What Buyers Are Testing During Due Diligence
A buyer does not conduct due diligence simply to collect documents. The process tests the assumptions supporting the proposed transaction. Before signing the Letter of Intent, the buyer develops expectations about the company’s earnings, operations, risks, and future opportunities. The buyer due diligence review determines whether the available evidence supports those expectations.
Validate the Financial Performance
Financial diligence examines the quality and sustainability of the company’s historical earnings. Buyers typically review financial statements, tax returns, monthly results, working capital, debt, and capital expenditures. They may also examine customer profitability, margins, revenue recognition, and the normalizing adjustments.
As financial scrutiny increases, buyers compare information from different sources for consistency. Material discrepancies may affect normalized EBITDA, purchase price, working capital, or other transaction terms. A Quality of Earnings analysis may provide additional financial diligence, depending on the transaction.
Understand the Business Behind the Numbers
Financial performance represents only part of the buyer’s analysis. Commercial and operational diligence examines how the company generates revenue and whether that performance appears sustainable. Buyers may evaluate customers, suppliers, employees, management, competition, backlog, technology, facilities, and operating systems.
They may also test assumptions concerning growth opportunities and potential synergies. Through this examination, the buyer develops a clearer understanding of the risks and opportunities underlying future performance.
Identify Legal and Transaction Risks
Legal diligence examines the company’s contractual relationships, ownership, compliance, and potential liabilities. Transaction counsel may review customer agreements, leases, employment matters, intellectual property, litigation, licenses, and corporate records.
The findings may influence transaction structure, representations, warranties, indemnification provisions, and closing conditions. Tax, environmental, insurance, information technology, and other specialized reviews may also become necessary.
Investigate the Exceptions
A comprehensive checklist provides structure, but effective diligence requires more than completing a standard document request. Buyers should investigate unusual trends, inconsistencies, and potential risks specific to the company. When an issue surfaces, the buyer must determine whether it changes the original investment thesis. Some findings require explanation. Others may lead to additional diligence, revised terms, or a decision not to proceed.
Prepare for Buyer Scrutiny
An experienced M&A advisor should anticipate the buyer due diligence review before taking a company to market. The advisor can help organize information, identify likely questions, and coordinate responses among the seller’s transaction team.
Preparation cannot eliminate legitimate business risks. However, it can prevent avoidable surprises from undermining buyer confidence after the LOI. Due diligence should confirm the transaction the parties negotiated. When it reveals a materially different business, the transaction may need to change.
