Pre-Due Diligence in M&A

If you’ve been thinking about buying a company, you’ll assuredly have some high-level criteria for the size and type of company you are looking for. You’ve identified and contacted those you are most interested in based on what you already know about them. Now one of those companies has responded to your inquiry via their business intermediary. They are interested in talking with your team. You’ve signed a confidentiality/non-disclosure agreement and received the information prepared by the intermediary.

That information is helpful, but you’d like to know more. Before you prepare an offer for the seller’s company, you will benefit from undertaking a pre-due diligence review. This is an informal and inexpensive investigation into the company’s financial health, customers, employees, risks and culture. You’ll find out why the seller is really selling and if there is a good match between your company and the seller’s company.

You’ll be able to identify any potential “red flags” that might slow down or kill a potential deal. Most importantly, you will be more confident that — absent any huge issues that come up in the more formal due diligence — you can stand behind your LOI offer without having to back out or renegotiate after the fact.

In most cases, a seller would be willing to provide information on a summary basis or samples to verify:

• Corporate form of organization is properly documented, correct filings are made and interrelated business ownership is noted.
• Accounting records are accurate and kept up to date.
• Tax returns have been filed and all taxes paid on a timely basis.
• All material agreements (redacted as appropriate) are up to date, complete and any particularly large contracts are assignable, or a plan exists to handle such contracts.
• Intellectual property is properly registered and up to date.
• All software licenses and uses are authorized and accurate versions.
• Employee records and payroll are kept in good order and proper documentation exists.
• All real property leases or titles are in good order and transferable.
• Environmental inspections have been completed as required by federal state and/or local authorities.
• Legal disputes and/or litigation are minimal and those existing are professionally handled by appropriate methods.
• Any other material issues that would be important for the seller to tell the buyer before proceeding is revealed.

From the seller’s perspective, completing a pre-due diligence review often reveals insights and knowledge about the company the owner or senior leadership didn’t even know about. Some actual examples we’ve seen include:

• Significant variances in accounting records have occurred.
• An effort to unionize a group of workers was quelled, exposing that manager and company to federal action.
• Material client contracts were not corrected and updated as required and at minimum will be embarrassing to correct.

Any of these issues can be difficult to face. It would be worse to find out about them only after you’ve entered the due diligence phase. If an issue is serious enough, it may require a significant adjustment in the price offered or worse, kill the deal for the seller completely.

Some other areas to investigate prior to putting the company on the market:

• Review of books and accounting records by an experienced outsider (not a complete audit, but a selective view into the P/L, balance sheet, and income statement).
• Review employee handbook for most up-to-date laws and best practices.
• Review existing and future high value employees’ retention plans, development plans, and total compensation now and as objectives are met.
• Executive compensation and benefits review with long-term profitability goals included.
• Cyber security review.

The benefits to having completed a pre-due diligence review can be a positive for both the buyer and the seller. The buyer can make the best offer for a company based on his knowledge. The seller is certain that he is putting his best version of the company forward when selling. The result should be a better combination for both.