What is due diligence?
Think of due diligence as homework on the acquisition target before deciding whether to acquire. It describes the process of verification, investigation, or audit of a potential deal. That means if a business owner wants to sell their internet company to a buyer, the seller needs to let the buyer take a very close look at the business. The due diligence process helps buyers and sellers understand the nature of a deal and the risks involved. That way, all parties can make an informed decision.
Why is due diligence so important? It makes the buyer feel a lot more comfortable before signing the check, knowing they have validated all of their assumptions about the business. But going through due diligence can also be beneficial to the seller. Reviewing all of the different data points might reveal that the fair market value of the seller’s business is actually higher than previously assumed.
What does the process look like?
Before the buyer can pop the hood of the seller’s business and take a close look, usually two documents are exchanged and signed: a Letter Of Intent (LOI) and a Non-Disclosure Agreement (NDA). Sometimes the NDA is simply part of the LOI.
The LOI includes items such as description of the assets to be purchased, any assumed liabilities, the terms of the seller’s non-compete agreement, due diligence requirements and an exclusivity provision, also called a “no shop clause.” An LOI is non-binding.
The NDA is a legally binding contract that establishes a confidential relationship. The buyers and sellers signing the agreement agree that sensitive information they may obtain will not be made available to any others. This allows for the sharing of sensitive information without fear that it will end up in the hands of competitors or other unwanted third parties.
What to prepare and look out for during due diligence
Firstly, the buyer will take a closer look at the acquisition target itself, especially to understand why the business is being sold. Common questions can be:
- Why does the owner want to sell the company?
- Has the owner tried to sell the business before?
- What is the long-term strategy and outlook for the business?
- How is the company structured geographically?
Secondly, due diligence includes a financial audit. Important points of investigation can be:
- All mandatory financial statements
- Assessment of the financial health of the company
- Performance over time (e.g. have margins increased or decreased?)
- Are future growth projections reasonable and believable?
- Outstanding debt
Thirdly, the legal landscape. Important questions can be:
- Are there any pending, threatened, or settled litigations?
- Are there any governmental proceedings against the company?
Finally, the buyer will take a closer look at the quality of the business’ technology and intellectual property. Commonly asked questions are:
- What patents does the company have?
- What trademarks does the company have?
- What copyrighted products and materials does the company use or own?
- How are trade secrets preserved?
Moreover, the team and employees will be scrutinised. Oftentimes the following topics are given a closer look:
- Employee and management compensation and benefits
- Employee and management backgrounds
Of course, there are many more areas potential buyers might explore more in-depth, such as sales and marketing, the technology stack, environmental issues, the shareholder structure, the customer base and so on. As a seller, try and put yourself in the shoes of the potential buyer and anticipate which could be the most important areas of inquiry - and prepare the information in advance.
Further resources: Corporate Finance Institute, What is a Letter of Intent?, Non-Disclosure Agreement (NDA), Investopedia