Mergers and acquisitions (M&A) offer businesses strategic opportunities to expand their capabilities, gain market advantages, or reduce costs. Unfortunately, not all M&A deals achieve their objectives due to overlooked risks or unexpected challenges.
While some obstacles are understandably beyond either party’s control, many failures can be prevented by identifying and addressing potential issues immediately. This is where due diligence and the guidance of an M&A advisor become pivotal.
What Is Due Diligence in M&A?
Due diligence is one of a merger or acquisition’s most critical and comprehensive processes.
It involves a thorough review of a target company’s operations, finances, and risks before any transactions are made to confirm the accuracy of the seller’s claims and assess the company’s overall value. As such, the process helps the buyer determine whether the acquisition aligns with their strategic goals.
Ultimately, the primary goal of merger and acquisition due diligence is to identify any red flags and ensure the transaction adds value. Carefully analyzing a target company’s past performance and future potential helps minimize risks and maximize returns.
What Are the Types of Due Diligence?
Given the complexity of most businesses, there are many types of due diligence – each focusing on a different aspect of the target company to provide a comprehensive assessment.
Let’s look at the primary areas of inquiry included in a due diligence analysis below.
1. Administrative Due Diligence
Administrative DD in mergers and acquisitions focuses on assessing the administrative aspects of the target company to ensure all relevant operational costs are documented. The goal is to verify that the administrative structures are efficient and sustainable post-acquisition.
Administrative due diligence often includes:
- Verifying lease agreements and occupancy rates
- Reviewing the number of workstations, office facilities, and related infrastructure
- Assessing the company’s operational costs, including maintenance and utility expenses
- Ensuring proper documentation and systems for administrative operations.
Finally, as a buyer, this type of due diligence helps you identify potential hidden costs and understand the scope of administrative expenses you will inherit from the transaction.
2. Operational Due Diligence
An acquisition may look promising financially, but operational inefficiencies such as supply chain delays can undermine its potential post-transaction. This makes operational due diligence one of the most essential due diligence types in any merger or acquisition deal.
Operational DD thoroughly assesses the target company’s core operations, including facilities, processes, IT systems, and human resources. Closely examining these elements helps determine the sustainability and scalability of the target company’s operations and any risks that may require attention.
Tasks may include:
- Analyzing supply chains for efficiency
- Assessing the scalability of production systems
- Evaluating IT infrastructure and support
- Identifying bottlenecks or inefficiencies in processes.
As it is forward-looking and strategic, operational DD ultimately focuses on how the business can create value after the acquisition.
3. Tax Due Diligence
Also referred to as fiscal due diligence, tax due diligence evaluates the target company’s tax liabilities and compliance with relevant tax laws. This process ensures that all taxes, including income, sales, and withholding taxes, have been correctly reported and paid. More importantly, it examines how the merger or acquisition will impact future tax obligations.
Essential tasks in reviewing tax compliance and risks include:
- Reviewing tax returns from the past three to five years
- Verifying any pending or past tax audits
- Assessing net operating losses (NOL) or unused credits
- Analyzing correspondence with tax authorities
Fiscal due diligence helps you avoid unexpected tax liabilities and ensure full compliance post-transaction.
4. Financial Due Diligence
Financial DD dives deeper into the target company’s financial health, verifying the accuracy of its financial records.
It scrutinizes historical and current financial performance to confirm that the financials presented in the Confidential Information Memorandum (CIM) are accurate. As such, it gathers the insights you need to assess future profitability and cash flow, ensuring that any risks are factored into forecasts.
The financial due diligence process can include the following:
- Auditing financial statements and reports
- Reviewing cash flow, expenses, and revenue trends
- Analyzing debt structure and repayment ability
- Appraising assets like real estate and intellectual property
A comprehensive analysis can help ensure your investment has a solid financial foundation.
5. Legal Due Diligence
Legal issues can significantly derail a transaction, making legal due diligence one of the most critical steps before proceeding with any M&A deal. Undisclosed liabilities, unresolved disputes, or unfavorable contracts can lead to costly consequences, impacting the long-term success of an acquisition.
Some examples of legal DD are:
- Reviewing material contracts, such as partnership or licensing agreements
- Examining loan and financing agreements
- Assessing ongoing litigation or disputes
- Verifying corporate governance documents
- Reviewing guarantees and liabilities the company is party to
- Analyzing joint venture or partnership agreements
6. Information Technology Due Diligence
With the growing reliance on digital systems today, information technology DD is crucial in safeguarding acquisitions. Ideally, a company’s IT infrastructure must not only support its current operations but also protect sensitive data and ensure compliance with evolving data privacy laws. Gaps in security or system scalability can create serious risks.
As this is among those highly technical due diligence types, it’s best to have IT, compliance, and legal professionals assist you in assessing and reviewing the following:
- Cybersecurity protocols and defenses
- Data protection practices, such as encryption and access controls
- Compliance with relevant data privacy laws (e.g., GDPR, CCPA)
- Disaster recovery and backup plans
- System vulnerabilities and patch management
7. Intellectual Property Due Diligence
Intellectual property (IP) due diligence is essential for evaluating the target company’s intangible assets, such as patents, trademarks, copyrights, and trade secrets.
These assets often represent a significant portion of a company’s overall value, especially if its products or services rely on unique innovations or branding that differentiate it in the marketplace. Ensuring that the company holds clear ownership and rights over its IP is critical to avoid future legal disputes or disruptions.
Essential areas of review include:
- The ownership and validity of patents, trademarks, and copyrights
- Licensing agreements and third-party IP rights
- Pending patents and any associated clearance documents
- Ongoing or potential litigation involving IP violations
- The strength of IP protection and any lapses in coverage
The IP due diligence process confirms that the intellectual property is well-protected and enforceable. As the acquiring company, this lets you fully capitalize on these assets and avoid potential legal risks after the acquisition.
8. Asset Due Diligence
As its name suggests, asset DD involves a comprehensive review of the target company’s physical and fixed assets to check that all assets are accurately accounted for and properly maintained.
This process is critical when the acquisition includes significant property or equipment, as it identifies both value and potential liabilities associated with those assets.
Asset due diligence reports typically involve:
- Detailed schedules of fixed assets
- Lease agreements for equipment and real estate
- Review of recent sales and purchases of major capital equipment
- Verification of real estate deeds, mortgages, and title policies
- Evaluation of use permits and compliance with local regulations
9. Human Resources Due Diligence
Human resources DD is often underestimated, but it’s one of the most essential and extensive types of due diligence. It covers a range of employee-related matters, from contracts and benefits to workforce dynamics and potential risks, offering insights into the company’s workforce, policies, and overall culture.
Examining fundamental areas like the following can help you assess the stability of the target company’s workforce:
- Employee contracts, such as nondisclosure or non-compete clauses
- Compensation structure, including salaries, bonuses, and benefits
- HR policies on leave, sick time, and employee grievances
- Ongoing or potential legal disputes involving the workforce, such as claims of wrongful termination or harassment
- Workforce demographics, including retirement projections and vacancies
Additionally, HR due diligence helps you understand employee satisfaction and the likelihood of key personnel leaving after the acquisition. Identifying workforce issues early, such as grievances or dissatisfaction, can help prevent costly disruptions and align expectations during the transition.
10. Environmental Due Diligence
Environmental issues can significantly impact a business financially and operationally, making due diligence related to ecological regulations critical in M&A transactions. Overlooking environmental risks can lead to not only costly fines but also legal actions or even business closure.
These steps can help you get started with understanding a company’s environmental standing:
- Validating the company’s environmental permits and licenses
- Investigating waste disposal methods to ensure they comply with regulations
- Reviewing communication with agencies like the EPA
- Assessing sustainability practices and their alignment with industry standards
- Examining any existing or potential environmental liabilities
Set Up Your M&A Due Diligence for Success With Wilcox Investment Bankers
Due diligence is an essential process in mergers and acquisitions, as it ensures the buyer and the seller fully understand the risks and opportunities involved in the transaction. Its different types play crucial roles in providing a comprehensive evaluation of the target company, enabling businesses to make informed decisions that reduce risk and maximize the potential for success.
If you are considering an acquisition, Wilcox Investment Bankers can support you from start to finish. We guide you through relevant due diligence processes so you can uncover any risks or opportunities that might affect the deal and secure the best terms.
On the selling side? Preparing your business for sale can be complex, but we’re here to help you get the outcome you deserve. Whether you’re looking to merge, recapitalize, or sell outright, our M&A advisors add significant value by positioning your business to meet both your financial and personal goals.
Contact us today, and let’s discuss how we can help drive your next transaction to success.