In the M&A process, there are several phases of diligence, including preliminary and confirmatory due diligence processes. Many people think that preliminary and confirmatory diligence are the same, but it is imperative to understand what differentiates them, as both serve different purposes and entail separate processes.
Due diligence is the act of investigating, analyzing, and fully understanding the details of the matter under consideration. Even if you are not aware of it, we all do diligence on basic transactions in our daily lives. For instance, when you're buying a house, you want to see the inside of the house, the neighborhood, the furnishings, materials used in the construction, and many other things.
However, in the matter of M&A and the complexities of buying a business, diligence is separated into two phases.
The purpose of the preliminary due diligence is to get a basic understanding of the target company. You already know who they are and what they do, but you haven't decided yet whether this acquisition will advance your strategy or not. This includes getting sensitive information that the seller is willing to provide for you to assess and evaluate their company correctly and accurately. Typically, you will be required to agree and sign a non-disclosure agreement (NDA) before you can access such information.
During this phase, you will get an overall sense of the company's financial condition and capability, as well as marketing, sales and manufacturing processes. This will allow you to get a more accurate estimate of the company's value and determine the price that you are willing to offer. In short, you are here to answer the questions: should you buy this company? Will it advance your strategy? Will it fit in your company?
Another significant difference between the preliminary and confirmatory diligence is the timeline. Preliminary diligence is at the front end of the deal, right after you sign an NDA. It is designed to be early in the process so that you can save time if the deal is not suitable for you. You want your diligence to be as efficient as possible to carry out its purpose.
On the other hand, the confirmatory due diligence process is much more detailed and is known as formal due diligence. When you are in this phase, you know you want to buy the target company unless something catastrophic happens. The goal of this process is to confirm every assumption that you have regarding the company. You are now looking for risks and liabilities that you will be inheriting after the deal is closed.
Also, this would be the best time to plan for integration. As you are looking at the entire company, planning how it will look after the deal is closed is in your best interest. There will be many risks that you will uncover in this process and you need to mitigate those risks before the deal even closes.
The confirmatory due diligence process happens right after an LOI or term sheet has been issued. LOI signifies your formal offer to the target company and sometimes includes the initially agreed terms between the two parties. And because of the degree of certainty to close, it is now time to bring in your team to help you investigate the target company.
Because of the scope of work that needs to be done in the confirmatory due diligence process, you need to have a dedicated group of professionals to help you conduct your investigation. Your team may or may not need more than what is listed below, but this is just the commonly used team breakdowns with a high-level view of their roles and responsibilities.
The legal corporate team is an essential part of your M&A team during confirmatory due diligence. This team usually consists of external parties working with your internal lawyers, all with the primary task of coordinating entire legal diligence. They are the ones who look at the business capitalization, review the board minutes and plans, assess how the target business is incorporated, and determine if the seller has the adequate authority to sell the company.
They are also the ones responsible for uncovering lawsuits and debts that the target company may have. This could be a deal-breaker and needs to be detected and mitigated as quickly as possible.
Outside of their diligence role, they are also responsible for negotiating and drafting all the agreements, including the purchase agreement. They are the ones talking back and forth with the seller's legal counsel to adjust language and terms in those contracts.
The next team on the list is the legal IP team. This is extremely important, especially in the tech business when most transactions are about intellectual property. Their primary role is to ensure that the seller has proper ownership of the intellectual property that is being purchased, and that the IP will be correctly assigned to the buyer post-close.
If the seller doesn't have proper ownership for some reason, then it's up to the legal IP team to protect the buyer from outside parties who can claim rights to the IP. This could be a previous employee who knows, and has worked, on the IP for years but didn't correctly sign over their rights to the seller. This could be a massive exposure to the buyer if that employee claims ownership post-close.
In this situation, the team usually tracks down the employee and buys the IP from them to prevent future litigation and mitigate the risk. Sometimes, they also amend some of the seller's agreements, such as; customer, contractor, and vendor agreements, before the deal even closes.
This team is specifically focused on the customers and vendor contracts. They also work very closely with the legal IP team, who will have some overlaps while looking into the risks associated with the contracts.
Their primary focus is to assess the risks, limitations, and liabilities that the seller took on in the agreements. Those contracts can be excluded from the transaction, or a special type of protection would be incorporated in the purchase agreement if it's too much.
Arguably your most crucial non-legal team is the human resources team. They will focus on the employees of the target company, which is an essential part of capturing the deal's value. Their primary goal is to review employment contracts and they should be working closely with the legal corporate team.
The first part is the liability section and truly understanding any Fair Labor Standards Act (FLSA) issues or violations. They ensure that the employees are appropriately compensated and have all the legal benefits required by the law to avoid risk exposure post-close. They also compare the difference between the benefit packages of both companies and figure out how to bridge the gap.
The second part of their role is the retention section. This includes identifying who the key talents are in the target company and developing retention strategies. The HR team is also hugely, but not solely, responsible for assessing the target company's culture.
The accounting team is responsible for reviewing the financial statements of the target company. This is a more in-depth review compared to the one completed during preliminary due diligence. Typically, this is a third-party team hired by the buyer to remove bias and improve objectivity.
The primary goal is to confirm the accuracy of their financial statements. It could go as far as digging into invoices, contracts, and employment arrangements to ensure that the revenue and balance sheets are in order. Another important role of the external accounting team is to provide a quality of earnings report (QofE).
They will work with the internal accounting team to review the balance sheet and come up with an overview of the assets and liabilities that the buyer will take on post-close. They will also need to develop an agreed-upon networking capital mechanism usually agreed upon in the LOI.
A tax team is also a third-party group of accountants, usually hired from the same firm where as the accounting team. Their sole purpose is to review the tax compliance of the seller, the accuracy of previous filings, and determine the potential exposure if there are errors and discrepancies. This includes direct and indirect taxes on the sale.
If there would be discrepancies, the team needs to inform the authorities and disclose them voluntarily. Additional payments must be made to adhere to any penalties associated with that violation. The tax team will need to generate the total number of costs to mitigate this exposure.
Lastly, this team will work directly with lawyers and help the buyer understand the most advantageous way to set up the deal from a tax standpoint.
The information technology team is responsible for assessing the technology of the seller. This includes computers, laptops, software, servers, and any other technology devices they use in their operations. The goal is to compare it to what the buyer is using and then calculate how to bridge that gap.
Usually, a more prominent company is buying the seller, and therefore they will have more advanced equipment. To bring the incoming company up to par, some equipment needs to be replaced and updated. The IT team is in charge of identifying the necessary upgrades and evaluating the cost of those upgrades to integrate the acquired business into the buyer.
This is an optional team because not all transactions will have real estate. But if the seller happens to have a building or office, you need to have a dedicated team to handle the real estate. The real estate team is in charge of looking at what happens to the property post-close.
If the seller is leasing the said property, then the real estate team needs to develop a new lease or a contract that would assign the existing lease to the buyer. This will vary depending on the situation and type of language and restrictions that the existing contract includes.
However, suppose the seller owns the infrastructure. In that case, the buyer needs to decide whether to include that infrastructure in the transaction, build or rent a new facility to accommodate the newly acquired business, or come up with a lease agreement with the seller. This team will be responsible for doing the diligence on the property as to how much it costs to buy or rent.
This team is responsible for reviewing all the insurance policies of the target company. If they have inadequate protection, the buyer could require the seller to purchase such insurance before the deal is closed. If the seller refuses to acquire proper insurance for a big issue, then it could also be negotiated in the purchase agreement.
When it comes to cash and bank issues, the treasury team is the one in charge. They will need to be more involved in the deal if the buyer has non-existing cash or line of credit and need capital raising efforts.
However, their primary role is to handle the bank transaction. If the buyer is inheriting a bank account in the name of the business that they are acquiring, then the treasury team is the one to facilitate that transition.
For instance, if the seller has existing cash in the bank account, withdrawing that full amount will cause issues from a business continuity standpoint. The treasury team will work closely with the corporate development team to understand the business's monthly and weekly cash needs and fund that bank account to avoid issues.
There are also instances where the seller leaves money inside the bank account, and that is just added to the overall purchase price.
These are all live discussions and documents constantly being fed to the deal team to provide the best protection for the buyer and negotiate the best purchase agreement possible.
If there are major and significant discoveries during the confirmatory due diligence, it usually results in a renegotiation of the purchase price initially agreed upon in the LOI. The worst thing that could happen is the buyer's walk away from the deal due to an unsolvable issue.
But if all things go well, the buyer and the seller will then proceed to sign the purchase agreement and formally close the deal.