Has Diligence for M&A Deals Gone Too Far?

iStock/Worawee Meepian

Investment Banking teams are focusing significant time collecting wide swaths of a client’s company data in the early deal phase prior to marketing the firm in a sell-process. The main reason for this action – anticipation of receiving the buyer’s third-party advisor diligence requests!

For 2023, sellers of their business should anticipate closing their transaction within eight to 10 months of hiring their M&A advisor. This is literally three quarters into the future with global headwinds and competitive variables that will challenge every assumption.

As much as we look forward, the vast majority of M&A due diligence is focused on the past.
Third-party advisors hired by the prospective buyer begin their efforts in earnest once the Exclusivity Phase of the sell-side process commences. As a quick reminder, the sell-side process may have reached the six to seven months milestone prior Exclusivity.

As a general rule, the M&A bankers believe this Exclusivity Phase should be completed in 45-60 days – the result is a closed transaction! It is in the best interest of the client to have all their data and anticipated data ready to be reviewed. Maintaining momentum in the final innings of the game is essential.

Unfortunately, a good percentage of clients tell the M&A banking team, “I want to wait for the buyer to ask specific questions before I get my team involved with pulling the data.” Can you hear the air rushing out of the balloon?

For deals expected to close in 2023, we are seeing more final diligence requests covering the main COVID years of 2020 and 2021. Oh boy!

Important Diligence Questions Prior to a Deal Close

We may have to read this diligence question a few times.

  1. For the employee “analysis of effective hourly rates” analysis provided, “There appear to be differences between the years as regards employees listed on the direct labour analysis provided (PDFs for 2019, 2020, 2021), with some staff names “re-appearing” having not been paid in the previous year’s data. Please would you look at/present the data from the start period January 2019 through to September 1, 2022, tracking by name to ensure that we can work out who was an existing employee, who joined and who left? For joiners and leavers, the date that they started/left is also needed to ensure that headcount numbers/movements reconcile for each year and year-to-year.

Most readers of this article would correctly think that either the human resources department, benefits administrator, payroll provider or the owner should readily answer the question. How certain are we that everyone knows exactly what they did with data, over three years old, from 2019?
The M&A banking team is more concerned that the client’s home-grown spreadsheet was not
properly reviewed and qualified prior to handing over to the prospective buyer’s
team. Yes, the prospective buyer’s diligence gets into the weeds.

Could this possibility have a negative impact on the deal?

Threats To the Purchase Agreement

In parallel with the Exclusivity Phase and Final Diligence, the draft Purchase Agreement begins to work its way through the legal firms on both sides of the deal. Gamesmanship is taken to a higher artform.
We continue to see more blanket statements being included in the drafts of the Purchase Agreements. Your M&A banking team will work with you to identify these items, but the owner should pull in their legal team prior to the Exclusivity Phase – preparation is critical:

  • All former and current employees of Seller have executed written Contracts with seller that assign to seller all rights to any inventions, improvements, discoveries or information relating to the business of seller.
  • With respect to each Trade Secret, the documentation relating to such Trade Secret is current, accurate and sufficient in detail and content to identify and explain it and to allow its full and proper use without reliance on the knowledge or memory of any individual.
  • Seller has taken all reasonable precautions to protect the secrecy, confidentiality and value of all Trade Secrets (including the enforcement by seller of a policy requiring each employee or contractor to execute proprietary information and confidentiality agreements substantially in seller’s standard form, and all current and former employees and contractors of Seller have executed such an agreement).
  • Seller has good title to and an absolute right to use the Trade Secrets. The Trade Secrets are not part of the public knowledge or literature and, to seller’s knowledge, have not been used, divulged or appropriated either for the benefit of any person (other than seller) or to the detriment of seller. No Trade Secret is subject to any adverse claim or has been challenged or threatened in any way or infringes any intellectual property right of any other Person.

While many of these threats may be outside of your control, their impact can be mitigated (or even deflected) with proper strategic planning.

Closing the M&A Transaction

Congratulations on having survived the nine-month process to sell your business. Your seasoned and experienced M&A team has helped you and your management team avoid the major pitfalls that can occur along those 270+ days!!

For deals expected to close in 2023, we are seeing more final diligence requests covering the main
COVID years of 2020 and 2021. Oh boy!

Finding, collecting, analyzing and storing your historical company data is an essential function as you enter a sell-side process. Embrace the challenge!

Before finishing this article, I thought you might be encouraged by the words of one buyer’s third-party advisor:

“I have to point out that as our draft report goes through both internal reviews and eventually to our client, there may be additional requests/questions arising.”