Due diligence in mergers and acquisitions: what it is, the benefits and the risks

If you are looking to buy an existing business, proper due diligence is essential. It is the part of the process where you find out what you are actually buying, and it is the difference between an informed decision and a gamble. This guide covers what due diligence is in an M&A context, what the process involves, the benefits it gives you as a buyer, and what can go wrong if you do not do it properly.

What is due diligence in M&A?

Due diligence in mergers and acquisitions refers to the process, or the efforts, that the buyer undertakes to investigate the target business. The aim is to fully understand what you are looking to buy and to identify any issues or red flags before you commit to the purchase.

It is the buyer's exercise. The seller provides information and documents, but it is the buyer who has to ask the right questions, review the answers and decide what they mean for the deal.

What does the due diligence process involve?

In an M&A deal, you will want to look at a range of factors. The main ones are:

• Legal compliance. Making sure the company has been complying with the laws that apply to it.
• Financial records. Looking at the financial records of the business to see how it has actually been performing.
• Business operations. Understanding how the business runs day to day.
• Key contracts. Analysing the contracts between the target business and its customers and suppliers, which you will be bound by if you buy the shares.
• Employment contracts. Reviewing the contracts for the employees of the business, who will become your employees.
• The balance sheet. Looking at the assets and liabilities of the business, so you know what it owns and what it owes.

That is a lot of ground, and it is why the most important thing to do, if at all possible, is to appoint lawyers and accountants to carry out the due diligence for you. Your solicitor covers the legal side, your accountant covers the numbers, and you get a picture of the business that you would struggle to build on your own. For a more detailed look at the legal side, see what lawyers look for in due diligence.

Benefits of due diligence when buying a business

Conducting due diligence properly gives you three main benefits.

• A better idea of what you are buying. You go into the deal with a clear understanding of the business, rather than relying on what the seller has told you.
• Stronger bargaining power. What you find in due diligence feeds directly into the negotiations. Issues you uncover can be used to negotiate the price, or to negotiate protections in the purchase agreement.
• The ability to identify and minimise risks. You cannot manage a risk you do not know about. Due diligence is how you find them, and once found they can be dealt with before completion rather than after.

Risks of not doing proper due diligence

What happens if you do not conduct due diligence properly? In my experience there are three main risks.

• Unforeseen risks with customers and suppliers. If you are buying the shares of the company in particular, you will be bound by the contracts that are already in place. If you have not read them, you do not know what obligations you have just taken on or what rights the other parties have.
• Being sued for claims you were not aware of. Claims against the company do not go away because the shares have changed hands. If there is a dispute brewing that you did not find, you will be the one dealing with it.
• Overpaying. You might be paying a price for a business that is actually worth less, because the problems that reduce its value were never uncovered.

Each of these is avoidable. The cost of due diligence is small compared with the cost of discovering any one of them after completion.

Next steps

Before you make an offer, decide who is going to carry out your due diligence and build enough time into the deal timetable for them to do it properly. Appoint a corporate solicitor for the legal review and an accountant for the financial review, and make sure what they find is reflected in the price and the purchase agreement. My due diligence series starts with corporate records due diligence and continues with finance due diligence, commercial contracts and property due diligence.