M&A Due Diligence: The Process, Step by Step, and What It Decides

How Deal Structure Sets the Scope

Structure decides what the buyer takes on, and so how deep each workstream has to go.

• Stock purchase. The buyer acquires the shares, and the entity keeps everything it owns and owes, including liabilities nobody has found yet. Legal, tax and compliance diligence go deepest here.
• Asset purchase. The buyer chooses the assets it takes and the liabilities it assumes. Contracts, permits and licenses often need consent to move, and the IRS treats the sale of a business for a lump sum as a sale of each of its assets, so buyer and seller must allocate the price across them.
• Merger. Two entities combine, and the survivor carries both sets of obligations. When the consideration includes the buyer's stock, each side is investing in the other.
• Carve-out. A division sold out of a larger group arrives without the shared services it ran on. Diligence has to establish what the business costs to run on its own, and what the seller will provide for a period after closing.

Tax law can blur the line between the first two: in some stock purchases the buyer may elect to treat the deal as a purchase of assets for tax purposes. And where the buyer is foreign, the deal may need a national-security review. In the United States that is the work of the Committee on Foreign Investment in the United States (CFIUS), which reviews certain transactions involving foreign investment for their effect on national security.

Where the Findings Go

A finding that changes nothing was not worth the time spent on it. Each one needs a destination before signing:

• The price. Adjusted earnings, a revised working capital peg, or debt-like items deducted from the equity value.
• The purchase agreement. A representation the seller stands behind, a specific indemnity for a known exposure, an escrow or holdback to fund it, or a condition that must be met before closing.
• Insurance, where the deal uses it. Representations and warranties insurance covers breaches the buyer did not know about. Issues found in diligence are generally excluded, so a known problem needs its own answer in the price or the agreement.
• The integration plan. Findings that do not move the price often decide the first hundred days: a person to retain, a system to replace, a contract to renegotiate.
• The decision. Some findings end the deal.

Diligence does not end at closing, either. Some problems only surface once the buyer is inside the company, and the U.S. Department of Justice has a policy for exactly that: it presumes it will decline to prosecute an acquirer that voluntarily discloses misconduct found at a company it acquired, generally within 180 days of closing, and remediates it, generally within a year. A buyer whose diligence keeps going after closing is the one positioned to use it.

Why Acquisitions Disappoint, and What Diligence Can Catch

Acquisitions can cost the buyer's shareholders a great deal. A study of the 1998 to 2001 merger wave, published by the National Bureau of Economic Research, found that acquiring-firm shareholders lost 12 cents at the announcement for every dollar spent on acquisitions: $240 billion in total, most of it on a small number of acquisitions by firms with extremely high valuations. The market was judging the price, and the price rests on what the buyer believed about the company.

Diligence cannot rescue a price set on enthusiasm, but it can test the beliefs the price rests on. Three of them deserve lines of their own:

• Synergies tied to records. Every cost or revenue synergy in the model should rest on something observable: overlapping suppliers, sites, systems or customers, measured from the company's own records.
• The people the plan depends on. Research on acquired startups, published by MIT Sloan, found that 33 percent of acquired workers left within the first year, against 12 percent of regular hires with similar skills and experience. Knowing who carries the knowledge, the customer relationships and the decisions is a diligence question, not an integration one. See key person risk.
• How the company actually works. Two companies that decide, meet and hand off work differently will collide on their first joint project. The post-merger integration work starts from what diligence found.

What the Data Room Cannot Show

The data room holds what the seller assembled, and the representations hold what the seller will stand behind. Both are necessary, and both are drawn up by the party on the other side of the table. A buyer that works only from them confirms that the company is what it says it is on paper.

Three kinds of evidence answer different questions:

• Documents prove that things exist. A policy, a contract, an organization chart. They do not show whether the work follows them.
• Answers carry a view. Interviews and questionnaires return what people believe, or what they would like the buyer to believe.
• Records show what happened. The ledger, the billing system, the code repository, the ticket queue and the calendar were written as the work happened, before anyone knew there would be a deal. They show whether the close slips, who approvals wait on, where knowledge sits and how fast decisions move.

The workstreams that read records, not only documents, find what an acquisition depends on: operational due diligence, organizational health and technology due diligence. The M&A due diligence checklist tags every line with the evidence that confirms it.