M&A 101: The role of due diligence in mergers and acquisitions
This article is one in a four part series on Mergers and Acquisitions from PitchBook.
Brett Dearing, Senior Director at BNY Mellon Wealth Management, is a Certified Exit Planning Advisor and a Certified Merger & Acquistion Advisor with over 27 years of experience. His areas of focus include platform preparation, contingency planning and succession planning. He specializes in M&A, recapitalization, stock purchases and asset sales.
We caught up with Dearing to learn more about the basics of due diligence with respect to mergers and acquisitions for the fourth installment of PitchBook’s M&A 101 series. The interview below is edited for length and clarity.
PitchBook: What is due diligence?
Dearing: It is an evaluation process used by an interested buyer to better understand the selling business and the risks in potentially becoming an owner of that business, and to see if the information stated in a document referred to as a confidential information memorandum (CIM) checks out. There is a legal component that makes up about 10% to 20% of the process. The remaining 80% to 90% of this evaluation process focuses on the intangibles. The process is not only about checking financials and projections for the business, but also gaining a strong understanding of the business model; how the company conducts business, works with and services customers; vendor relationships; the talent of employees; and most importantly, how your business competes against other businesses in that industry.
A lot of times business owners are reluctant to share negative information about their company. They want to put their best foot forward, but I always share early on in my engagements that everything will come out in the due diligence process, that it’s better to get in front of the potential issues and control the narrative. A good rule for business owners to remember is that you don’t want a potential buyer to find out about potential problems in your business for the first time in due diligence. They should be disclosed ahead of time with an executable plan that you, your management team and advisors created to fix any pending issues—whether the interested buyer continues and purchases the business or not.
Why is due diligence important to the M&A process?
A lot of people will answer the question with something like, “to get the seller the best deal,” or some will say, “to get the most money for the buyer.” To some degree, these answers are both correct. However, the reason due diligence is important to the M&A process from a buyer’s perspective is to better understand how the business, its owners and its management operate. The due diligence process helps understand synergies, potential scalability of the business with enhanced operations and more access to customers from the buyer’s company. Potential buyers will also look at ways to reduce the overall expenses of the business to increase profitability.
In my experience, it is important to remember the seller should have a business preparedness assessment conducted before even engaging an investment banker. This assessment will identify potential value-detractors in your business, as well as assisting in the preparation of key documents, business plans, growth plans and overall preparation for the M&A process. PricewaterhouseCoopers conducted a study that showed only a 20% to 30% success rate for transition planning by business owners. On average it could take 12 to 16 months to prepare a proper transition plan by a certified exit planning advisor. The study went on to conclude that a lack of pretransition planning was a large contributor to eight out of 10 companies failing the M&A process.
Who carries out due diligence?
Usually it is the buyer and their third-party advisors that carry out the actual due diligence. The process of due diligence can last from 30 days to, in some complex cases, 90 days. The third-party advisors will spend time at the main headquarters of the business under review, going through prepared information. These third-party advisors hired by the potential buyer may include a CPA firm for accounting and tax review, industry consultants to review the company’s business model and future opportunities, attorneys for legal review of the due diligence process, environmental consultants and labor attorneys—just to name a few that will be hovering around the office and the prepared data room reviewing documents.
When in the M&A process do buyers and sellers engage in due diligence?
There are five steps in the M&A process:
- Exit Planning is the process where the business owner has decided to sell the business and is looking to get the business and the financial aspects of the transaction prepared to maximize enterprise value and after-tax proceeds while personally preparing the owner for the life transition
- Preparation is where the transaction team begins the process of getting information together, reviewing the strategic plan for the business, material contracts, preparing audited/reviewed financial and accounting reports and the CIM
- Formal Marketing is where your investment banker will send out teasers to potential buyers, negotiate confidential agreements, distribute the CIM to potential buyers, finalize the data room, complete a detailed management presentation, engage bidders and receive preliminary letters of interest (LOI)
- Due Diligence & Final Bids is where the investment banker and team will assess and prioritize nonbinding bids, invite a number of bidders (three to 10) for a management presentation, site visit and access to the data room, conduct management meetings, set a deadline for offers with committed financing and circulate draft contracts
- Negotiation & Closing is where you receive firm offers with marked-up contracts, select the best offer, negotiate the sale and purchase agreement and ancillary contracts, set up a last round of final due diligence, execute contract(s) and fulfill conditions leading up to closing (regulatory, accounting and legal). Up to this point, before getting to negotiations with an interested buyer, the owner could be six to eight months into the M&A process. On average it could take up to 12 months to complete and finalize the sale. There are usually two rounds of due diligence: phase one, which happens after the LOI is received and the potential buyer(s) are interested in moving forward. When you receive an LOI, there is usually a price associated with the interested buyer. As an example, let’s say the offer price is $120 million. This price, 90% of the time, will be the highest price you receive from the buyer. Within the due diligence process if the interested buyer finds issues with the business, which is defined as risk of ownership, they will look to discount the original price. The discount caused by the issues found in due diligence can impact up to 10% to 30% of the offer price, which in this case would be between $12 million and $36 million in discounts. The discounts would impact the final offer price range down to $108 million to $84 million, respectively, from the original offer of $120 million. It is easy to see how due diligence can become a major cause for a transaction falling apart.
Where does due diligence take place?
Due diligence is conducted in two places:
- A data room
- On-site with the business owner
A data room is cloud-based centralized file sharing system set up by the seller or the buyer where data is stored for review. The data in the data room is usually a compilation of requested information by the buyer. Third-party advisors representing the buyer will use the data room to conduct due diligence. In the case where there are ultra-sensitive documents, they may be withheld until later in the process. The data room has a file system that may be organized by financials, business plan, legal documents, growth plan, management presentation, etc. In phase two due diligence, the final phase of due diligence, there is a need for third-party advisors to conduct due diligence on-site. This may include environmental, labor and business model/management due diligence. This on-site due diligence can take up to 3-6 weeks or longer.
Examples of a few of the documents requested in the due diligence process include:
1. The last three fiscal years and the current year to date:
- Company financial statements
- Breakdown of sales by product/service group (in both dollars and units)
- Sales and gross margin for top 25 customers
- Gross margin by major product/service group
- Breakdown of the cost of goods sold (e.g. material, labor, overhead), depreciation included in COGS
- Breakdown of general and administrative expenses
- Breakdown of selling expenses
- Product development expenses
- Details of any extraordinary one-time or nonrecurring items in historical financial statements
- Accounts receivable aging report, write-off & bad debt history
- Inventory valuation and inventory write-down history
- Accounts payable aging report
2. Next year’s budget
3. Current strategic plan and five-year forecast with detailed assumptions
4. Summary of terms and covenant of existing indebtedness
5. Commitments for pending and proposed major capital projects
6. Description of major capital projects over the past three years including dollar amounts
7. Capital budget for the next three years
Like most coaches would say to their players, “The game is won in practice and in preparation for the game.” The due diligence process is set up for success through exit planning and having a real transition plan leading up to the M&A process. The M&A process is very challenging and one that most business owners are not prepared for. My parting advice: “Don’t leave money on the table.”
When selling your business, there is usually a multiple range of net earnings before EBITDA. Solid preparation and transition planning can raise offers to the higher end of the multiple range—working out to be millions of dollars. In addition, exit planning could add an “additional turn,” or even higher multiple exceeding the top range of the multiple for the seller. Take advantage of having a well-thought-out transition plan. You only have one opportunity to maximize the enterprise value of your business before the M&A process.
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