When conducting due diligence for M&A, it is important to rely on both historical information as well as information relating to the future. The process normally begins when the buyer and seller have determined the basic terms of the deal. This usually includes the purchase price and other significant terms.
Due diligence should be much more that reviewing the target’s historical results of operations. The procedures should include reviewing the customer list, background checks, legal matters and management. The buyer should concentrate on the future prospects of the target and (the risks that affect those prospects) affect what risk there are that can affect those prospects. Due diligence is controlling the risk to the purchaser and can be best demonstrated by the following examples.
While performing the due diligence for the buy side of a transaction, we noted that the target company had acquired $5 million dollars of computer equipment even though all of the computer processing was being contracted out to another company. We determined that the target had capitalized operating expenses during the year in order to meet regulatory capital requirements.
In another case we performed an analysis of the accounts payables and other liabilities and determined that the buyer would need to provide additional cash in the next six months that exceeded the original cash investment.
The importance of reviewing the current and future operations verses historical results can be illustrated by the acquisition during the 1990’s of a modem manufacturer. The buyer’s due diligence consisted of thoroughly analyzing the December 31 annual results but failed to include a review of the first quarter of the next year. During the first quarter new technology came onto the market that wiped out the sales of the target company. The buyer did not discover this until after the acquisition was closed on March 31.