Understanding Due Diligence in Mergers & Acquisitions

By: R. Austin Stevenson

Whether you are in the middle of a transaction that will land on the front page of the Wall Street Journal, or a local SBA backed transaction, several core functions of mergers and acquisitions remain the same. 

In fact, before a business can undergo a transformative merger or acquisition, and before an exiting owner can reach the proverbial closing table, both parties will interact with the due diligence process first. The function of the diligence process, and especially its scope, oftentimes surprises or frustrates sellers and likewise can exhaust buyers, but nonetheless remains critical to successful dealmaking. 

The Importance of Due Diligence in Mergers & Acquisitions

At a very high level, due diligence in the context of a business acquisition is a comprehensive investigation by the buyer and its advisors into all aspects of a selling business to identify risks and opportunities that could affect the transaction's success. This process serves a variety of purposes, legal and otherwise.

First, it helps uncover liabilities, such as lawsuits, debts, or regulatory issues, which could affect the target company’s value. Buyers do not want to buy assets that are saddled with debt or liens, or walk into litigation or other liabilities that are unknown to the buyer.

Second, it offers a clear picture of the company’s financial health, operational capabilities, and future prospects. In other words, buyers want to know what they are buying, know that they are paying an appropriate price, and know that the target company will fit into the buyer’s operations seamlessly.

On the seller’s side of the table, due diligence (and although not the subject of this article, proper disclosure in the definitive purchase agreement for the applicable transaction) also affords the seller an opportunity to disclose any potential issues to the buyer. This potentially saves the seller from litigation or disputes with the buyer in the future. Broadly speaking, participants in a transaction can expect to experience three main types of diligence.

1. Financial Due Diligence

The first stage involves reviewing the financial health of the target company. Business owners should examine the financial statements from the past few years, analyze tax filings, and assess revenue streams. Key elements will include profitability, cash flow, and existing debts. Additionally, evaluating customer concentration helps determine if the company relies too much on a small group of clients, which could be risky in the long run. Further, it is not uncommon for buyers to not only review the financial statements prepared by the seller, but to conduct the buyer’s own Quality of Earnings report to verify that the financial picture of the target company is accurate.

2. Legal Due Diligence

Legal due diligence involves reviewing contracts, intellectual property rights, and any potential legal issues the target company may face, which oftentimes vary based upon the industry that the target company operates in.

Common inquiries include verifying whether any pending litigation exists, ensuring that all contracts are properly assignable to the buyer (or in the case of a stock deal, that the sale will not trigger a default or require consents from counterparties), determining the extent to which the target’s assets are encumbered, whether employees have been properly classified, and various other inquiries.

Additionally, understanding relevant market terms and local laws and regulations in your location, whether it be locally in Cincinnati, Ohio or Covington, Kentucky, or elsewhere, ensures compliance with local laws, regulations, and market terms.

3. Operational Due Diligence

This phase focuses on evaluating the operational efficiency of the target company. Buyers should examine (if applicable) the company’s supply chain, technological infrastructure, and day-to-day operations. Further, the buyer must understand how the target company will fit into its platform. Analyzing how the target company’s processes work helps determine how well both companies can integrate. Reviewing employee dynamics, management structures, and scalability will support smooth post-merger integration.

Comprehensive Legal Support for M&A Success  

Thorough due diligence is foundational to any merger or business acquisition, offering valuable insights into potential risks and opportunities. By carefully evaluating financials, legal structures, operational systems, and cultural compatibility, buyers and sellers alike can make informed decisions that help ensure a smooth transaction.

For expert legal guidance and tailored support throughout your business acquisition, whether as a buyer or as a seller, turn to Strauss Troy. Our business and corporate team, deeply embedded in the Greater Cincinnati community, is committed to helping you navigate the complexities of due diligence and ensure a seamless transaction, in addition to drafting and negotiating the eventual definitive agreements for your transaction. Reach out to us today to discuss how we can assist in achieving your business goals.

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