The Art of M&A® / Due Diligence: How Extensive Should Due Diligence Be?
An excerpt from The Art of M&A Due Diligence, Second Edition: Navigating Critical Steps and Uncovering Crucial Data by Alexandra Reed Lajoux and Charles M. Elson
How far a buyer wishes to go in the due diligence process depends in part on how much time the buyer has and how much money it has to investigate the company it wishes to buy.
This will depend to some extent on the status of the company in the community, the number of years it has been in business, whether it has been audited by a major firm for some years, whether executive turnover is low, and any other factors that help to establish the basic stability of the firm, such as long-term customer retention. If a broker is involved in the transaction, the broker may wish to require some basic level of acquirer due diligence.
In fact, it is not unusual for brokers to include a contractual requirement that the purchaser undertake due diligence.15 Furthermore, due diligence can vary depending on the type of company.
The due diligence work required for the acquisition of a large, diversified, global company in a highly regulated industry is obviously far more extensive than the work involved for a small, single-product, domestic firm in a relatively unregulated sector. Also, it makes a great difference whether a firm is publicly or privately held, as discussed later.
Also, the type of transaction can limit the due diligence effort, since stock purchases trigger more due diligence responsibilities than do asset purchases.
- In any sale of stock, no matter how it is accounted for, the resulting entity will bear all the liabilities of both parties to the transactions, so the level of due diligence obviously has to be as extensive as possible.
- In sales of assets, by contrast, the structure of the transaction can make a significant difference. In general (with some exceptions), when a company sells or otherwise transfers all its assets to another company via acquisition, the successor is not liable for the debts and legal liabilities of the predecessor unless it expressly assumes them.
In classic asset sales, therefore, the due diligence effort need not include a study of debts and legal liability exposure.
On the other hand, acquirers that are used to the protections of securities laws should realize that these laws do not apply to any transaction that is structured as an asset sale. Note also that if the asset sale is structured as a merger, then the acquirer does assume debts and legal liabilities unless the seller expressly retains them.
Asset sales that are structured as mergers are rare, but they can and do occur. For example, there may be a sale of multiple assets (in which some of the assets of a business are purchased separately from the stock of the company that owns the rest of the assets), followed by a merger of the seller and the buyer. This hybrid form of transaction puts debts and legal liabilities squarely in the hands of the acquirer, unless they are expressly assumed by the seller.
Source of financing is another factor that can influence the intensity of due diligence.
In acquisitions that are financed through equity, all parties are interested in uncovering problems early, because post-deal problems that could or should have been uncovered can be very expensive to solve, and can result in lawsuits against all parties involved.
Risk disclosure is cheap. Defending litigation is not.
As one due diligence expert states, "Risk disclosure is cheap. Defending litigation is not."16 So it is useful for a company that is conducting due diligence to continually ask itself (as well as those interviewed during the due diligence process) what could possibly go wrong, and to disclose all material risks that have any likelihood at all of occurring.
We emphasize the term material, because it is crucial to due diligence – and a staple of U.S. disclosure rules. Public companies must disclose “material” contracts, debt, litigation, and risks in their 10-Ks, 10-Qs, registration statements, and proxy statements filed with the Securities and Exchange Commission (SEC), and the SEC’s Regulation Fair Disclosure requires prompt public disclosure of “material” information. 17
In a word, material means “important,” and the point of due diligence is to identify potential risks that could be important later on.
In the aftermath of Sarbanes-Oxley, the due diligence lexicon gained more conceptual clarity in the important area of internal controls. The SEC defined “material weakness” and a “significant deficiency.”
- Material weakness in internal controls is “a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis.”18
- By contrast, a significant deficiency in internal controls is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the registrant’s financial reporting. 19
The judiciary has provided helpful guidance on what is and is not material information. Consider the cases cited in the U.S. Supreme Court’s finding in Nacchio v. United States of America (2009), which threw out the criminal conviction of Joseph Nacchio, the former CEO of Quest. 20
Over time, a number of quantitative benchmarks for materiality have evolved – “more than 5 percent,” “more than $1 million,” and so forth. Many of these are contained in U.S. securities and tax laws themselves. (Consider the 5 percent ownership disclosure triggers of Section 13B and the $1 million pay cap for compensation deductions under Section 162(m) of the tax code.)
Setting numerical benchmarks is helpful, and such benchmarks usefully appear in due diligence documents. But these thresholds, while useful, may not be enough. According to the August 1999 Staff Accounting Memorandum 99 (SAM 99) of the SEC, materiality is not merely a matter of percentages or amounts. Rather, it is a highly relative term. It refers to a level that would be considered significant by the average prudent investor. 21
Learn more about diligence and risk topics like this at our two upcoming in-person training events:
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The Art of M&A® for Due Diligence Leaders / In-Person / Boston, MA / Sep 2023 - September 12-14, 2023
The Art of M&A® for Integration Leaders / In-Person / San Diego, CA / Oct 2023 - October 11-13, 2023
Lajoux, Alexandra Reed and Elson, Charles M. “How extensive should due diligence be?” The Art of M&A Due Diligence: Navigating Critical Steps and Uncovering Crucial Data. United States of America: McGraw Hill, 2011. Pp. 8-11. Print.