A Comprehensive Guide to Due Diligence Issues in Mergers and Acquisitions
By Richard D. Harroch, David A. Lipkin, Richard V. Smith, and John Cook
Mergers and acquisitions typically involve a significant amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying, what obligations it is assuming, the nature and extent of the seller’s contingent liabilities, problematic contracts, litigation risks, intellectual property issues, and much more. This is particularly true in private company acquisitions, in which the seller has not been subject to the scrutiny of the public markets.
Recent M&A activity and litigation have highlighted the need for a buyer to conduct careful due diligence as to potential risks, especially investigating financial statements, data breach and cybersecurity issues, intellectual property issues, and potential employment law and sexual harassment liability.
The following is a summary of the most significant legal and business due diligence activities the buyer will undertake in a typical M&A transaction involving a privately held company. A buyer will employ additional highly specialized due diligence activities, beyond those set forth below, when investigating companies in regulated industries, such as telecom, banking, insurance, or finance.
By planning for the buyer’s due diligence activities carefully and properly anticipating the related issues that may arise and risks that the buyer may identify, the seller will be better prepared to negotiate mitigation measures and successfully consummate a sale of the company.
1. Financial Matters
The buyer will be concerned with all of the seller’s historical financial statements and related financial metrics as well as the reasonableness of the target’s projections of its future performance. Topics of inquiry or concern will include the following:
- What do the seller’s annual, quarterly, and (if available) monthly financial statements for at least the last three years reveal about its financial performance and condition?
- Are the seller’s financial statements audited, and, if so, for how long? Does the audit report include a “going concern” qualification?
- Do the financial statements and related notes set forth all liabilities of the seller, both current and contingent?
- Are there internal controls over financial reporting issues?
- Are the revenues and margins for the business growing or deteriorating?
- Are the seller’s financial projections for the future and underlying assumptions reasonable and realistic?
- How do the seller’s projections for the current year compare to the board-approved budget for the same period?
- What normalized working capital will be necessary to continue running the business?
- How is “working capital” determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance of the dollar number.)
- How much is the seller investing in research and development? Is this amount sufficient?
- What capital expenditures and other investments will need to be made to continue growing the business, and what are the seller’s current capital commitments?
- What is the condition of tangible assets and liens thereon?
- What indebtedness is outstanding or guaranteed by the seller, what are its terms, and when does it have to be repaid?
- Are there any unusual revenue recognition issues for the seller or the industry in which it operates?
- What is the aging of accounts receivable, reasonableness of …read more
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