In a cycle of merger and acquisition, due diligence plays a very important role.

Comprehensive due diligence helps to understand whether a prospective M&A deal will
bring value in the future or wash out the value. The process of merger and acquisition consist
of four phases as follows –

 Phase 1 – Merger and Acquisition Strategy

 Phase 2 – Target Screening
 Phase 3 – Due Diligence
 Phase 4 – Integration Planning and Execution

Today our agenda is to analyze the process of due diligence phase in detail. The due diligence
process can differ from organization to organization, however, the basic framework remains
the same. Let’s understand the general step-by-step process -

*For ease of understanding we will assume that an analyst is conducting due diligence of
behalf of the buyer/ investor*

Due Diligence Process

Create a Hypothesis

The first step to starting a due diligence process is to create a hypothesis. A hypothesis is a
supposition for which further evidence is required. It is the starting point for further
investigation. To start the process of due diligence, the hypothesis can be an assumption such
as – “The valuation that the target company has submitted is correct”. Now the acquiring
company has to conduct due diligence to conclude whether this assumption is true or false.

Once the hypothesis is decided, an investigation is started in every area of the company. Let’s
look into it.

Determine Company Size

In the second step, the analyst needs a rough idea about the size of the company. A lot of
future analysis and decisions become easier if the analyst knows how big or small the
company is. If it is a public company, the size of the company can be determined by its
market capitalization. It may fall under either one of the three - large cap, medium cap or
small cap. If it is a private company equity capital is a good indicator of its size. It is also a
good time to determine the potential size of the company, i.e. in future say in 5, 10 or 20
years how big the company will be?

This will give the analyst a rough map as to what he is dealing with.

Study Sales and Profit Margins

It is very important to study the revenue and profit margins of the company. Historical study
of this data helps to identify the trend – whether the company is growing, stagnant or
shrinking. Thereafter the analyst finds answers to questions such as – If the company is
growing, what are its growth drivers? Are these sustainable? Can the merger bring any value
addition to the target company’s revenue and profit margins? This will give insights to test
the hypothesis.

Industry Trends and Competitor Analysis

Once the analyst understands the company, its size, and its profit model, it is time to
understand where the target company stands in the market. One must recognize the industry,
the sector and the segment that the target company operates in. Also, the analyst must
compare the target company’s data with its peer/ competitor date to understand if it is doing
better or worse than its competitors.

Management and Ownership

The previous three steps show how the target company from outside, now it’s time to take
look inside. The most important part of any company is its ownership and management. The
ownership or the owners make sure that the company is financially sound and doesn’t over-
leverage. On the other side, the management makes sure that the company is working
smoothly, efficiently and its internal culture is that of harmony. A company that doesn’t have
good owners and management staff eventually makes mistakes and fails.

Valuation Multiples

Valuation multiples help understand whether the price that the buyer is paying for the target
company is a good price or not. It shows whether the M&A deal or investment is value for
money. Valuation multiples include equity multiples such as – P/E Ratio, P/B Ratio,
Dividend Yield, and Price/Sales. Another subcategory of valuation multiples is enterprise
value multiples. Together both the multiples shows us the real value of the company, and if
the price demanded by the target company is the right price.

Analysis of Financial Statements

One cannot stress enough about the importance of analyzing the financial statements of the
company. The most well-covered information can be exposed by a thorough examination of
the target company’s financial statements. One can find fairly simple facts such as the
company’s cash flow and cash conversion cycle, how leveraged the company is, how
efficient it is, etc. However, the analyst also find eye-opening information such as - has the
company set us sister concerns just to deleverage itself? Is the majority sale of the company
from one customer or multiple customers? Etc.

These answers can reveal a lot about the company and can raise questions for further
investigation.

Company Stock Analysis – Stock Price History and Stock Options

When an entity targets a public company for an M&A deal, it has to pay a price that is partly
determined on the basis of the market price of its stock. One must study the historical stock
prices and short-term and long term volatility in the target company’s stocks. Furthermore,
one must also look into the future planning of stocks which includes factors such as future
stock splits, dilutions, buy-backs, etc.
Industry-Wide and Company Specific Threats

When investing in a company, an investor must understand the threats that he will have to
deal with after the acquisition of or investment in the target company. These threats can be
industry-wide such as slow economy, shortage of raw material, etc. or they can be company
specific such as a very strong competitor, high debt expense, technology obsolescence, and
its replacement expense, etc. A SWOT analysis is useful in this step of the due diligence
process. Further precautions can be taken during the deal to reduce the effect of threats.

Future Expectations

By this time the analyst has a rough estimate about everything from future revenue, profit,
etc. to future investments in assets, future exit strategies, et.. The main question asked during
this step of due diligence process is “What is the future of the company?” & “What is in it for
me?”. Now the investor has a rough idea of where the company is standing today and what
can be expected in the future. Further, the investor asks

Test Hypothesis and Draw Conclusions

Finally, after the step-by-step due diligence process is conducted, the final report is made.
This final report concludes and draws assumption about the current and future valuation of
the target company, the fair price that can be paid for the company, and how the target
company will add value after the merger/ acquisition. These conclusions are tested for the
hypothesis established in the first step of the due diligence process. If the hypothesis is true
the investor will move further, otherwise, there are chances of the deal falling apart.

Reference –

 https://www.upcounsel.com/due-diligence-process