by Tom Allen
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Get a comprehensive overview of how you should approach M&A due diligence and where to focus your efforts.
With such high stakes, there is no room for cutting corners, rushing, or skipping over questions during due diligence. Underpinning this is the need to have a customized due diligence checklist for your M&A deal. From both the acquirer’s and seller’s perspectives, a due diligence checklist provides much-needed structure, ensures that informed decisions are made, increases confidence in the deal, reduces risk and uncertainty and builds trust between parties.
Put simply, an M&A due diligence checklist provides an organized, systematic, and proven way to analyze a Target company. Using a checklist enables due diligence teams to learn about critical areas of a target company such as revenue streams, assets, liabilities, contracts, strengths, weaknesses, risks & opportunities and people. Such information helps a due diligence team build a detailed picture of every aspect of a target – therefore reducing the likelihood of surprises post-close.
It’s important to acknowledge that even the most thorough checklist is only as strong as the team running the due diligence process. A due diligence checklist cannot make up for lack of expertise, a rushed schedule, poor communication or project management issues – so be sure these areas are given due attention to increase the odds of a successful due diligence process.
Every M&A transaction is unique, requiring a customized due diligence checklist. Accordingly, we urge you never to use a stock M&A due diligence checklist downloaded from the internet.
Read the Midaxo Guide to Due Diligence for M&A due diligence best practices and guidance on how to use a due diligence checklist effectively during the due diligence process.
What to Include in Your M&A Due Diligence Checklist
It’s equally important to include both hard and soft due diligence factors within an M&A due diligence checklist. Hard due diligence centres around areas including operations, finance, technology, contracts, legal, etc. Soft due diligence includes gaining an understanding of people and the culture of the target and how this will – or will not – fit with that of the acquirer.
It’s impossible to overstate the importance of not overlooking people, culture, and future expectations during due diligence. Indeed, deal success depends on much more than customer contracts, EBITDA margins or what an Excel model says.
We recommend you include at least the following critical areas in your due diligence checklist. And remember to customize your checklist as required by the specifics of the target company, its related industry vertical and the nature of the proposed transaction.
Financial Due Diligence
The objective of financial due diligence is to provide the acquirer with a detailed and comprehensive view of the drivers of the target’s past and forecast business performance – along with a deep dive into any potential financial issues that should be further addressed pre-transaction and corrected post-transaction. Detailed financial due diligence will provide valuable information to support the proposed transaction – or perhaps identify critical issues that could save an acquirer from doing the wrong deal.
Example areas to include within a financial due diligence checklist:
- Balance sheet
- Profit and loss
- Cash flow
- Scheduled projects and contracts
- Quality of earnings (contracted, recurring, and one-time)
- The validity of future financial projections
- Quality of management reporting
- Tax issues
- Pension schemes
- Schedule of expenses – covering COGs, administrative and any exceptional items
A financial due diligence checklist should be customized to the nature of the target company’s products and services. For instance, a SaaS company with recurring revenue streams will require analysis – and therefore, due diligence items/questions – not relevant to a large manufacturing company.
Commercial Due Diligence
Commercial due diligence considers the market in which a target company sits and may include, for example, analysis of top customers, an assessment of competitors and a detailed analysis of assumptions underpinning the future business plan. Commercial due diligence should cover a review of a target’s current operations, historical and forecast performance from the perspective of markets, customers, competitors, high-level finances and its internal capabilities.
Example areas to include within a commercial due diligence checklist:
- Market structure, size and conditions specific to the sector
- Sector-specific legislation
- Any geographic specifics – such as economic/political instability
- Competitor analysis, market share, and positioning
- Product/service offering and future roadmap
- Barriers to entry
- Customer and supplier feedback
- Customer relationships/satisfaction, net promoter score and product/service quality levels
- Business plan viability, forecast success rate and known obstacles
Operational Due Diligence
Operational due diligence covers a broad category of analysis and review with a focus mostly on non-financial matters. A deal team should not just defensively approach operational due diligence from the perspective of risk reduction. Indeed, as well as mitigating risk, the goal of operational due diligence is to highlight areas for improvement, which can translate into increased productivity and profitability for the acquirer and the capturing of cost and/or revenue synergies. After operational due diligence, the due diligence team should understand the costs and benefits of any potential areas of improvement and how they may impact on value creation within post-merger integration – and therefore, support the underlying deal rationale.
Example areas to include within an operational due diligence checklist:
- Legal entity structure
- Real estate footprint
- Internal controls
- Key management and senior staff review
- Staffing levels and requirements
- Supply chain management
- Insurance and risk assessment
- IT & systems (see below)
Notably, many areas of operational due diligence will cross-over with other functional workstreams – for instance, while legal entities should be understood from an operational standpoint, the legal due diligence workstream should understand the legal ramifications of a target’s legal entity structure.
Legal Due Diligence
The legal due diligence process entails an investigation of any legal risks associated with the rights and obligations of a target. Legal due diligence includes the following benefits:
- Enables a full assessment of the possible legal risks related to the corporate status, assets, contracts, securities, intellectual property and employment of personnel of the target;
- Supports detailed analysis of existing employment conditions to help define the HR legal impact of the proposed transaction and assist an acquirer in anticipating possible burdens to any post-deal employment conditions;
- Ensures that complex corporate legal documentation is appropriately drafted within all relevant legal documentation – such as the SPA.
Example areas to include within a legal due diligence checklist:
- Legal entities and ownership structure
- Asset and property ownership
- Employment matters
- Intellectual property
- Corporate governance
- Customer/supplier disputes and any pending litigation
- Adherence to regulations (including a history of any breaches)
- Existing contracts such as with customers and suppliers
- Insurance status (including claims history)
- Litigation (past and ongoing)
- Licenses & Permits
- Industry regulation compliance
Human Resources (HR) Due Diligence
Human resources due diligence covers both hard and soft areas of due diligence. Admittedly, soft due diligence factors are challenging to quantify in a checklist. Therefore, impress upon the due diligence team the importance of getting to know the target and understanding its culture, levels of employee job satisfaction, key employees, and how these areas might factor into the integration plan.
Example areas to include within an HR due diligence checklist:
- Organizational chart and structure
- Compliance with employment laws
- Employee contracts
- Employment-related liabilities, such as redundancies and social taxes
- Face-to-face interviews with key management and staff members
- A review of the organizational culture/cultural diagnostic
Environmental Due Diligence
Environmental due diligence serves an essential role in terms of evaluating and managing potential liabilities, satisfying corporate fiduciary responsibilities and developing information required to meet corporate disclosure requirements under financial reporting and accounting rules. In framing and scoping environmental due diligence, additional “drivers” may be identified in applicable industry or commercial standards for environmental assessments, state standards for environmental due diligence, and various federal and state audit laws and policies.
As with other areas of due diligence, every target company will require a customized environmental due diligence checklist – depending on the nature of operations and related industry vertical.
Example areas to include within an environmental due diligence checklist:
- Any environmental investigations, litigation, or fines
- Environmental risk factors including Target location and surrounding area
- Details on hazardous substance controls, disposal, and management
- Ecological studies and assessment risks
- Details on any underground storage tanks and off-site disposal areas
- Environmental permits and licenses
IT & Systems
IT & systems due diligence should paint a clear picture of how technology helps a target run its operations. It should also reveal any “deal breakers” that could cause the acquirer to abort the transaction or to seek a price reduction (for instance, due to significant capital expenditure being required to upgrade IT systems).
IT & systems due diligence is becoming increasingly important as technology becomes a more significant component of growth and scale in many companies. At a fundamental level, IT can “make or break” a company. For instance, products, services, customers, staff, e-commence, databases and servers are central to the business operations of many companies and all reliant on a well-functioning IT environment.
Example areas to include within an IT & Systems due diligence checklist:
- Software and hardware – including current condition and planned capital expenditure
- Networks and servers
- Approach to security and disaster recovery
- IT operating budget
- Maintenance and support (e.g. in-house or outsourced)
- Intellectual property
- Ability to scale via IT & systems
- Ability to integrate IT & systems
A Word on Virtual Data Rooms
When developing and working from a due diligence checklist, it’s essential not to overlook the many ways in which a virtual data room (VDR) can expedite the due diligence process and make it more efficient. One of the biggest challenges of due diligence is having the right tools and software to enable effective team communication, simplified project management, M&A process guidance and support, and real-time reporting. These challenges, while preventable, can easily overshadow the due diligence process, resulting in mistakes, missed information and bottlenecks.
Be sure your chosen virtual data room has robust security features, supports the easy import of due diligence checklists (e.g. from Word or Excel files), quick upload of files via drag & drop or bulk upload and has detailed permission settings to let you control who can view, print or download documents obtained from a target company.
Read our Guide to Due Diligence for expert insight into how to overcome M&A challenges with due diligence best practices and processes.
- A due diligence checklist provides an organized, systematic, and proven way to analyze a target company in relation to a proposed M&A transaction.
- Every deal is different, so ensure you scope/customize your due diligence checklist to fit with the target company, its related industry vertical and the nature of the proposed transaction;
- It’s about people, too – so don’t overlook the softer areas of due diligence and be sure to consider the human side of the deal;
- A due diligence checklist cannot make up for a lag in expertise, a rushed schedule, poor communication or project management issues – so be sure these areas are given due attention to increase the odds of a successful due diligence process.