The M&A Due Diligence Process
Explained

Key Areas of Due Diligence

There are several key areas of due diligence - some of which will generally require more attention than others. Of course, this varies based on the companies in question; for example, purchasing a target company that sells software may require due diligence from an IT expert, whereas a target company in eCommerce may be subject to a review of marketing channels.

Below, we examine some of the main facets of due diligence.

Financial Due Diligence

This is one of the most critical aspects of the M&A process as it helps buyers assess the true financial health of a target company - which, of course, directly impacts how much that company is worth. The goal is to verify the accuracy of financial statements, evaluate the cash flow stability, identify any potential liabilities and uncover any potential risks.

Key areas of financial due diligence include:

• Revenue & profitability analysis - ensuring that the revenues and profits which have been reported align with the actual business performance.
• Debt and liabilities review - identifying outstanding loans, hidden liabilities or off-balance-sheet obligations that could pose future risks.
• Cash flow examination - evaluating the company's ability to generate a sustainable cash flow, in order to support operations and future growth.
• Accounting policies and compliance - ensuring the company follows proper accounting standards and identifying any irregularities or aggressive accounting practices.

Proper financial due diligence is necessary to understand whether the perception of a company matches its actual value - plenty of mergers and acquisitions have failed because financial due diligence uncovered something untoward.

We can point to Microsoft's intended acquisition to acquire Yahoo! For approximately $45 billion in 2008, which was highly publicised. Seeking to compete with Google, Microsoft saw an opportunity to expand - but financial due diligence uncovered several issues that led to the deal being abandoned. Among them were declining revenue trends, profitability issues which ultimately raised concerns about the profitability of the deal.

Legal Due Diligence

A thorough review of the target company's legal matters is important, as potential risks, liabilities and compliance issues must be uncovered. The goal is to ensure that there are no hidden legal obstacles that could impact the transaction or future operations post acquisition.

Key areas of legal due diligence include:

• Corporate structure and governance - verifying the ownership structure, organisational hierarchy and legal authority of the company - including bylaws and articles of incorporation.
• Contracts and agreements - reviewing existing contracts with customers, suppliers, employees and any other third party to try and uncover potential liabilities or obligations which could transfer to the acquirer.
• Intellectual property (IP) rights - ensuring that the target company in question owns its intellectual property (such as trademarks, copyrights, patents etc) and that they are properly protected.
• Disputes and litigation - if there are any ongoing or potential legal disputes (such as lawsuits or investigations) that could affect the company's value or future operations they must be examined
• Compliance - the target company must comply with all applicable industry regulations, environmental laws, employment practices and other relevant legislation.

In 2008, Electronic Arts (EA) attempted to acquire Take-Two Interactive, the video game company responsible for popular franchises like Grand Theft Auto. EA offered around $2 billion, but abandoned the acquisition during the due diligence process; Take-Two were involved in several ongoing legal battles related to Grand Theft Auto over allegations of obscene content, and faced scrutiny over its content ratings and business practices.

Operational Due Diligence

Operational due diligence focuses on the target company's day-to-day business operations to identify any inefficiencies, risks or integration challenges that could affect the success of the acquisition. This is essential for understanding how well the business functions and how smoothly it can be integrated into the buyers existing operations.

Key areas to examine include

• Business processes & efficiency - reviewing the target companies core business processes, supply chain, production methods and resource management to identify possible inefficiencies and bottlenecks.
• Customer & vendor relationships - understanding the strength of the company's relationships with customers, suppliers and other key stakeholders - identifying any potential risks.

Operational due diligence helps buyers understand hidden risks that could disrupt the business post-acquisition and are important not just for the deal itself but also for integrating the target company and developing a post-acquisition plan.

Cultural Due Diligence

We are big believers in cultural due diligence. Yes - whatever business you are buying or acquiring is valued based on revenue, profit, industry multipliers and all that good stuff. But it's also valued based on the people who work there - and ultimately it is people, not profits, that can make or break the success of a company.

These include

• Management style and leadership - understanding the leadership style and approach of a target company to determine how decisions are made and how teams are managed.
• Employee morale and engagement - evaluating employee satisfaction, turnover rates and other indicators of employee morale to understand the health of the workforce (and also any potential retention risks post-acquisition).
• Company values and norms - analysing the target company's values, communication styles and work environment to understand what life is like at this company - and whether that aligns with the buyer's organisational culture.

It's often underestimated, but we believe that cultural due diligence is critical for helping buyers anticipate and address potential integration issues before they arise. It will be one of the most important ways to understand how successful a target company could be, post-acquisition.

The Due Diligence Process

Due diligence must be structured, methodical and precise in order to evaluate potential acquisitions properly. There are several phases needed to gather the relevant information, fully scrutinise the company and assess risks and opportunities associated with the deal. Here is a step by step guide to the DD process.

Preparation

The first step in the process is preparation, during which both parties are in initial discussions to discover whether they are strategically aligned. This stage sets the foundation for the deal - really it is pre-due-diligence.

The preparation stage includes a strategic review, during which the buyer outlines their acquisition strategy, targets companies and begins initial negotiations. When a target company is identified, both parties will begin discussing the potential acquisition and the buyer will assess some information about the target company.

Ultimately, this stage ends at Heads of Terms - this is often a turning point. Heads of Terms are a non-binding document which outlines the key terms and structure of the proposed deal, and is a show of intent from the buyer.

Heads of Terms often mention confidentiality provisions related to the transaction, but normally a separate NDA will be signed here, which allows the seller to share information about their company confidently in the knowledge that it will remain confidential.

Due Diligence

After Heads of Terms are agreed upon, the due diligence process can formally begin. This phase is crucial for assessing the target company's true value and uncovering potential risks.

We have discussed the key players in the DD process, and also some of the key areas which must be analysed and scrutinised in order to give both parties the confidence to go ahead with the transaction.

The Due Diligence phase varies depending on the complexity and size of the deal - it can take anywhere from a few weeks to several months. Financial Advisors, legal counsel, operational experts, industry specialists and management teams may all be involved to assess finances, operations, risks, sector specific factors and various people in the company.

The Due Diligence process may uncover red flags or reaffirm the perceived value of the company. Sometimes the outcome of DD will halt the transaction completely if something is uncovered that devalues the company or increases the risk too much. It may affect the initial valuation in the non-binding Heads of Terms agreement, and should give both the buyer and seller a firm idea of how much the target company is worth.

Post-Due Diligence: Decision Making & Negotiation

Once due diligence is completed, the buyer reviews all of the findings and assesses whether they still want to go ahead with the acquisition. Once enough information has been gathered, key decisions and negotiations can be made with transparency and in a fully informed manner.

If any red flags were uncovered, the buyer may renegotiate the terms of the deal - including price adjustments, specific warranties, indemnities or post-acquisition contingencies. Negotiations may also include altering the structure of the deal or securing additional protections for the buyer.

Ultimately, due diligence is a critical part in allowing the buyer to decide whether to proceed with the deal and finalise the purchase agreement.

The Importance of Due Diligence

In mergers and acquisitions, due diligence is more than just a procedural step—it's a vital process that ensures both parties are fully informed and prepared. It helps buyers assess potential risks, validate financial claims, and understand the operational and cultural dynamics of the target company. Whether uncovering hidden liabilities, verifying financials, or evaluating strategic fit, due diligence provides a clear foundation for decision-making.

By diving deep into every aspect of the target company, due diligence enables smarter negotiations, reduces the risk of surprises, and ultimately sets the stage for successful post-acquisition integration. For both buyers and sellers, a thorough due diligence process is crucial to navigating the complexities of M&A, ensuring that deals are structured for long-term success and stability.