and its role in operations is also a key issue in order to fully appreciate the human resources and related costs to maintain it. Of course, you also want to have a complete understanding of back up procedures and network security. (You would be surprised at the number of companies that keep their backup in their head office.)
To further illustrate my concept of due diligence I have posted below a sample due diligence information request. While it is a generic request for information, and may occasionally need to be edited, resist the temptation to edit or delete. The list is designed to be open ended in the hopes of encouraging the receipt of new and complete information. Resist editing out subjects that "do not apply". You may be surprised what shows up.
Several years ago I found on the web Arthur Andersen's standard due diligence list. Many years later I still think it's the best basic information request for due diligence that I have seen. Click to download a copy.