Importance of conducting comprehensive M&A Due Diligence – Part 1

M&A due diligence

In this blog, we shall discuss the importance of conducting a comprehensive M&A due diligence by the acquirer during a M&A transaction.
M&A Due Diligence becomes very important in private company acquisitions because the seller is not subjected to scrutiny by the public markets.Hence before committing to the transaction, the buyer should know what it is buying, obligations it is assuming, nature and extent of seller contingent liabilities, issues in contracts, litigation issues, IP risks and much more.
The buyer needs to conduct careful due diligence with respect to investigating seller financial statements, data breach and Cybersecurity issues, IP issues, employment laws followed and any liability related to employee sexual harassment.
A detailed due diligence is necessary to identify risks in seller business and negotiate how to mitigate the risks to successfully consummate the sale of the company.
This post comes in two parts.The final part will be covered tomorrow.

Financial M&A Due Diligence

The buyer will be evaluating the past financial statements of the seller, its track record, related financial metrics and reasonableness of the target financial projections of its future performance.
Important topics that needs to be covered would include:

• Evaluate target financial performance and its health by analyzing the last 3 years annual, quarterly and monthly financial statements.
• Is the seller financial statements audited?
• Does financial statements cover the current and contingent liabilities?
• Does the seller financial reporting have strict internal controls?
• Identify the revenues and margin trends for past 3 yrs – whether it is growing or declining?
• Is the seller assumptions on its future financial projections reasonable?
• What normalized working capital would be required to run the target business?
• How is the Working capital peg determined?
• Seller investments in R&D, CAPEX and whether it is sufficient?
• Condition of seller tangible assets
• Seller outstanding debt, duration of the debt, repayment terms and conditions along with interest rates and payments.
• Is the seller recognizing revenues as per accounting rules/principles?
• Ageing of accounts Receivable, any reserve kept for doubtful accounts and outstanding receivables issues?
• What does the Quality of earnings report say?
• Review capital and operating budgets to check whether any of these expenditures are deferred.
• Calculation of EBITDA and adjusted EBITDA
• Can the seller cover its regular financial expenses along with transaction expenses between the time of due diligence and when the deal is closed?
• Review auditor and counsel comments on the seller business
• Does seller have Net Operating Losses and how much buyer can leverage it post closing?
• Is the seller business cyclical? What is the seasonality in revenues and Working capital requirements that it experience?

IP M&A Due Diligence

Most of the acquisition are done primarily to get access to the seller superior IP capability. Hence due diligence is important to validate the seller capabilities.
Hence some of the key points to focus on from the buyer end is:

• Total patents (domestic and foreign) submitted, registered and pending from the seller
• Has seller taken steps to protect its IP by including confidentiality and invention assignment agreements with employees and consultants?Does the employees have any right over the IP?
• No of trademarks/copyrights registered by the seller?
• Does seller business depend on the proprietary IP and whether it has taken enough measures to protect this IP
• Has the seller infringed/infringing on any of third party IP rights and vice versa?
• Is the seller involved currently in any IP litigation?
• Technology licenses seller has to run the business and whether these licenses can be transferred to the buyer post acquisition
• Has the seller granted any exclusive rights of its licenses to third parties?
• Does the seller use any Open source software for its business?
• Does the seller share the source code of its IP to others?
• Is the seller a party to any source or object code escrow agreements?
• Is the seller subjected to indemnification provisions as result of IP breaches?
• Any encumbrances/liens on seller IP?
• Quality of seller software to check if it has defects and bugs.
• Does the seller have the right IT infrastructure for existing and future needs ?

Customer and Sales M&A Due Diligence

The acquirer needs to evaluate the target customer base, its relationships with customer and the current sales pipeline.
Some of the important areas to evaluate would be:

• Top 20 customers and the revenue breakdown by these customers
• Any customer concentration issues and risks observed?
• Change of control issues and whether the customers are objecting to the proposed deal?
• CSAT rating and the customer satisfaction towards the seller services. Often customer calls would be appropriate to solicit feedback
• Any warranty issues with current/former customers?
• Does the seller face any penalties or claims towards its customers?
• What is the customer and revenue backlog?
• How are the salespeople compensated and any incentives need to be provided to retain them post closing?

Strategic fit of Transaction

For a strategic buyer, it is not only concerned with the future standalone performance of the seller but at the same time how the target business can also improve the overall business performance of the acquirer.This case can only to Private Equity buyer where the target business is aligned with its one or more portfolio companies.
Some of the areas for strategic fit to be evaluated during the due diligence is:

• Does the buyer and seller already have a strategic relationship in the past?
• Does the seller provide complementary services or talented key resources that the buyer does not have?
• How will the integration happen and what will be the time and cost of the integration?
• What are the cost savings and revenue additions as a consequence of this transaction and will the transaction be accretive/dilutive to the acquirer earnings?

Material contracts in M&A due diligence

The buyer also needs to review the material contracts of the seller which is a very cumbersome process.
Some of the categories of contracts that requires review are:

• Guaranties, Loans, Equipment leases and Credit agreements
• Customers and suppliers contracts
• Partnership agreements, JV and other operating agreements
• Past acquisition agreements
• Indemnification and settlement agreements
• Employment agreements
• Real estate leases, Purchase agreements and Power of Attorney
• Approvals from third parties due to change in control

Employee / Management issues in M&A due diligence

Evaluating the quality of the seller management and its employee base is essential to a successful due diligence.
Important points to review are:

• Seller Org structure and bio of its leadership
• Any disputes, sexual harassment claims whether past or current
• Employment and Subcontracting agreements
• Salaries, Bonuses and Non cash compensation of the leadership team and key employees for the last 3 fiscal years
• Summaries of employees benefits, pension copies, retirement plans and deferred compensation
• Compliance to IRS Section 409a in case of ESOPS incentives and IRS Section 280g for golden parachute agreements
• Employment manuals and policies
• Involvement of key employees in Civil or Criminal proceedings
• Plans related to severance, leave policies, relocation assistance, education and tuition payments
• Compliance with employment laws including wages, hours, immigration, employment discrimination and rules on disability
• Incentive bonuses provided for retention of key employees
• Extent of layoffs along with severance costs as a result of this transaction and whether buyer/seller will bear these costs
• Accrued but unpaid bonuses along with deferred compensation agreements
• Historical attrition rates, % of voluntary and involuntary attritions

Litigation and Legal issues in M&A Due Diligence

The buyer needs to evaluate all the litigation issues both past and pending along with arbitration settlements
The review needs to cover

• Pending litigations and settled litigation with relevant petitions and orders
• Matters in arbitration and mediation
• Insurance and other material claims against the seller

Tax M&A Due Diligence

Tax due diligence is primarily done to evaluate the historical tax liabilities of the seller and amount of tax that can be carryforwarded to the benefit of the buyer.
The review will include:

• Sales and tax returns filed at local, state and at country level
• Any notices provided by the local, state and country tax agencies with regards to failing to file taxes
• Transfer pricing agreements
• Net Operating losses and how the buyer can take advantage of it post the change in control
• Any potential sales and income tax liabilities
• Any exemptions provided and whether it can be extended
• Allocation of acquisition price issues
• Compliance to Withholding tax

Anti-trust and other regulatory issues in M&A due diligence

Due to the recent trade war between US and china along with increase in scrutiny by the Regulators, it is necessary for the buyer to assess the antitrust /regulatory implications on the potential deal

• When the buyer and sellers are competitors, then the seller can impose limitations on access to confidential data.In that case, the buyer can use clean rooms to facilitate the exchange of sensitive information.
• Analyzing the scope of any antitrust issues
• If the seller operates in a regulated industry, then the buyer need to understand the issues involved in pursuing and obtaining the approval
• Addressing issues in order to prepare of HSR – Hart Scott Rodino filing
• Increased consolidation trends might impact the likelihood and speed of obtaining antitrust approvals
• Considering US sanction laws and prohibition of trade with embargoed countries

The final part of the remaining areas of Due diligence will be covered tomorrow