What is due diligence?
If you’re running a company and you are doing something that either requires an investment or attracts the attention of competitors or other parties interested in buying a part or all of your stock or your business then sooner or later you’ll run into the words ‘Due Diligence’.
The response to those words ranges from indifference to fear or even hostility, mostly based in a lack of understanding or familiarity with the process. In this (small) guide I’ll try to clarify the process and the reasons why it exists, give an overview of the process and a bunch of tips on how to successfully navigate a due diligence.
Due diligence is a part of a larger process called ’M&A (merger and acquisition)‘, typically indicating that one party wishes to acquire all or part of another, either as part of an investment or to achieve some other strategical goal.
The ‘seller’ or ‘target’ (the party that is either selling their stock, emitting new stock or selling some assets) and the ‘buyer’ (or ‘acquirer’) have agreed on the basics of a deal to be made, typically a terms sheet has been signed outlining what gets sold by who to who. A valuation has been agreed upon and everybody involved should have the feeling that they fully understand the terms of the deal.
The seller has presumably informed the buyer about anything that is material to the deal (the seller has fulfilled their ‘duty to disclose’), and has done so in writing.
What’s left then is for the buyer to ascertain that the seller has indeed disclosed everything that is important. This matters because sellers are not always aware of everything they should have disclosed (either through negligence or simply a lack of knowledge or experience), not all sellers are equally trustworthy and because the buyer usually has a responsibility to others (for instance, in the case of a company that has shareholders itself, or in the case of an investment fund with multiple participants). Buyers also have the obligation to research the object of their interest (for liability reasons) to make sure that if there is a problem afterwards that they can show that they have done their best to ascertain the state of the target.
So due diligence is all about verification and risk assessment. The upshot of this is that if you want to successfully get through a due diligence (with the terms, conditions and valuation as agreed upon intact) that you’ll need to lay the groundwork for this well before the due diligence starts!
Surprises during the due diligence phase are almost always exclusively to the detriment of the seller, any skeletons falling out of cup-boards or figures that turn out to be lower than stated in the run-up to the due diligence will result in either a deal done at a lower valuation, with substantial changes to the terms and conditions or even a complete annulment.
It is generally understood that both parties carry their own costs until the final contracts are signed. If you get into the due diligence phase but the deal does not go through that reflects badly on the target, others will assume that stuff came to light during the due diligence that caused the deal to fail. For this reason alone it is good practice to keep the negotiations with potential acquirers very quiet.
Due diligence can be seen as a painful necessity, another way to look at it is that you’ll have a free audit of your whole operation (due diligence expenses (other than your time!) are on account of the acquirer) and you’ll come out of it knowing more about your business and the state that it is in than you went in. If you’re extremely good at running your company you’ll learn nothing at all, but in all the years that I’ve been doing this that has not happened even once (though we’ve come close a couple of times).
Typically, just the outsiders perspective alone is worth several points and will help to gain a level of insight that is difficult to achieve when you are running the company day-to-day.
Due diligence will take anywhere from a few days (for a small operation) to several weeks (for a much larger one, or one that is complicated). If you’re a start-up with a few months of history then due diligence will of course be much abbreviated, but if you’ve been operating for a couple of years you can expect to put in quite a bit of time, which is also a ‘cost’, so maximize your chances of getting a deal done and don’t go into a due diligence process unless you are sure that the other party is not just using it as a fishing expedition to gain knowledge about your operation.
Don’t do anything resembling due diligence before a terms sheet has been agreed upon and has been signed and make sure that the people doing the due diligence are bound by a solid NDA. (dd is a ‘one sided’ process, your business is pretty much laid bare). The harder you’ve negotiated during the run-up to due diligence the more you can expect the findings from the due diligence to be used to open up the terms.
During a due diligence you’ll likely be visited by a lawyer for the legal affairs, an accountant for the financial portion, and if you’re a technology company someone that looks at the tech side of things.
Normally I will look only at the technical portion of a business, but if I come across information that I think is of interest to the people doing the legal or the financial part of it then I’ll pass that on.
Due diligence can be very confrontational, especially when things go bad for the seller.
Fortunately these cases are pretty rare but occasionally it does happen that during the process you find that things are not as they were initially reported. The important thing to remember here is that the people doing due diligence are not your enemy. Yes they’re paid by ‘the other side’ but the most they can do is to verify that the information that you supplied is accurate and that there is no more information that is of importance. So the better you prepare during the run-up to due diligence the smoother the process will go. You are in the drivers seat here.
Transparency will help a lot in establishing trust, in the end the deal may be between two companies but the trust can only be built between people. If anything comes to light during due diligence that affects that trust in a negative way (or even breaks it completely) then the chances of actually getting the final contract signed diminish rapidly.
The typical format of a (technical) due diligence is that I’ll visit once to meet the team, tour the facilities, there will be presentation on the main product of the company and the technology behind it, there will be an information memorandum to study and usually a website.
Then I’ll go home and work for a couple of days on a list of items that I think are material to the business and I’ll formulate a list of questions around these items. (Some companies that do due diligence work with fixed scripts, I don’t think that’s the way to go so I’m a little slower but I think that customizing the process to the company is a must).
During the second visit I’ll typically interview CEO, COO and CTO (sometimes these are all rolled into one person, sometimes there are three or more individuals, possibly assisted by the people in their department), and I’ll make lots of notes. Then after working out all those notes there may be follow up questions about things that were possibly not clear or in cases where different people gave different answers. Bit by bit I’ll formulate a representation of the state of the business, how knowledgeable the people are that run it, whether or not there are ‘single points of failure’ in terms of tech or people and so on.
If during this phase substantial issues are uncovered the process will suffer delays, for instance, either to verify the exact state or impact of things or to figure out what the cause of the gap in understanding was. Now, in my experience, if this happens the chances of a deal going through unaltered or at all diminish very rapidly. If a third - or even fourth - round of questions is required that is indication that either information is not being given out freely (‘pulling teeth’) or that there is an active attempt to obfuscate. Regardless of which of the two is the cause this will put a pretty hefty damper on the process because both of those imply a deeper lying trust issue.
At the end of the second week or so I should be able to tell my employer (say a VC) what I think of the way the business is being run and the state it is in. If there were ‘surprises’ then these have been added to the data room (and they may cause re-negotiation with respect to terms). If there are major discoveries (bad!) that were not disclosed during the run-up to the due diligence there is a real chance that the deal will be off, this can be either because of the actual findings or because of a breach in trust, usually in situations like this a mix of both.
If there are smaller issues these will result in a list of recommendations, things to be taken care of either before or in the period immediately after the investment / acquisition.
All this is condensed into a report which gets passed to the customer and they’ll use that to guide them in their decision, back out of the deal, continue but with provisions or continue as agreed upon.
The closer the situation presented during the run-up to due diligence matches reality the bigger the chance that the deal will go through as agreed upon.
The key to a successful due diligence is surprisingly simple:
Know your business (from a legal, technical and financial point of view)
If there is bad news get it out of the way as soon as possible, well before the due diligence process starts
Be truthful and honest
don’t fall into the trap of ‘dressing up’ the company, it will come back to bite you during due diligence
Make sure that those that talk to the people doing due diligence know their stuff to avoid miscommunication
Take those to heart and you’ll be fine, the smaller the gap between reality and presentation the faster the due diligence will go and the bigger the chance the deal will go through unaltered.
I hope this was useful to you, and if it wasn’t useful to you today then I hope that you will at some point be in a position where it will be useful to you, because your business is so successful that suitors come calling :)
The next part is here: http://jacquesmattheij.com/Due+Diligence+survival+guide-part+II-Nuts+and+Bolts