What Actually Happens During Diligence: The Process Between Letters of Intent and Closing

In the world of mergers and acquisitions (M&A), the diligence period is a critical phase that occurs between the signing of a letter of intent (LOI) and the closing of a deal. This period typically spans the last two to three months of a transaction process, which usually takes about six months from start to finish. The diligence phase is essential for both the buyer and the seller to confirm the details of the transaction and ensure that both parties are satisfied before finalizing the deal. In this article, I’ll walk you through the key components of the diligence process, focusing on financial, legal, and industry-specific diligence.

Understanding the Diligence Period

The diligence period serves as a confirmatory exercise where the acquiring party thoroughly examines the business they intend to buy. This examination helps them verify that the information provided during the negotiation phase is accurate and that there are no hidden surprises that could affect the transaction’s value or feasibility. It’s also an opportunity for the seller to ensure that the buyer is a suitable partner and that the transaction terms are favorable.

Financial Diligence

Financial diligence is one of the most crucial aspects of the diligence process. It involves a deep dive into the financial records of the business to verify their accuracy and identify any potential issues.

Reviewing Financial Records

During financial diligence, the buyer typically requests a comprehensive set of financial documents, including monthly profit and loss statements (P&Ls), balance sheets, and breakdowns of customer concentration. The goal is to ensure that the financial information aligns with what was presented during the initial negotiation and that there are no discrepancies.

For example, a quality of earnings report may be generated to analyze the company’s revenue streams, expenses, and profitability. This report helps the buyer understand the sustainability of the company’s earnings and spot any anomalies or inconsistencies.

Addressing Potential Issues

If any issues or inconsistencies are found during the financial review, it’s important to address them early in the diligence process. These issues could affect the purchase price or the terms of the transaction. Therefore, being forthright and transparent about any potential problems can help prevent delays and build trust between the parties.

Legal Diligence

Contract Review and Compliance

Legal diligence runs parallel to financial diligence and involves a thorough review of the company’s legal standing. This phase ensures that the business is compliant with all relevant regulations and is free of significant legal risks.

The buyer will review all major contracts, including those with customers, suppliers, and employees, to ensure they are valid and favorable. Compliance with industry regulations and standards is also scrutinized to avoid any legal liabilities post-acquisition.

Litigation and HR Considerations

Another critical aspect of legal diligence is identifying any ongoing or potential litigation that could pose a risk to the business. Human resources considerations, such as employment agreements, benefits, and potential labor disputes, are also examined to ensure there are no hidden liabilities.

Industry-Specific Diligence

Industry-specific diligence is tailored to the particular sector in which the business operates. This phase involves specialized reviews that can vary significantly depending on the nature of the business.

Technical and Operational Assessments

For example, in a software company, the diligence process might include a detailed review of the codebase to identify any technical debt or potential issues. In a manufacturing company, the buyer might inspect the machinery and equipment to ensure they are in good working order and properly maintained.

Site Visits and Inventory Checks

Site visits and inventory checks are also common in industry-specific diligence. For instance, a distribution company may require an on-site inspection to assess the physical inventory and operational efficiency. Similarly, a consulting firm might undergo a review of its client contracts and project pipeline to ensure ongoing revenue stability.

Sequencing and Logical Flow

The diligence process follows a logical progression, starting with financial diligence, followed by legal diligence, and finally industry-specific diligence. This sequence ensures that the most critical and potentially deal-breaking issues are addressed first, allowing the transaction to proceed smoothly if these hurdles are cleared.

Conclusion

The diligence period is a vital phase in the M&A process, involving a thorough examination of the target business from multiple angles. Financial diligence ensures that the numbers add up and there are no hidden financial issues. Legal diligence confirms that the business is compliant with regulations and free of significant legal risks. Industry-specific diligence tailors the review to the unique aspects of the business, ensuring all operational and technical factors are in good order.

By understanding what happens during the diligence period, both buyers and sellers can better prepare for this critical phase, ensuring a smoother transaction and a successful outcome.