The use of technology in due diligence has never been more important than it is now. The increased use of virtual data rooms and video conferencing services have facilitated the process to some extent but carrying out of the due diligence in a remote world really presents new challenges that were not relevant before Covid-19.
Many of these technology tools will remain a part of the process into the future, as deal participants move away from in-person meetings, visits and tours. Sellers start playing a critical role in making the remote due diligence efficient, including a shift to the digital collection of business documentation, contracts and financial data. Having the resources and skills to collaborate on-line is critical.
As we enter 2022, it is no longer business as usual. Most dealmakers are skeptical that in-person meetings will go away or be less important but we should be aware that things will not go back to the way it was before and we will have the new “normal”. The new “normal” for M&A transaction processes will probably involve a host of considerations, issues and deal terms that were not relevant before Covid-19. For buyers, due diligence will be more important than ever before.
Naturally, transactions that undergo a due diligence process offer higher chances of success. Due diligence contributes to making informed decisions by enhancing the quality of information available to decision makers.
Why due diligence matters
Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions.
There are several reasons why due diligence is conducted:
- to confirm and verify information that was brought up during the deal or investment process
- to identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
- to obtain information that would be useful in valuing the deal
- to make sure that the deal or investment opportunity complies with the investment or deal criteria
What are the problems in remote due diligence
The main problems is poor communication, incomplete information and careless approach.
1. Poor communication
It’s all too easy for the various teams in due diligence (operations, finance, legal, etc.) to work in silos without ever touching base with the other teams. It is absolutely vital for the information to be exchanged and discussed by various team members on a regular basis. Traditionally, in-person meetings and site visits were very effective tools in understanding the business and discovering facts. Relying on virtual data rooms and the lack of any possibility to talk to human beings during the process increases the risk of missing something really important.
But this is just one communication shortcoming that causes the failure of due diligence. There’s also the issue of communicating properly with the other side of the transaction, and providing transparency to everyone involved in the process. The deal participants need to find ways to communicate well in the virtual deal room allowing them to gain insight into how every step of due diligence is progressing.
2. Incomplete information
Incomplete information has been a common challenge of due diligence and it does not necessarily mean that the seller is being opaque. It could be a case of bad record keeping or simply an inability to access the information that the due diligence team is requesting. Sometimes it is a part of the sellers’ tactics, and at other times it may be an attempt to hide problems. Lawyers must be tough on this point because collecting all documents is of paramount importance. Lawyers must be sure that they have comprehensive information about the target company and so they can fully analyse the situation from a legal and accounting point of view. There is no "one size fits all" solution and lawyers must adopt a very flexible approach, especially in a remote world.
Because the valuation analysis is much more difficult due to the effects of the pandemic, buyers and sellers should turn to other forms of contingent consideration in the form of earnouts and other adjustments to purchase price. Buyers should learn early in the due diligence process that an earnout mechanism is a viable way to reduce risk while still allowing sellers to obtain what they perceive to be full purchase price value if the future performance of the business is strong and in line with pre-pandemic results.
3. Careless approach
The main goal of the due diligence process is to prevent surprises after the deal is done. There is a tendency for a careless due diligence among executives who know each other well. Executives who know each other well are more likely to rely on the representations and warranties given by the seller. The lawyers must be tough on this point because nothing can be assumed. The on-line cooperation should be based on strict rules and careless approach should be avoided.
One of the challenges of due diligence is knowing how to divide work between in-house due diligence team and external team of professionals. A regular accountant, for example, is unlikely to be able to provide the kind of analysis required for a deep-drive into the target firm’s financials. Buyers should be honest about their capabilities, as a lack of expertise in any part of due diligence can prove to be highly expensive further down the line.
Importance of due diligence
Due diligence is important both for the buyer and the seller.
For the buyer: it allows the buyer to feel more comfortable that his expectations regarding the transaction are correct. In M&A, purchasing a business without doing due diligence substantially increases the risk to the buyer.
For the seller: due diligence is conducted to provide the buyer with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.