Preparing for Due Diligence in M&A Transactions

David H. Crean, Ph.D., Managing Partner at Cardiff Advisory, addresses the necessary preparation by the Management team with due diligence and relevant information pertaining to the M&A process of selling a company.

Recently, I met with a CEO and the Board of a life sciences company regarding their interest in starting a sales process for their company. Unfortunately, I did not take on the client engagement at the time because they were unprepared with their requisite financials and, equally important, all of their relevant company and technology documents. I did offer them specific guidance on how to prepare for this critical aspect of a sales process and hopefully will represent and market them to strategic companies or private equity firms in 2023.

My guidance is neither rocket science nor meant to denigrate the intelligence of the reader, but merely key considerations as a reminder to sellers, especially teams that do not have extensive experience in selling a company, of the impact of diligence on a process. A similar process can also be used by investors for investment considerations.

Have We Learned Anything Where Others Have Failed?

Nearly one year ago, Elizabeth Holmes, the founder, and CEO of the now-defunct Silicon Valley blood-testing company Theranos was found guilty of conspiracy to commit fraud against investors and three charges of wire fraud. Much has been written about Theranos and Holmes in the years since the company ceased operating in 2018. From a legal perspective, one of the most fascinating aspects of the case has been the flaws in (and sometimes lack of) due diligence carried out by investors.

It is interesting to note that traditional biotech investors largely stayed clear of Theranos. Thankfully, the Theranos case is unusual as most companies seeking investment or being bought are not engaged in fraud. However, it stands as an important reminder to potential investors and buyers of the importance of conducting a well-scoped and thorough due diligence exercise before closing the deal. 

Get Your House in Order

My legal colleagues have always stressed the saying, "preparation, preparation, preparation." It is what makes companies stand out from the crowd. Getting your company prepared for a sale is time-consuming but requisite to ensure a smooth process, avoid delays and increase the probability of transaction success. This process is coined due diligence and involves collecting or drafting the key business formation, organizational, operational, financial, and sale-related documents that an interested buyer will ask to examine prior to closing a deal. It is critical that the selling business begins organizing these documents prior to beginning the sales process.

Due diligence serves a number of purposes. It allows an investor in or an acquirer of a business to:1) Gather information about a target company; 2) Test assumptions about a company and its business and technology; 3) Check whether the proposed valuation is accurate; 4) Identify risks that may need to be covered in legal documentation (though warranties, indemnities, and post-closing obligations); and 5) Identify any potential deal breakers. 

Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial and non-financial information and to verify anything else that was brought up during a deal or investment process.

"Trust but verify."

Ronald Reagan, Former U.S. President

Sellers need to assess their risk and address potential problems ideally before placing their business on the market. In order to attract a quality buyer to your company, you must prepare for the due-diligence process well before you begin the sale process. This can take up to 6 months to 2 years depending on circumstances but I rarely will take on a client and initiate a sales process with a company that is unprepared for diligence. It represents too much risk for the sales process, as well as my time and effort.

Due diligence is conducted to provide the buyer with trust, or what will mitigate their risk ("caveat emptor"). Due diligence, however, also benefits the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is substantially different than what was initially thought to be the case. The process also is an indication of the quality of the buyer, their processes, and how they view the acquisition and ultimate integration of the seller's company into the buyer's.

Pre-acquisition due diligence is only the starting point. The data that is gleaned in pre-acquisition due diligence should serve as a baseline for ongoing monitoring of any company that is acquired in the post-acquisition phase. It is this coupling of pre-acquisition due diligence with the post-acquisition phase in a best practices compliance program that is another key lesson from Theranos.

Costs of Due Diligence

The costs of undergoing a due diligence process depend on the scope, complexity of the business, and duration of the effort. Associated costs are an easily justifiable expense compared to the risks associated with failing to conduct due diligence. Moreover, it should be an expense that is considered when evaluating earnings on an adjusted basis. Parties involved in the deal determine who bears the expense of due diligence. Buyers and sellers typically pay for their team of investment bankers, accountants, attorneys, and other consulting personnel.

Pre-due Diligence Preparation

Due diligence areas of interest

Create a due diligence structure and process similar to what a competent buyer would do. View your business through the lens of a buyer. A more thorough approach is preferable to a cursory approach.

Conducting due diligence 

I always recommend having an external third party conduct a pre-diligence audit. It is important to realize that the output from this exercise is not only valuable in identifying any shortcomings, but the output may also form the baseline of the due diligence that gets handed out to potential buyers at a later date. More work up front almost certainly means less work later. It is also important during this process that the results are staged on an internal server and ready for later use.

Develop strategy

For any opportunities or negatives that surface in pre-diligence, a concrete action plan should be made to exploit the opportunities or to create positive messaging for the problem areas or action plans to address any weaknesses.

Go / No-Go decision

The strategy that emanates from the prior steps will determine and highlight valuation opportunities and challenges and the seller can decide if they should continue with the current exit strategy and the desired sales process.

Key Considerations

Protecting confidential information

Sharing confidential information about your business with a potential buyer or interested third party can be super stressful, especially if the other party competes in your swim lane. A Nondisclosure Agreement (NDA) should establish ground rules for what information will be shared and when (e.g., sensitive competitive information may be shared later on as the deal progresses). The NDA stipulates how information is to be used and may include restrictions on the solicitation of employees. It also outlines the processes and ongoing obligations in case a proposed business deal falls does not materialize.

Assembling the due diligence working group

The buyer will assemble a due diligence working group, usually comprised of people with different areas of expertise. So should the seller. It’s important that the team reviewing the deal understands the deal structure, economics, and business purpose. They need to ensure that everything is reviewed correctly by the right people in a timely manner. Lastly, I always recommend a point person and central coordinator to manage this process.

Buyer Requests

The buy side party nearly always will send the seller their wish list outlining which documents and information they would like to review. The seller is recommended to index their diligence documents and note the requested materials. M&A advisors and investment bankers leading the deal will typically use a document-sharing platform or virtual data room. There are many good platforms that are sold commercially as subscription-based models. I do not recommend "drop boxes" or similar file-sharing apps since the seller is not afforded great flexibility on forensics or printing/ sharing. Invest the money to use a quality system. It also sends a strong signal to the buyer that you are serious about the process. There's nothing more frustrating for a buyer than dealing with a poor-quality data room service or platform.

What Information Can You Expect to Be Reviewed?

Expect an extensive list of possible due diligence questions to be addressed by the seller for the buyer. Of note, I also request that the seller perform reciprocal diligence on the buyer to determine fit and appropriateness as a buyer. Diligence should not be one-way.

Typical due diligence areas and questions addressed, albeit not exhaustive, in an M&A transaction are noted in the presentation below, courtesy of Intralinks, a provider of a virtual data room platform. Certain industries (e.g., life sciences, biotechnology, and pharmaceutical companies) may require additional diligence in certain areas.

FINAL THOUGHTS

Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. When it comes to selling a business, there are generally three major factors that can prevent a deal from occurring after the letter of intent (LOI) stage, or materially change the terms of the deal. They are: 1) deterioration of business post-LOI and before the close; 2) complexity of terms and extended delays in finalizing the deal terms; and 3) negative surprises identified during the due diligence process.

Most of these problems can be reduced significantly by the seller preparing for due diligence beforehand. Surprises cause delays and can be deal killers. Delays take management attention away from running the business, and delays introduce complexities. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment and buying decisions. Be prepared early.

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Disclosure

David H. Crean, Ph.D., is Managing Partner for Cardiff Advisory LLC, an M&A investment banking strategic advisory firm focused on the Life Sciences and Healthcare sectors. This article is provided for informational purposes only and does not constitute an offer, invitation, or recommendation to buy, sell, subscribe for or issue any securities.

The principals of Cardiff Advisory LLC are registered representatives of BA Securities, LLC Member FINRA SIPC, located at Four Tower Bridge, 200 Barr Harbor Drive, Suite 400 W. Conshohocken, PA 19428. Cardiff Advisory LLC and BA Securities, LLC are unaffiliated entities. All investment banking services and securities are offered through BA Securities, LLC, Member FINRA SIPC.