Study: Due Diligence Guide for Merger and Acquisition

28 February 2018, Bachir El Nakib (CAMS) Senior Consultant Compliance Alert LLC 

Financial Institutions have often realized the importance and benefits of good due diligence and data quality. The fact is that most of these organizations struggle with imported-outsourced data quality issues. The costs associated with poor data quality to build a proper due diligence are not only ignored but budgeted into the overall category of the cost of doing business. However, a financial institution can eliminate these costs and insure proper regulatory compliance by instituting a data quality improvement program as a core component of its overall business intelligence strategy.

Scoping a Due Diligence Engagement

The first stage of a due diligence engagement should be to consider the scope of the work required. In doing so, consideration must be given to the significance of the proposed transaction in the eyes of the acquirer, the size of the Target relative to the acquirer and the degree of access to information expected to be granted by the Target. There is no prescribed format for what a due diligence engagement may encompass – rather, each engagement will be bespoke and tailored to the specific transaction and needs of the user.

Financial Due Diligence

Covering a review of historic financial results including the balance sheet, profit & loss and cash flows of the Target (including any subsidiary companies to be acquired) with the possibility of particular attention being given to significant projects/contracts, the quality of earnings (contracted and recurring or one-off in nature), how realistic future financial projections are, the strength of the balance sheet (including the composition of assets and liabilities), the quality of management reporting and any tax issues arising – such as historic compliance with mandatory (corporate and social taxes) and any other specific taxes.

Commercial Due Diligence

Commercial due diligence includes a review of various commercial factors and should result in a detailed assessment of the Target’s positioning within its sector. Areas in scope may include market structure, size and conditions specific to the sector; sector specific legislation (including that which may be implemented in the future); key competitor analysis, market share and positioning; barriers to entry; health of customer relationships/customer satisfaction and business plan achievability/limiting factors.

Operational Due Diligence

Operational due diligence gives attention to non-financial matters of a Target and highlights aspects of a transaction, which can foster improvements in productivity and profitability for the acquirer. These may encompass review and appraisal of systems and processes (including IT systems and the internal controls environment); review of the key management team and senior staff; staffing levels and other HR matters; insurances and risk assessment.

Legal Due Diligence

Legal due diligence is as important as financial and commercial due diligence in ensuring the success of a transaction and entails an investigation of any legal risks associated with the rights and obligations of the Target. Areas covered under the scope of an engagement typically include: Asset and property ownership; intellectual property (IP); loans; securities; employment; corporate governance; customer or supplier disputes and any pending litigation; incorporation, existence and ownership of the Target; existing contracts and adherence to regulations (including a history of any breaches).

Human Resources (HR) Due Diligence

The emphasis of due diligence into areas of human resources should be on compliance with employment laws; employee contracts; employment related liabilities (such as redundancy payments and social taxes).

Environmental Due Diligence

Environmental liabilities can be substantial and difficult to uncover – thus presenting the possibility for an acquirer to be subject to unforeseen costs, which can be disproportionate to the overall transaction size in a worst-case scenario.

Pricing the Engagement

When using external advisors to perform due diligence, it is important to define the scope of the work required in the letter of engagement, in order to be clear on the costs to be incurred and to specify what the deliverable will be – i.e. a summary “exceptions based” report, or a detailed document covering every aspect of the Target. A summary exceptions based report is usually advisable since it focuses on any key risks identified and is more reader-friendly.

When asking external advisors for engagement proposals it is important to provide as much detail as possible to those you are putting the due diligence engagement out to tender with (of course, being mindful of any confidentiality issues) in order for the advisors to put together a realistic and comprehensive quote. Any time sensitivities should also be communicated so these can be accounted for in proposals.

If possible, request a comprehensive service package (often covering financial, tax, legal, HR) since it is much easier to deal with one external advisor. In addition to using a single advisor, it is also common to appoint external advisors to cover the areas of financial and legal due diligence and to cover commercial, HR and operational due diligence in-house.

If working with external advisors it is important to ask for details of past deals/projects the advisors have worked on (ideally in the in the same sector as the Target). A strong understanding of the sector in which the Target is based will maximise the chance of the advisor(s) spotting key issues, price reducers or potential deal breakers.


As early as practically possible the acquirer should form and begin briefing the due diligence team. A team should consist of skilled financial and legal advisors (all preferably with M&A experience – ideally in the sector of the Target but not essential) as well as being subject matter experts in all key areas falling within the scope of the due diligence engagement.  

§   External advisors should be considered if the acquirer lacks any of the required expertise necessary for a successful transaction – for instance, lawyers, accountants, consultants and/or investment-bank. 

§  Due diligence checklists should be drafted to cover the areas in scope (typically financial, commercial, operational, legal, human resources and other such as regulatory and environmental). 

What is a Due Diligence Report?

The report is often sent as an internal memo to members of the executive team who are evaluating the transaction. Due diligence is a term most of us have heard somewhere at some point. But what does it actually mean and how does it play out in specific contexts?

#1 Corporate Records

  • State of incorporation and in good standing with the state
  • Capitalization and authorized and issued shares of stock and seller of each subsidiary
  • Articles of incorporation and bylaws
  • Copies of all correspondence with shareholders and obtain a shareholder list
  • Existence of any warrants, options, or other potentially dilutive securities 

#2 Financial information

  • Copies of financial statements for the past five years that have been audited, including all notes and management’s discussion and analysis
  • Copies of correspondence between management and auditors
  • List of federal and state jurisdictions where the seller has filed taxes for the past 5 years
  • Federal, state and local tax returns for the past 5 years
  • All board of directors’ presentations
  • All internally generated financial models and forecasts  

#3 Indebtedness

  • Investigate indebtedness or seller and subsidiaries, including loan agreements, notes, mortgages, and security agreements
  • Review correspondence with lenders demonstrating compliance with financial covenants
  • Order uniform commercial code searches with each subsidiary  

#4 Employment and Labor

  • List and biographies of officers, directors, and employees of a certain level
  • List of all employees, their job function, department, location and compensation
  • Documents detailed any profit sharing, pensions, deferred compensation, stock plans, and other non-salary compensation or benefits
  • Copies of all employee handbooks, codes of conducts, and policies
  • Copies of employment, consulting, termination, parachute and indemnity agreements
  • Pending litigation related to labor and employment law  

#5 Real Estate

  • Address and legal description for all real property
  • Copies of title issuance policies with respect to real property
  • Copies of all appraisals
  • Copies of all studies, site evaluations, and government filings and reports prepared by consultants  

#6 Agreements

  • All agreements entered into by the company and its subsidiaries
  • All real estate leases
  • All partnership or joint venture agreements
  • All marketing, sales, commission, distributor, franchise agreements
  • All brokerage or investment banker agreements
  • All customer or client agreements
  • All licenses and subscriptions
  • All material contracts not otherwise obtained from this list  

#7 Supplier and Customer Information

  • List of all material customers including dollar and volume of sales
  • List of all material suppliers including dollar and volume of purchases
  • Correspondence with customers or suppliers related to complains or disputes  

#8 Legal

  • Copies of each report or document filed with government agencies
  • Descriptions of all litigation, administrative proceeding, governmental investigations
  • Copies of all government licenses
  • Environmental liability assessments and environmental compliance audits

 Top 10 types of financial models

There are many different types of financial models.  In this guide, we will outline the top 10 most common models used in corporate finance by professionals: 

  1. Three Statement Model
  2. Discounted Cash Flow (DCF) Model
  3. Merger Model (M&A)
  4. Initial Public Offering (IPO) Model
  5. Leveraged Buyout (LBO) Model
  6. Sum of the Parts Model
  7. Consolidation Model
  8. Budget Model
  9. Forecasting Model
  10. Option Pricing Model

“Due diligence is an investigation or audit of a potential investment to confirm all facts, such as reviewing all financial records, plus anything else deemed material.”

The process involves many individuals, many conversations and many documents. It is non-linear and different for every company. We can’t provide you with a step-by-step graphic or anything too prescriptive. The questions and answers below are designed to equip you with intel about the process and with the right framework and attitude to tackle the process well – whether it’s happening now or something you’re looking forward to in a couple years.


1. Why is due diligence necessary?

Due diligence is open kimono for the buyer to learn as much about the company as possible. Buyers are seeking information that answers critical questions they have about what really matters. They should rely on their advisors and the good faith of the seller to point things out that they’re not thinking about or blind spots or things off-camera.


It’s a process of discernment.

“The main purposes behind due diligence are:

(1) verifying the information provided by the seller and

(2) uncovering any material information that the seller hasn’t provided, either intentionally or unintentionally.”

2. What documents are required for due diligence? What’s included in a due diligence checklist?

The items required for due diligence fall into five main categories and many sub-categories:


1. Financial and Accounting

a. General
b. Revenue
c. Operating Expenses & Other Income
d. Cash
e. Accounts Receivable
f. Inventory
g. AP and Accrued Expenses
h. Property and Equipment
i. Other Assets
j. Other Liabilities
k. Tax


2. Risk

a. Insurance


3. Human Resources

a. Employee Matters
b. Employee Benefits


4. Legal and Regulatory

a. Organizational Documents
b. Agreements
c. Intellectual Property
d. Real Property
e. Regulatory and Environmental Matters
f. Litigation

Feeling a bit overwhelmed by these lists?
Here’s a bit of stress relief – due diligence is driven by the conviction,
“If we don’t ask for it, we won’t get it”.

These lists are designed to be comprehensive. Not every item will be applicable to every business.
Don’t feel weird if many of the questions can be answered with “NA.”

As the seller, simply being aware of what is required gives you an impressive leg up on other business owners. Being able to promptly present cohesive documents when it’s time for due diligence saves time and money for everyone involved.

Nobody wants “an Easter egg hunt for information and documents delivered in 10 unmarked jumbled boxes with little input from management” (Venture Law Corp).

Keeping track of these organizational considerations is something you can and should be doing continually throughout your years as a business owner.


3. What does due diligence cost?

It depends.

In due diligence you are mostly paying for people’s time. The longer the process takes the more you will pay. A complex or unusual deal will cost more than a straightforward or standard deal.

You are paying for the hours and energy of your attorney, your accountant, your insurance broker, any of your professional advisors.

Sellers are also paying for their own time and the time of their employees working to prepare documents.

Each entity pays their own fees. Buyers pay for their advisory services and sellers pay for theirs.


4. Who is involved in due diligence?

Business ownership transfers happen with a group of people – the deal team.

The due diligence process is the deal team’s time for shine.

Outside of the buyer and seller (who obviously have a huge role to play), there are four main groups that make up the deal team:

  1. Insurance Broker
  2. Banker
  3. Accountant
  4. Attorney

Remember that these four groups will be represented on both sides of the table so at minimum you’ll have eight people (along with the buyer and seller) working on this process.

Each person is tasked with collecting, analyzing and evaluating specific parts included on the due diligence checklist. Where appropriate results need to be shared. So, each group has a distinct mandate but each group will also continually peak out of their lane a little because the process requires it.

Due diligence is not just a set of smart questions it’s verifying the viability of a major decision.

Beyond the four main groups above there are others interested in the decision as well. The buyer may have equity partners or an investment banker that will need to be considered. Don’t forget that spouses, family and friends will also have something to say about the information gathered throughout the process and the decisions that leads to.

5. How long does due diligence take?

We operate our process under the assumption that due diligence will take 60-90 days.

But, just like cost, the timing depends on the complexity of the business. If the business under examination is complex or esoteric, due diligence could extend to 120 days.

Buyers should trust but verify throughout the due diligence process.

One of the more sophisticated strategic acquirers we’ve worked with had a unique way of structuring their due diligence time line. This team broke the process up into three phases. Each phase led to a different and deeper level of discernment – mitigating the shock and potential paralysis caused by presenting a due diligence checklist in its entirely immediately.


6. When does due diligence start? When does it end?

Discernment and information gathering begins the minute you meet the other side of the table.

The formal process of due diligence begins after a Letter of Intent (LOI) has been signed by both parties. That is generally when the due diligence checklist is presented to both sides and the deal team is unleashed to collect, analyze and evaluate information.

Due diligence in private business transactions is different than due diligence for very large or public companies. With less structure and regulation, due diligence with private businesses will likely take longer and be more complex. We love the challenge! This guide will tackle due diligence from this unique perspective.


What’s a Due Diligence for Merger and Acquisition?

The formal due diligence process is complete when a Definitive Purchase Agreement has been signed by both sides. At that point, the buyer and seller are both satisfied with the amount and quality of information disclosed. Risk has been identified and minimized. The surprises have been taken care of and terms have been agreed to.

Example due diligence checklist items

  1. What is the bank’s current and historical involvement with the corporate issuer and its management?
  2. Has the lead underwriter/agent reviewed the issuer’s business and operations with the issuer’s management?
  3. Does management have a written business plan, corporate strategy and/or internal budget/forecast? If so, were such materials reviewed by the lead underwriter/agent in the context of this transaction? {optional for bought deals}
  4. What are the key factors for issuer/ industry success?
  5. Has the lead underwriter/agent reviewed the issuer’s current and historical financials? Were any material issues identified that have not been disclosed adequately?
  6. Has the lead underwriter compared the issuer’s actual financial performance against the issuer’s plan? {optional for bought deals}
  7. Has the lead underwriter/agent been provided with any forecast financial information?
  8. Review of TTM financials and monthly performance plan.
  9. Has the lead underwriter/agent conducted any site visits? {optional for bought deals}
  10.  Has the lead underwriter/agent consulted with any experts (e.g. Independent engineers, environmental consultants, tax accountants, forensic investigators, etc.) In connection with the offering?
  11. Has the lead underwriter completed any customer / supplier checks to determine relationships/ reputation? {optional for bought deals}
  12. How well does the bank know the issuer’s management team? Does the bank have any reason to be concerned about the competence or integrity of the issuer’s management?
  13. How much time has the bank spent with the issuer’s management in connection with the offering and/or any historical transactions? Has the issuer’s CEO/ CFO been involved in preparing the issuer’s public disclosure documents?
  14. In the case of an issuer that is already a public company, is the lead underwriter aware of any concerns about the issuer’s disclosure history?
  15. Has the issuer’s management and external advisors been fully cooperative with the underwriters and underwriters’ counsel during the due diligence process?
  16. Has the bank equity research department been involved in the due diligence process? Does the bank equity research department cover the issuer’s securities? Is the bank equity research department familiar with the issuer’s business generally, as a result of covering some of its competitors or otherwise? {optional for bought deals}
  17. Has the issuer’s independent auditor been involved in the due diligence process and/or participated in drafting any of the issuer’s public disclosure documents? Has the issuer instructed the auditor to deliver an auditor’s long form comfort letter to the underwriters/placement agents in connection with the offering? Does the bank have any reason to be concerned about such auditor’s competence?
  18. Has the lead underwriter/placement agent reviewed the auditors’ management letters for the preceding three years?
  19. Has the issuer changed any of its accounting policies in the preceding three years where such changes were material to the issuer’s financial statements? Has the issuer indicated any intention to change its current accounting policies during the next 12 months?
  20. Has the lead underwriter/placement agent reviewed the issuer’s management information systems and technology infrastructure?
  21. Who are acting as external legal counsel (name of firm and lawyers principally involved) for the underwriters/placement agents? Has external counsel completed a customary legal due diligence review of the issuer? Has the lead underwriter/placement agent indicated any dissatisfaction with the degree of counsel’s participation in the prospectus process, the extent of counsel’s access to the issuer’s management, litigation records, material contracts and minute books or the results of counsel’s due diligence investigation? Does the bank have any reason to be concerned about such counsel’s competence?
  22. Who are acting as external legal counsel (name of firm and lawyers principally involved)’ for the issuer? What is such counsel’s history with issuer? Has such counsel been involved in the due diligence process and in drafting the offering memorandum or prospectus used to complete the offering? Does the bank have any reason to be concerned about such counsel’s competence?
  23. Who are the issuer’s directors? Does the bank have any reason to be concerned about the competence or integrity of the issuer’s management?
  24. In the case of an initial public offering or a secondary offering by a major shareholder, has the major shareholder(s) been involved in the due diligence process and/or participated in drafting the offering memorandum or prospectus used to complete the offering? Is the major shareholder providing any representations, warranties or indemnities in connection with the offering? {optional for bought deals}
  25. Has the lead underwriter/placement agent and/or external counsel reviewed the issuer’s material contracts to confirm that they are disclosed sufficiently and accurately?
  26. Does the issuer’s success depend significantly on any proprietary intellectual property including relevant patents, trademarks or websites? If so, has counsel to the underwriters/placement agents reviewed the adequacy of the issuer’s legal protections and any related risk disclosures?
  27. Apart from the offering, what are the issuer’s other sources of material financing?
  28. Has the financial modelling and valuation work been vetted by multiple parties?
  29. Does the issuer have any significant environmental issues, liability or exposure?


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