Due Diligence in Mergers and Acquisitions

As part of our ‘M&A Deconstructed’ series, M&A experts Nick Davies and Justin Levine discuss Due Diligence. Throughout this detailed conversation, M&A Solicitor Nick, and M&A Consultant Justin, discuss Due Diligence and its pivotal role when buying or selling a business.

In addition to covering the basics, such as ‘what is due diligence?’ and ‘how long does the due diligence process take?’, the two M&A specialists discuss employment and HR due diligence, the scrutiny of tax arrangements and managing the stressful nature of the due diligence process, whether you are buying or selling.

Take a look at this in-depth discussion in the video or read through the transcript below…

Video sub-topic timestamps:

00:00 – Introducing due diligence
00:34 – What is due diligence?
01:05 – Unprecedented scrutiny of a seller’s business
01:40 – What to expect in the due diligence phase
02:00 – The challenge for SEM business owners
02:08 – How long does the due diligence phase last?
02:40 – What is the purpose of due diligence?
03:49 – What support is required?
04:40 – Importance of quality financial systems and data
07:40 – Advice for business owners prior to due diligence
11:28 – Evaluating stock levels / Stock due diligence

Video Transcription

What is Due Diligence in mergers and acquisitions?

Nick Davies:
Justin hi, so we’re moving on to due diligence, today. We’ve talked about heads of terms. So we’re now at the sort of second big step in an M&A transaction. What does the due diligence phase mean for you and for your clients and what’s your take on that in perspective of ‘DD’ generally?

What are types of Due Diligence?

Justin Levine:
So well, due diligence is… I mean, the way I see this or try to explain it to clients is:

It’s a period of examination. It’s where the buyer will want to examine the seller’s business from a legal point of view, from an accounting point of view, from a tax point of view, from an environmental point of view could be an IT point of view, cybersecurity point of view. But it’s effectively a deal has been agreed, subject to the buyer checking the seller’s business. But I think the interesting thing that I always take from this, 10 plus years downstream of guiding sellers is: It is a period of examination that I think that a seller has never experienced before.

Nick Davies:
I’d agree.

Justin Levine:
And do you know something? I reflected, and I said this to a client recently, or prospective client. I said, I realise now it’s actually easy to say the words: “This is an extensive examination”. And that actually you’re going to need to dedicate a period of your life to answering those questions or having a team of people and supervising them, answering those questions. It’s different to saying the words than having the experience because actually X number of transactions downstream, you can see the period once the due diligence starts there is, within weeks, the seller goes from zero to stressed in a heartbeat and it’s as if they never expected it. And you say, “Well, we talked about this extensively six, nine months upstream.” I don’t know if you think the same or have the same experience.

How long does Due Diligence take in M&A?

Nick Davies:
Yes, I think that’s right. I think it’s difficult for a seller. Typically in an SME, that seller is also running the business and the due diligence phase might take four, six weeks. It might be longer. And a seller won’t typically be anticipating the extensive nature of the questions from the buyer. I mean, a typical due diligence questionnaire, as you know, it could be 20 pages, could be more. There could be the same again in respect of property, the same again in respect of accounting and tax. The buyer is not necessarily looking for problems and deliberately going to try and find an issue. But the intention of the due diligence is to suss out what might be missing or what’s not been done in the correct way. For a seller who has owned and run a business for 20 years or more, some of the questions they might sort of immediately think, “Well, I don’t know where that is or I’m sure we’ve done it, but where is it?”

What steps are involved in Due Diligence?

Nick Davies:
And it is just time consuming, going away and collating all of the supporting documents. It’s not a case of just answering the questions, you have to substantiate your answers, provide all your insurance documents, all of your employment documents, all of your statutory books and records, your register of members, your register of share allotments. A lot of owners of SMEs may not know what those are, or indeed where they are. They are a legal requirement, but before you get into a sale process you may not have any real need to be looking at those and checking on them on a regular basis. So the due diligence process, as you say is extensive, there’s a lot of people involved and it’s simply time-consuming.

Legal Due Diligence in mergers and acquisitions

Justin Levine:
It is and it’s normally… So I always ,with sellers, I always advise: Listen, once we’ve got heads of terms signed and you’re going into due diligence you will need an accounting slash tax support. You cannot do this on your own. You might have somebody internally, that’s a qualified tax attorney or whatever it might be, or you might have a team of people, but often as not, it’s outsourced. It’s the same as… You need a legal team in place that are experienced in corporate M&A transactions to support you. Don’t use your local solicitor for the house conveyancing and so on. But I think for me, the one thing that really jumps out is the period of due diligence typically can catch sellers out. And I can think of several areas where I see a repetitive pattern that comes up and it’s, I liken it to… Because we deal with SMEs, businesses turning over a few million up to 20, 30, 40, 50 million, whatever the number is. The smaller businesses, typically five / ten million turnover inevitably have very light internal financial systems.

Justin Levine:
And when I say that, they can be very successful businesses and it’s not a critique from that sense, but they can run their business and they get their annual accounts done by the local accountant. They might have light IT systems in the business and few checks and balances in a very granular level that you might find in a much bigger company. And the reason I highlight that is because I see this as a repetitive pattern that, typically, the seller and the corporate finance firm, could be us, could be somebody else, might be somebody else will have presented financial data to the buyers. The buyers will have said, “Okay, that’s great. We’ll sign up a deal according to the data you provided.” But then they’ll want to come and check it in due diligence. And this all comes down to the quality of the internal systems in the business to be able to generate repetitive, consistent, accurate financial data while the company is on the move, not just at year end, this is month-by-month. And that’s where I see things falling over quite a lot.

When to conduct Due Diligence internally, and when to outsource

Nick Davies:
It’s that resource, isn’t it? And it may not make sense in normal times, pre-transaction times, to have that expensive financial resource on tap at all times in an SME. Because you don’t need that specialist, bespoke reporting each and every month on some particular nuance that the buyer wants to know about. Those services and those skills can be added in for transactional purposes. You can find excellent local accountants, corporate finance advisors who can assist with that process. And it’s important, I think, to not let the DD process overwhelm a seller and recognise what you can and what you can’t do. As you say, there may be certain things which can be handled internally.

Nick Davies:
If you’ve got a good HR team you can probably deal with all of your employment due diligence. If you have got a particularly scrutineering buyer who wants to know about the intricacies of your tax arrangements for the last three years, with some particularly taxing questions it may be that your internal resource is not quite up to that. And that’s fine, it doesn’t mean that that person or that team you’ve got in the business is not operating as it should. It just means that you now need a different level of resource, which may be better served by an external advisor. So it’s recognising that I think.

Justin Levine:
It is recognising that. And I think that, as the years roll on, in terms of helping and guiding business owners to say, well listen, the due diligence process is extensive. The buyer is probably, not always, but probably going to look at the business in a level of detail that you as an owner have never looked at.

Nick Davies:
Yes, that’s right.

Preparing your business for sale and the Due Diligence process

Justin Levine:
They’re just simply going to analyse your financial data in a way that you probably just don’t look at when you’re running the business. So the question is, I suppose in my mind is, what advice would you give a business owner? Would you say: “Listen, just sell it and wait for the due diligence to happen and hope for the best.” I mean, this is as if we’re down the pub and we had somebody come in and say, “I’m thinking of selling my business.” What advice would we give? Would we say: “Do a dummy due diligence upfront, do the process before you go to market, flush it out” Or would you say: “Do something in between? Or just do nothing?” What do you think?

Nick Davies:
You shouldn’t do nothing. I mean, the more you can do to get your house in order, the easier it’s going to make your life. If you are rushing around trying to solve issues which have arisen in due diligence, whilst you’re in the middle of a transaction, that’s going to make life very challenging. You’re trying to run your business, you’re trying to negotiate the key commercial terms for the sale of your business and you’re trying to address issues which have arisen in due diligence, which might be historic share issues. It might be contracts have lapsed or IP has lapsed. So you’re trying to do too many things. If pre your heads stage, you have had a sort of dummy due diligence exercise where you’ve looked at some of that stuff in advance, you’ve hopefully spotted the issues in advance and had an opportunity to rectify them.

Reducing stress and surviving the M&A Due Diligence process

Nick Davies:
So I think in terms of time and stress management, the more you can do early on, the easier you will make your life. So we see people sometimes who set up or ask us to help them set up dummy data rooms. And that might be some service online where they start depositing key contracts, employment contracts, and insurance documents, and they start building up those folders so that they know they’ve got everything well organised in a great place. When the buyer says, “Well, we need to see all of that.” It’s a case of granting access to the data room and you’ve really streamlined that process. So there’s definitely things that can be done to make life easier and that’s what people need to be aiming to do really.

Justin Levine:
I think that’s my… I would actually sort of amplify that a bit actually, I would, because I think it’s… The business owners typically have run their businesses for decades.

Nick Davies:
Well, they’ve run it for themselves, haven’t they? And for their own, they’re not running it for the buyer. So they’re not doing all the things that a buyer would have necessarily expected them to do.

Justin Levine:
It’s right. But it is kind of like, if you, I don’t know… I don’t want to profile a typical seller, but age profile, 50 to 75, perhaps?

Nick Davies:
Maybe yes.

Justin Levine:
…is the bell curve maybe the 80%.

Justin Levine:
Yes, coming to the end of their… or the autumn period of their career saying: “Okay. What to do with this?” And of course having, often, a very valuable asset. Potentially a hugely valuable asset, a life defining value chain asset. And then there’s a window. And the thing is selling a business doesn’t take five minutes, it can take up to a year or more. So if you say, well, it all comes to a head in that due diligence period. And often as not is… of course, the emotions tend to get high because, of course, in the heads of terms might be a number that says: “Here’s 10 million quid for your business.” And the owner might be going: “That’s fantastic!” And of course in the owner’s mind, they’ve already written the cheque out.

Justin Levine:
They’ve not talked about this, but they’ve talked about that with a partner, the family, they’ve gone with the yacht the second home. And of course in their mind, it’s all happening.

Nick Davies:
Yes.

What happens when the Due Diligence process doesn’t go to plan?

Justin Levine:
And then the due diligence happens. And, of course, is that then the objective teams from the buyer turn up, clinical, looking at the data. So my view is actually, sorry, the reason I’m amplifying it a little bit is because actually I think it’s a period where you can’t afford to get it wrong. If it goes wrong, it potentially resets the whole process, either back to a renegotiation or the deal’s off the table. So I would argue that if I was down in the pub and somebody said to me: “Listen, I’ve got a decent sized business and I’m lining up for an exit.” I’d say: “Do the dummy due diligence. Don’t do it yourself.”

Nick Davies:
I think it’s about perspective actually, because I think that somebody who’s owned a business and run a business for 20 years in a way, which they’re happy with it, stock is a good example. Over that 20 years, you may have built up a pretty decent level, useful level of stock which, from your perspective, is fine and is healthy for the business. The buyer may come in and say: “Well, actually that stock is not turning over fast enough. We therefore are going to have an independent stock take, stock due diligence, and we’re going to write down the value in your slow moving or obsolete stock.” Well, the seller is going to say: “Well, no, I don’t accept that. I think that that is a genuine value to the business,” and the buyer’s going to have a different perspective.

Nick Davies:
So you’ve then got to balance those perspectives in some way to resolve that issue. But how up-to-date is your stock reporting pre the buyer starting their due diligence. Have you actually got a good handle on your stock? Can you actually make your argument in advance? Say, well, this is why we do hold that historic stock. It’s justifiable, it’s valuable, et cetera, et cetera. So, yes, happy to go along with your amplification of doing the DD first. So that’s probably due diligence in a nutshell really unless you’ve got anything to…

Justin Levine:
I think that’s it. I think we’ve covered it quite nicely. There’s always more, but…

Nick Davies:
Yes. Good talking to you.

Justin Levine:
Likewise.

_ _ _ _ _ _ _ _ _ _ _ _

More from Series 1 of M&A Deconstructed

As part of this in-depth series, other topics discussed include:

• What is EBITDA?
• What are Heads of Terms?
• Equity Share vs Asset Sale
• Completion Accounts vs Locked Box

Connect with the M&A experts

Justin Levine, Managing Director, The NonExec Limited M&A Boutique 
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies. Connect with Justin >

Nick Davies, Partner and Specialist M&A Solicitor, Steele Raymond LLP
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on on mergers, de-mergers and re-organisation. Connect with Nick >

Make an Enquiry

If you have any questions regarding your business, a business exit, a merger or any other corporate legal query, please contact Nick Davies on 01202 294566 or email [email protected]