A Primer on Preliminary Due Diligence in Mergers and Acquisitions
Conducting due diligence properly is the difference between a successful acquisition and a waste of time and resources
Not every potential target will turn out to be worth acquiring. We separate the process into several stages to ensure that even if things don’t work out, there’s a relatively low expenditure of time and effort, and the acquiring company’s reputation doesn’t take a hit from a failed deal
This is what preliminary due diligence is all about. Testing the water. Checking the essentials to find out if it’s worth pursuing the acquisition
I’m here to explain how it’s done, and what you need to watch out for
The Purpose of Preliminary Due Diligence
Long before you approach a potential acquisition target, you should already have a good idea of the company’s financial health, operational resources, and reputation. You should have a picture of the growth opportunities and potential risks you’ll inherit
Preliminary due diligence is a fact-finding mission that aims to paint this picture. I’m calling it a “rough” picture, but experienced acquisition entrepreneurs know better than to cut corners during this process
After all – once you’ve sent a LOI (Letter of Intent), you’ve committed countless hours of your time to exhaustive formal due diligence and negotiations. You’re indicating to your financial backers that you think a company is a good prospect, and committing your legal, financial, and HR teams to the process
That’s a big commitment if you can list everything you know about the target company on one side of A4
Preliminary due diligence is also referred to by several other terms, including:
- Pre-diligence
- Pre-LOI due diligence
- Desktop diligence
Pre-LOI vs. Formal Due Diligence
The two key differences between pre-LOI and formal due diligence are the resources the buyer commits to the process and the information available to the buyer.
Here’s an outline of how the methods differ
Pre-LOI
Pre-LOI checks often rely on publicly available information to help the acquisition entrepreneur understand if the target company is suitable
Third-party datasets are an invaluable resource, and you’ll seek out the company’s press releases, social channels, and relevant news stories to get a picture of how it operates
The acquisition entrepreneur will typically engage a small team to help with the Pre-LOI checks, or at least to double-check their findings. This may include:
- A legal expert
- A financial adviser
- An HR specialist
Depending on whether an IOI (Indication of Interest) is sent to the target company, pre-LOI checks can be further divided into pre-NDA and post-NDA due diligence
Pre-NDA
Any analysis you perform before reaching out to the target company is described as pre-NDA. This often relies on surface-level information, although third-party databases can be a really useful source if you want to do some digging
Post-NDA
You may send an IOI to the target company. This is less formal than an LOI, but will still require you to sign an NDA if the company is to provide you with key information about its financial, legal, and operational status
An IOI doesn’t guarantee exclusivity, but it does give you access to critical information that could help you make an informed decision. There’s also less reputational risk in backing out after sending an IOI than a LOI
Post-LOI
The due diligence conducted after sending a LOI is also covered by an NDA, but this is a much more exhaustive process. It’s generally referred to as formal due diligence, and you’ll enlist help from analysts to comb over every detail and work out an accurate valuation for the company
The assumption is that post-LOI due diligence won’t uncover anything that will destroy the deal – but may affect its terms
By contrast, preliminary due diligence is designed to uncover clear red flags and save you the hassle of beginning the formal process
Fact-Finding Before Making an Approach: Quick Guide
An acquisition entrepreneur should have the analytical skills to conduct due diligence with the help of their team
However, knowing how to investigate a business before you’ve approached it isn’t widely taught. Below are a few critical resources for your fact-finding campaign
Third-Party Databases
Certain M&A platforms let you view publicly available about a company – financial statements, recent news stories, reports, and more. These are among the most useful tools at your disposal before you make an approach
Some of the best platforms include:
- PitchBook
- Bloomberg Terminal
- AlphaSense
- S&P Capital IQ
- FactSet Research Management
Not all platforms have all companies listed, so it’s often worth using more than one. You’ll need these tools again and again, as they’re used during the earliest stages of investigating a target business, so I’d certainly recommend signing up
Press Releases & News
A company’s recent press releases can give you an idea of its current goals and direction. This is valuable information – it helps you understand whether the company aligns with your strategic goals, and can be an early indicator of whether you’re well-suited to work with this business
Recent news stories are also a goldmine, especially for potential legal issues. Few businesses’ dealings make major headlines, but local news sources often report if a nearby company has been in legal hot water
Socials
A business’s socials can tell you a few things during preliminary due diligence:
- How proactive the company is in promoting itself
- How the company views itself – its socials are its voice! This can help you understand if you’d be a good cultural fit
- What the company’s customers are saying about it
- How the company responds to customers with complaints or questions
Learning about the target company’s culture and relationships with its customers should absolutely be a part of your pre-diligence. It’s a goldmine of actionable data on what your target company does well, where it struggles, and what its customer base wants from it
Features of Preliminary Due Diligence
I’d advise consulting with at least one specialist in each of the following areas during preliminary due diligence
Even though it’s often referred to as “desktop diligence,” that doesn’t mean you can complete an effective review of a target company in just a few hours at your computer. Rather, it refers to the fact that you don’t yet have access to the company’s paperwork, so most of your fact-finding will be search-based
Financial
You’ll often be able to find a company’s financial statements on third-party databases (see above). If you come from a financial background, you’ll be able to make sense of these yourself – but I’d still recommend getting a second opinion
I’ll explain the risks of confirmation bias for the acquisition entrepreneur below. In the meantime, it’s well worth having a financial advisor look over the target company’s paperwork to get a second opinion on whether there’s potential there
Operational
It’s difficult to get the whole picture of a company’s assets at this stage. However, you may be able to find out information like:
- The number of employees
- The size of the company’s premises
- Certain fixed assets (based on the services outlined on the target company’s website)
- The company’s management structure – always look over its “About” page and cross-reference key staff on LinkedIn where possible! How long have they been there? What are their specializations?
Depending on the type of company you’re acquiring, you may need insight from different places
An HR consultant might have valuable advice based on the company’s personnel, structure, and socials. Meanwhile, an industry insider could help you size up a target company’s fixed assets if it operates in an asset-rich niche (e.g. manufacturing)
Legal
It’s absolutely worth getting a legal consultant on board from the very beginning. If the target company has faced legal issues in the recent past, that represents either a red flag or a significant drop in the company’s valuation. Your consultant will help you understand how serious the problem is
Just as important is knowing whether you’re looking at a company with potential legal risks. Will you be able to manage these? Will they impede your strategic goals?
Strategic
Every acquisition entrepreneur should build a list of trusted, knowledgeable M&A associates. Being able to reach out to someone who understands your strategic goals and can approach the potential deal with an impartial eye is such an advantage
When you find a potentially attractive business, you don’t want to shout it from the rooftops. But you should seek a second opinion. Explain your strategic goals to the closest members of your network and treasure honest feedback, even if it’s not what you want to hear
Preliminary Due Diligence and the LOI Exclusivity Window
Patience is a virtue for acquisition entrepreneurs, precisely because it’s not usually one of our strongest personality traits
Once you send an LOI, you’re afforded an “exclusivity window” under NDA. This gives you time to properly review the target company’s financial, legal, and operational information and work out a valuation. The company won’t respond to other approaches during this window
But sending an LOI is exactly as it sounds – it’s a statement of intent
Backing out because you hadn’t noticed something obvious is a really bad look. It makes you seem less than serious as an acquisition entrepreneur. Brokers really don’t like it when you do this, as you’ve wasted their time. This jeopardizes your future working relationship
When you think you’ve found a great prospect, you’re going to want to move as quickly as possible. But is it worth it, if that comes at the expense of proper pre-diligence?
Can You “Speed Up” Preliminary Due Diligence?
Kind of
My first recommendation would be to immediately get a team on the case, consisting of the experts outlined above. Having 4-5 people working together is far more efficient than trying to work at 4-5 times your normal speed
These consultants should be independent. By this, I mean that none of us are immune to confirmation bias – however dispassionate you think you are, you can always benefit from a frank second opinion
It’s natural to be enthusiastic about a potential new acquisition. This can lead you to minimize or dismiss potential issues in a bid to rush it through
Your team’s job is to speed up the process by stopping you from rushing.
You can also send an IOI to the target company. This may not give you an exclusivity window, but it may give you access to critical information that helps you make a decision
If you’re 50/50 on whether you’re ready to send a LOI, my advice would always be: don’t
50% is nowhere near confident enough to make an approach. If anything jeopardizes the deal after you’ve sent your LOI, it should be something that you couldn’t possibly have known before you made your approach
The “due” in “due diligence” means that it’s an obligation. It’s not optional. You can speed up the process by getting more hands on board, but you can’t rush to a conclusion
Summary
Like any fact-finding mission, preliminary due diligence is significantly easier when you have access to a wide range of resources
Like any type of analysis, it’s more effective when you have access to second opinions from industry experts
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