Due Diligence in M&A transactions has changed. You need to understand how and why.

Due diligence is one of those terms that every business person is familiar with but doesn’t actually understand what it means. The term originated on Wall Street, with investment bankers engaged in the underwriting of initial public offerings (IPOs) of companies. The SEC essentially said that underwriters and other investment professionals had an affirmative defense against charges of making false or misleading statements in a disclosure document (i.e., prospectus) if such party had used “due diligence” in undertaking a reasonable investigation of the company and its financial statements.

From those humble beginnings, “Due Diligence” (not capitalized to show its importance) has become a key stage of financing and M&A transactions alike. In the M&A world, Due Diligence typically refers to investigations by the buyer (or investor) during the time between signing of the nonbinding letter of intent (LOI) and signing of the definitive purchase or merger agreement.

The challenge for privately-held technology companies, many of which have little or no experience dealing with outside investors, is that Due Diligence cannot make a deal, but it can definitely break a deal. As the old sell-side saying goes, “nothing good ever happens during Due Diligence.” And this is where folks’ wisdom about Due Diligence departs from the actual practice of Due Diligence in current deals. People who had some passing connection to an M&A deal “back in the day” often think Due Diligence consists of:

  • Lawyers reviewing musty corporate documents and checking things off checklists.
  • Accountants asking technical questions about bookkeeping or financial statements.
  • Buyer HR personnel looking at the Employee Handbook.

Variations on these tasks do still take place in deals and do occasionally raise major issues related to the capitalization table (i.e., how was stock issued and to whom?)  or the financial statements (usually related to cash vs. accrual accounting-related impacts on revenue recognition).

The real action in Due Diligence, however, has moved totally beyond this. The areas that companies get tripped on these days far more frequently revolve around:

  • SaaS metrics (MRR, ARR, Logo Churn, Revenue Churn, Net Churn)
  • Marketing metrics (CAC, LTV, Conversion rates by channel, Marketing funnel analysis, In-bound vs. Out-bound lead generation, SEO performance, etc.)

If you don’t know what these metrics mean, much less have current (strong) data at your fingertips, Due Diligence may get very uncomfortable.

  • Sales pipeline analysis, including the methodology by which opportunities get entered, scored, sized and weighted.

Don’t assume the buyer is just going to take your methodology on faith. We’ve seen the largest and most sophisticated buyers start to ask for a complete data dump of all the CRM data so they can run their own pipeline analysis.

  • Technology due diligence, which has mushroomed into a whole cottage industry of specialized outside consultants and reports on specific areas, including cybersecurity threat assessment, open source, disaster recovery, scalability analyses, code quality, engineering processes (including looking at your configuration management and bug tracking tools), architecture evaluations and assessment of the talent on your engineering teams.

Sellers used to think they could put their CTO or VP Engineering in a room with the buyer for a couple of hours, show some slides, answer a few questions, and call it good. Those days are over. If you know your software cannot stand up to close scrutiny, don’t kid yourself that you’re going to sneak by during due diligence. It’s going to come up and result in one of two things: either the deal falls apart completely, or the buyer substantially retrades the price due to the need to rebuild or refactor the code line.

  • Customer due diligence. Buyers are increasingly insisting on talking to some or all of the major customers during this process.

This obviously raises huge issues for sellers, because you are exposing your (biggest) customers to your ongoing M&A process without any assurance that the deal is going to close. At the same time, resisting customer interviews just raises additional red flags for the buyer, who assumes that the only reason for resistance is that you have something to hide. And don’t forget about the customers themselves, who not infrequently take these conversations as an invitation to renegotiate those hard-won commercial terms that you spend the previous 6 months negotiating.

These are just some of the tough questions you will encounter during due diligence.  More often than not, you will find that there are no easy answers to them and you can quickly find yourself in very rough waters. This is not the time for anyone to be learning on the job, including you as CEO.

In short, Due Diligence is no longer a document review game played by lawyers and accountants. Modern Due Diligence is a complicated game of 3D chess involving sales pipelines, revenue forecasts, product roadmaps, and ship dates, cybersecurity audits, organizational matrices, and customer interviews.  In order to play that game effectively, you need to know the rules.  That’s where an experienced advisor comes into play.  Don’t let your deal die in Due Diligence. If you have questions, give us a call.