The Two Stages of Diligence
Here’s a quick summary from both sides: Mergers & Acquisitions.
There are two stages in diligence: initial diligence, the purpose of which is to determine whether to make an offer and to set the price and terms for that offer; and full diligence.
A buyer has one major goal in doing full diligence on the seller. The purpose of full diligence is to confirm the assumptions, stated and unstated, that underlie the offer that was made. Thus, each assumption that is not confirmed yields one of three responses: either the price changes, the terms change, or the deal is killed. (Assumptions that are confirmed have no effect on the deal; if your assumption doesn’t affect one of those things, then it wasn’t really an assumption supporting your offer.)
From the seller’s side, diligence on the buyer has more possible reasons, all depending on the deal. A seller may want to confirm the buyer’s ability to finance the deal, its history of post-merger integration and operations, its willingness to support higher earn-outs, or its culture and workplace environment. At the same time, seller diligence of a buyer will often be relatively light in comparison. Where would that change? In a deal that looks more like a merger of equals, where the seller is taking stock as consideration, the seller board has to form an opinion about whether the buyer’s stock is worth what the seller thinks it is.
Why Do Diligence At All?
Recently, someone asked about a pending deal “Do we really need to do due diligence?” The buyer is eager to get the deal done - they want to be on the other side. That’s a great mindset: long transactions cost more money and bring more external risks. Time kills all deals.
Stages of Diligence
First Stage: Initial Diligence
There’s an initial stage, which is different for every company. It’s the set of questions and types of information that the prospective buyer wants and needs to make an initial offer on a term sheet or letter of intent. Each buyer needs different things for different kinds of deals. The important information can be financials, projections, technology, customers, or employees. Here’s a short-form diligence checklist that a typical buyer might use.
The LOI or Term Sheet
After the buyer gets that information and reviews it, it generally proposes a term sheet or letter of intent proposing the genral terms of the deal. That non-binding offer is always subject to further due diligence.
Second Stage: Full Diligence
This second stage of due dligence is what most people think of when they talk about due diligence. It’s a more formal process than the first stage that typically revolves around a due diligence checklist.
The buyer’s lawyers traditionally provide a comprehensive checklist. A typical DD checklist will contain many sections, covering all of the company’s operations and is intended to uncover every significant piece of information.
What’s the purpose of this whole second phase, especially when the buyer has already made the decision to buy the company and proposed a deal?
It’s the same thing as doing an inspection after you’ve put in an offer on a house: you want to be sure that what you’re buying is worth what you’ve offered.
The second stage of due diligence is designed to uncover facts that either confirm or change your assumptions about (1) what’s true and (2) what might happen. So, facts, and risks/opportunities.
What Do I Do with Due Diligence?
Each piece of information you uncover will lead to one of four possible outcomes:
- no change (e.g., you confirm from the tax returns the historical financials the target provided to you)
- a change in terms
A very common fact pattern is when there is either outstanding litigation or an identifiable litigation risk, such as multistate sales tax or employee classification. The buyer will often change the terms to shift those known risks to the buyer, by increasing the amount of escrow, excluding those risks from the exclusive remedy of the escrow.
A second common fact pattern is when the target’s projected EBITDA, on which a multiple was based, look less realistic after diligence. In those cases, a buyer may shift some of the purchase price into an earnout to bridge the gap between the buyer’s price and the seller’s. This change in terms avoids a fixed change in price by shifting the risk of performance to the target.
- a change in price (example: a target had lower collections of its invoices than its cash-basis financials indicated. With only an 80% collections rate, the projections for the business shifted, leading to a lower offer from the buyer. This is also a common result of “normalizing” a target’s EBITDA.)
- killing the deal
Example: We had a client who’d offered to buy a small company. During due diligence, it became clear that the target didn’t have any meaningful contracts with its customers. It had relationships, but the buyer realized that it couldn’t rely on any contracted revenue for the next month, let alone any longer period. They killed the deal 2 days after learning this.
So, no, you don’t have to do due diligence, but you almost certainly should. As a director or officer, you’re quite likely violating your fiduciary duty of due care by doing none.
From a risk perspective, the kind of transaction you’re doing could lead to bigger losses than just the purchase price. There are some kinds of risks that are potentially larger than the value of the company: environmental; product liability; long-running wage/hour/classification problems. Other kinds of problems can quickly diminish the value of a target: IP issues; certain executive compensation problems; PR problems; internal ownership disputes; customer consent to assignment of contracts.)
Here’s the thing: you can’t know whether those things are actually there until you look. You can ask a seller and you can take their answer as the answer without looking at underlying documents, but even that’s a different risk than not asking the questions first.
Is There Another Path?
So is there an alternative position? Sort of, and I’ll give you a real example.
The alternative position is to still do first-stage diligence and make it clear to the seller that you’re going to rely on that information in the deal.
You send out your term sheet, and then you draft deal documents with a typical set of statements of fact (traditionally called representations and warranties), with the risk of falsehood of any of those items falling on the target. This is all standard. The difference is that you’re assuming these things: (1) that nothing you’d find would cause you not to do the deal at any price, and (2) that nothing you’d find would cause a change in terms or price that you can’t recover under the agreement.
Here’s a real-life scenario about an entire industry. When I was working in SIlicon Valley, it was common for venture funds to get “full” due diligence from companies in the course of a financing. I would read each of those documents and make sure there weren’t any dealbreakers in the pile. But eventually, that practice died out. Now, I can’t remember the last time that a VC requested diligence materials from an early stage company, or even from a later-stage company in a small deal. Investors have essentially determined that under their business model, doing a deal quickly with lower transaction costs is often a good tradeoff for the potential risks to them. If you take the position that ⅓ of all venture investments (and 60% of angel investments) go to $0, then it makes a bit more sense.
And similar trends are showing up in more traditional M&A deals. With asset purchases becoming far more common even for $50–100m deals, buyers are less concerned with unknown liabilities, as compared with 20 years ago when even small deals like that were typically mergers. (With a merger, the buyer takes on all the liabilities, known and unknown, of the target.) An acqui-hire is another good example of the kind of deal where limited diligence is necessary because most of the risks that process looks for just don’t apply to the post-deal world.
So that’s the counterargument. But that’s not an inconsistent position, really: it’s more like a special case where for an investor for the kind of deals it’s doing, it's worthwhile trade-off. And that brings you back to the first stage of diligence. If you can learn what you need in that step, and don’t have to worry about other risks, then you’re in good shape. But that’s usually not the case.
We primarily do diligence to mitigate risks in advance of closing. No one wants to be on the receiving end of a nasty surprise, and most folks would rather avoid those deals than get the “wonderful” option of suing the other side.
There’s another pro-level reason to do full due diligence in an acquisition, but we’ll save that for another post on deal execution.