Merger and acquisition (M&A) activities can be an essential component of a business’s growth plan. In terms of market presence, a successful acquisition will help a business make a quantum leap, fill in holes in the service or product portfolio of a company, and increase profitability and other performance metrics.
On the other hand, transactions that eventually do not perform as expected, including not delivering positive returns or resulting in significant negative surprises, may cause serious harm to corporations and their corporate boards, ranging from lawsuits to the dismissal of management and even board members. In 2015, shareholders opposed 65 percent of M&A transactions valued at over $100 million or more, concerning Delaware-incorporated corporations through litigation.
Given the possible ramifications of M&A operations for firms and their boards, managers are interested in managing the acquisition process from an early stage through post-closing integration. The due diligence process relates to a crucial component of this oversight duty. In particular, boards should aim to reassure themselves that management performs a rigorous due diligence process designed to identify potential risks and evaluation factors, determine their severity and the likelihood of the occurrence of the risks, consider whether mitigation is feasible, and react appropriately.
In other words, due diligence, or due diligence audit, be it financial due diligence or M&A, if done well, can provide valuable insights into the target business and allow a more informed evaluation of the transaction’s potential risks and expected benefits. Thus, it is in the board’s interest to stress the value of a well-thought-out diligence method and promote it.
As a high-level study restricted to a hunt for ‘red flags,’ grappling with killers or fatal defects, several businesses approach diligence. While this may be a rational starting point based on time and cost, a systematic approach requires a more rigorous review of the goal’s data, market, and economic outlook.
Due diligence audit can uncover fundamental observations, threats, and exposures far beyond fatal flaw evaluation, which can have a major effect on valuation, the terms of the purchase agreement, culture/people risks, technologies, operations, or the regulatory climate that can dramatically change the interest of a buyer in the deal or valuation. A formal/ financial due diligence method may also help management evaluate the probability of the post-transaction phase’s success and minimize surprises.
Transactions undergoing a financial due diligence procedure are more likely than those not to be successful. The subsequent points are some of the main reasons why financial due diligence should be considered:
You will naturally (if inadvertently) bias all buyers and sellers. Sellers usually present optimistic projections and base their projections on potentially unrealistic growth assumptions. The magnitude of synergies and the speed at which they can be accomplished may be impractical for buyers. (This could be particularly true if the acquirer is a public entity that is expected to report financial data pro forma)
The parties to a deal–executives and other staff of both the buyer and seller—and some of their stakeholders may earn sizeable pay-outs if the transaction closes and can take a cut or obtain little or nothing.
Even if formulated with the best intentions, financial information could be insufficient, inaccurate, or deceptive due to the various difficulties involved in recognizing contingencies, non-recurring problems, tax results, and other related items.
It is essential to remember that even if due diligence does not disclose major problems or deal with issues, the deal’s basics will affect valuation and price. The financial due diligence process, for example, can include details on issues such as reserve releases or other non-recurring products, tax exposures, benefit payments, or other financial obligations which may provide the buyer with an ability to restructure conditions, such as the selling price and future escrows or holdbacks, independently or proportionally.
If renegotiation is not necessary or successful, better information would be available to the buyer to determine whether to continue with the deal at the initial price. A transaction would not be effective per se with a rigorous due diligence process; however, it will improve awareness and mitigate a range of possible threats and risks to a successful transaction and lead to better-informed prices, valuation, or required modifications.
Pushing the limits in the M&A survey, 75% of respondents indicated that their organization has a clearly defined due diligence process and M&A approval process, of which 54% indicated that their boards must approve all M&A transactions and 82% of respondents indicated that their board approved M&A transactions of up to $50 million. ‘The M&A process should be designed to take advantage of the experienced input of experienced directors at the appropriate moments and make it easier to keep the board properly informed throughout the process so that it can meet its oversight duties and shareholder duty of care.’
Our detailed review of financial reports, monthly or quarterly historical financial information, review of audit work papers, analysis of the facts supporting publicly accessible financial data, as well as interviews with financial managers and external auditors, are usually included in the financial and accounting diligence. Our method can yield valuable observations on the earnings of the aim (such as quasi or one-time operations and reserve releases) and due diligence processes’ observations into networking capital post-transaction needs and shed light, among other areas, on debt-like exposures and patterns in operating results and operating expenses.