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What’s the point of due diligence?

by on May 13, 2013

Due DiligenceEveryone knows you have to do due diligence in the M&A process, if you’re buying or selling a company.  But what does that mean, what’s the point?  The easy, and wrong, answer is to find the problems in the company you’re looking at.  This will only tell you if you should NOT do a deal.  But that perspective, of looking for problems, will not tell you if you SHOULD do a deal.

I’m not saying you shouldn’t look for problems.  In fact, it’s crucial that you do, particularly in the financial and legal areas.  Financial and legal due diligence are focused on determining the potential value of a deal and concern buying the company “at the right price”.

What I am saying is that the due diligence needs to do more than look for problems.  It also needs to focus on the combination itself.  It’s called “Strategic Due Diligence”.  Strategic due diligence explores whether the potential of the combination — however enticing — is realistic. It tests the strategic rationale behind a proposed transaction with two broad questions:

  1. Is the deal commercially attractive?
  2. Are we capable of realizing the targeted value?

The first question requires external inquiry; the second demands an internal focus. Each question partially informs the other, reinforcing an line of questioning that thoroughly aligns the wisdom of the proposed deal.

Strategic Due Diligence turns the focus into the following:

  1. Compliance Risks:
    • What are the internal controls and reporting procedures?
    • What is the maturity of existing compliance efforts?
    • Timing and reporting deadlines?
    • Complexity and materiality of target company compliance efforts?
    • Fundamental issue: Can we achieve our compliance requirements?
  2. Strategic Integration Risks:
    • What are we buying and why?
    • What type of integration strategy is needed to get to the essential value drivers?
    • What level of integration is necessary to achieve the desired synergies?
    • What common integration “deal killers” must we avoid?
    • Fundamental issue: Can we blend the companies as needed?
  3. Cultural Analysis:
    • Define the cultural analysis model for both companies
    • Document essential differences and similarities affecting integration
    • Are these manageable through cultural integration?
    • Fundamental issue: Can we overcome our differences?
  4. Human Capital Risk:
    • Quantify items that effect sales price or integration
    • Provide input into the negotiation process
    • Facilitate immediate transition to integration process
    • Fundamental issue: Can we align and motivate our people?

Notice that with Strategic Due Diligence the focus is more forward and takes into consideration integration issues very early in the process.  Above all, strategic due diligence ensures that no two transactions are treated the same way; each deal has its own value drivers.   Strategic due diligence counterbalances the danger of going through the motions of due diligence and looking for the same issues every time.  Although some standard due diligence best practices should be a part of the  strategic due diligence, companies must tailor their process to the issues and potential integration challenges of each specific deal.

Strategic due diligence thus adds an important deal-screening filter.  CEOs must be convinced not only that the potential deal value justifies the significant investment being made, but also that the business is truly capable of realizing this value. Indeed, a sober strategic due diligence evaluation should help set the purchase price. The buyer should demand a price that should correspond to the level of integration risk uncovered.

There is no such thing as a risk-free transaction because there will always be unanticipated issues or factors that can effect a deal.  However, if you value companies using a defined, systematic approach of strategic due diligence, you can vastly improve your chances of success.

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