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8 Key Due Diligence Steps for Mergers and Acquisitions

Mergers and acquisitions

Mergers and acquisitions should involve a substantial amount of due diligence activities on the part of the acquiring company.

It simply makes good sense to fully understand what obligations, risks and opportunities you are assuming with mergers and acquisitions before committing to a contract. This is particularly important if you are merging with or acquiring a private company, as they have not been subject to the same level of scrutiny as a public company. Information on private companies is less accessible to the public.

Due diligence activities can usually be looked at through the lens of either business or legal matters. Here, we’re taking a closer look at mergers and acquisitions, due diligence and key areas to look at:

Download our list of financial documents to check for M&A deals here

The purpose of due diligence for mergers & acquisitions

The primary purpose of due diligence for mergers and acquisitions is to conduct an evaluation process to understand the target company better. The acquiring company (or merging company) needs to know that the information they have been provided already checks out and that there are no additional legal or business risks they may be exposed to.

Due diligence generally consists of a 10% to 20% focus on legal aspects, with the remaining scrutiny on business aspects. Some of these may be described as “intangibles,” such as a general view of how the company conducts business and its relationships with vendors or customers.

A company will always want to show itself in the best possible light, but that may gloss over areas that can present a risk to an acquiring company. The due diligence process should see everything pertinent come out, ensuring that you have a clear picture. You’re checking that you really do want to go ahead with the M&A deal, and that you’re paying a fair purchase price.

It’s worth noting that a similar due diligence process should be conducted for any joint ventures with other companies. In any case, due diligence is usually carried out by buyers and their third-party advisors (this is part of what we do at Coker James).

Mergers and acquisitionsDue diligence should always be conducted for M&A, partnerships or joint ventures Click To Tweet

Key terms

Here are a few key terms used with mergers and acquisitions:

Acquiring company – The company making the purchase.

Acquisition – Where the purchasing company acquires more than 50% of the shares of the target company, and both companies remain trading.

Amalgamation or Consolidation – The joining of two or more companies into a new entity. None of the original entities remain.

Conglomerate – A merger of companies that have seemingly unrelated businesses.

Friendly takeover – Where the board and/or management of the target company approve of the takeover.

Hostile takeover – The board of directors and management of the target company don’t approve of the takeover and advise shareholders not to approve.

Merger – The acquiring company purchases 100% of the target company’s shares and/or assets, and the target company ceases to exist.

Target company – The company that is being acquired.

#1. Corporate structure of the target company

The law firms of the acquiring company will usually give careful scrutiny to the corporate structure and organizational documents of the target company. This usually includes a review of the organizational chart, and minutes from board or executive meetings.

Every business requires clear structure to help it grow, be profitable and avoid potential risk issues associated with people being pulled in different directions. Structure relates to the flow of information and how equipped people are to do their jobs well.

From the perspective of the acquiring company, you can also get a sense of whether there may be any clashes with “how you do things.”

#2. Due diligence over taxes and financial management

The financial situation of the target company is also vital to examine during due diligence. For example, tax due diligence should scrutinize what the company has been paying, any correspondence from tax authorities (foreign or domestic), and whether the company has been subject to a government audit. You will also want to know about any historic tax liabilities that may be ongoing. Usually, you will want to go back through five years of taxes.

Cash flow, profit and loss, and other key financial reports should also be examined. You’ll want to know about margins and any positive or negative earning trends, and confirm that projections seem to be reasonably calculated. Importantly, you also want to know that the company has the financial resources to continue trading over the period before the close of the acquisition, including paying expenses. For this assessment, you’ll want to see at least three years of financial reporting.

#3. Intellectual property of the new company

The intellectual property and any technology owned by the target company should also factor into due diligence for mergers and acquisitions. The acquiring company needs to know the extent and quality of any intellectual property.

This includes a review of patents (both current and pending), trademarks, copyrights and overall, whether the company has taken the steps needed to protect its intellectual property. This should be looked at both in-country and cross-border. For example, if you were acquiring any company that relies upon trade secrets as part of its business (secret recipes, for example), you’d want to know that they’ve put steps in place to preserve that secrecy.

Along those lines, the acquiring company also needs to know that the target company isn’t embroiled in any arguments with other companies over intellectual property.

If the company relies on using software of any type during the course of business, due diligence involves checking that they have the appropriate licenses and that their usage is compliant with any terms.

#4. Strategic fit with the acquiring company

Strategic fit is probably just as important as profitability in assessing the viability of mergers and acquisitions. To what extent does the target company fit strategically with the acquiring company? How will they work together in the future?

Examples of strategic fit might include things like: products and/or services that the buyer doesn’t offer, technology the buyer doesn’t have, key people that the acquiring company will be able to work with, achieving economies of scale, market share, tapping a broader customer base, cost savings and revenue enhancements.

#5. Material assets of the target company

Due diligence for M&A transactions should always include a review of the material assets of the target company. You will want to consider the total value of the assets, any debts or liabilities against them, and their overall condition. For example, you will want to know if any vital pieces of expensive equipment are due to be replaced.

In this age of e-commerce, assets might also include websites and systems used to sell online. This will be particularly important if online sales form a key part of the business.

Other assets include: real estate, equipment, vehicles, inventory stock, technology, and any research and development.

#6. Material contracts of the target company

Your law firm should review all material contracts and commitments that the target company has. This tends to be one of the most time-consuming parts of due diligence for M&A transactions.

This review should include items such as:

  • Loans, credit agreements or guarantees
  • Customer and supplier contracts
  • Joint venture or partnership agreements
  • Equipment leases
  • Settlement agreements
  • Employment agreements
  • Past acquisition agreements
  • License agreements
  • Powers of attorney
  • Non-compete and exclusivity agreements
  • Franchising agreements
  • Distribution agreements
  • Schedule of accounts receivable and payable.

Mergers and acquisitions

#7. Review of management team and employees

It’s important to understand the value of the management team, board of directors and employees to the structure and operations of the company. Will you be able to retain key people post-merger?

Besides structure, policies and procedures, the following may be reviewed:

  • Details of any labor disputes or threatened stoppages
  • Employee benefits, compensation, retirement plans and pensions
  • Breakdown of salaries, bonuses and non-cash compensation for management and employees
  • Any stock options and evidence that they comply with IRS Section 409A
  • Company policies and treatment of employees and contractors
  • Any involvement of key management or employees with legal issues
  • Any layoff or severance costs associated with the M&A process.
Get our list of key financial documents to review here

#8. Regulatory compliance of the target company

During all mergers and acquisitions, it is in the best interest of the acquiring company to review the regulatory compliance of the target company. You will want to understand to what extent the company is subject to regulations and how well they have complied with them.

“Regulatory compliance” may be quite broad, but here are a few key areas to look at:

  • Environmental laws
  • Tax and employment laws
  • Antitrust laws
  • Review of jurisdictions where the company is permitted to do business
  • Review of any citations or notices, and documents showing remedies made in respect to those
  • Permit and license agreements or exemptions.

Final thoughts

All mergers and acquisitions should go through a hefty due diligence process to ensure that the acquiring company understands exactly what they’re getting into.

Typically, the buyer will go through due diligence along with third-party advisors such as their accountants and legal counsel. Depending on the size of the target company and their holdings, this can take six weeks or longer to complete.

Due diligence is essential for making informed investment decisions and should always be entered into with the intention of a thorough review. While this may be time-consuming, it pays to learn about any potential issues before an M&A deal is done, to ensure a better chance of a successful business into the future.

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