What is Due Diligence in an M&A Transaction?

If the letter of intent is the foundation of your deal, due diligence is the inspection. It is the process by which a buyer investigates the business they are acquiring before committing to close. Done properly, it protects the buyer from surprises after closing. Done poorly, or not at all, it can result in a buyer inheriting problems they did not know existed and have no recourse to fix.

What is Due Diligence?

Due diligence is a comprehensive investigation of a target business conducted by the buyer and their advisors after the LOI is signed. The buyer's lawyers, accountants, and sometimes industry specialists review the business across every material dimension; financial, legal, tax, operational, and commercial.

The purpose is simple: to confirm that what the seller has represented about the business is accurate, and to identify any risks, liabilities, or issues that affect the value of the transaction or the buyer's willingness to proceed on the agreed terms. To quote Donald Rumsfeld, the buyer is trying to maximize the number of known-knowns and the known-unknowns in order to reduce or eliminate the unknown-unknowns.

What Does Due Diligence Cover?

A thorough due diligence process in a lower mid-market transaction typically covers:

1. Financial due diligence. A review of historical financial statements, management accounts, revenue recognition practices, working capital levels, and any off-balance sheet liabilities. The buyer's accountants are looking for whether the numbers are what they appear to be and whether the business can sustain its reported performance going forward. There is a “normalization” process that needs to happen, meaning that the buyer will try to determine what the business looks like without erroneous expenses (e.g. auto lease for a vehicle used primarily for personal purposes) or with replacement personnel for the departing sellers. The buyer will also evaluate whether revenues are growing or shrinking, and whether there are any anomalies in the revenue. They will evaluate the “concentration risk”, meaning they will look at the sources of revenue to try to determine if it is sustainable and whether client loss is manageable.

   
   

2. Legal due diligence. A review of the corporation's minute books, share structure, material contracts, leases, employment agreements, security registrations, and any litigation or regulatory proceedings. The buyer's lawyers are looking for anything that creates unexpected liability or affects the transferability of the business. Leases are often a cause of complexity or delay, including whether the lease is coming up for renewal, guarantees given by the shareholders, assignment and change of control provisions, security registrations, landlord lease termination rights, and more. Each contract that is material to the operation of the business must be reviewed to ensure that the business can be handed over to a buyer in a reasonable manner.

   
   

3. Tax due diligence. A review of the corporation's tax filings, assessments, and any outstanding or potential tax liabilities. Experienced buyers will look at the way various income or expense items have been reported for tax purposes to evaluate the risk of reassessment. This is particularly important in a share purchase, where the buyer is inheriting the corporation's entire tax history.

   
   

4. Operational due diligence. A review of the business's key operational dependencies; its people, its systems, its processes, and its customer and supplier relationships. Buyers are particularly focused on whether the business can operate independently of the owner after closing. Depending on the arrangement between the parties, the buyer will want to try to identify who the key internal persons and customer contacts are to ensure a smooth transition.

   
   

5. Commercial due diligence. An assessment of the business's market position, competitive landscape, and growth prospects. This is more common in larger transactions but is increasingly relevant at the lower mid-market level.

   
   

How Long Does Due Diligence Take?

In a lower mid-market transaction, due diligence typically runs four to eight weeks. The timeline depends on the complexity of the business, the quality of the seller's records, and the responsiveness of both parties and their advisors.

Sellers who have organized their records in advance, maintained clean minute books, and kept their key contracts accessible consistently move through due diligence faster and with fewer complications. Sellers who have to reconstruct years of corporate records under time pressure add weeks to the process and give buyers reasons to ask questions they otherwise would not have asked.

What Happens When Due Diligence Finds Something?

Due diligence almost always finds something. That is not a reason to panic. In most transactions, the issues uncovered during due diligence are manageable; they are addressed through representations and warranties in the purchase agreement, specific indemnities, price adjustments, or conditions to closing.

One of the most important things to understand is the relationship between what due diligence uncovers and how it gets documented contractually. Finding an issue in the data room is not the same as disclosing it properly in the purchase agreement. As our article It was in the data room is not a defence explains, sellers who assume that uploading a document protects them are often wrong. Proper disclosure happens through Disclosure Schedules, not through the data room. For a deeper look at how that works, see Diligence finds the issues. Disclosure Schedules decide who bears them. and The importance of disclosure schedules in M&A transactions.

The issues that cause real problems are the ones that were not disclosed, or that the seller did not know about because they had not organized their affairs properly. A buyer who discovers a material undisclosed liability during due diligence has leverage they did not have before, and they will use it.

This is one of the most important reasons to prepare for a sale years in advance. A seller who has identified and resolved their own due diligence issues before going to market controls the narrative. A seller who discovers them under a buyer's microscope does not.

The Seller's Role in Due Diligence

Due diligence is not something that happens to a seller. It is something a seller participates in. It is incredibly time consuming, and much more painful when the seller isn’t well-organized. Sellers who are organized, responsive, and transparent move deals forward. Sellers who are disorganized, slow to respond, or evasive create uncertainty, and uncertainty is a deal killer.

The most effective sellers we work with treat due diligence as an opportunity to demonstrate to the buyer that the business is exactly what it was represented to be. That confidence, backed by clean records, is one of the most powerful closing tools available.

Outsiders Law manages the due diligence process for Alberta buyers and sellers on every transaction. If you are thinking about buying or selling a business, the best time to talk to us is now.

For more on the M&A process, visit our Mergers & Acquisitions page or our Selling Your Business in Alberta page.

This article is for general informational purposes only and does not constitute legal advice. It does not create a solicitor-client relationship and should not be relied upon as a substitute for advice tailored to your specific transaction or circumstances. If you're navigating the complexities of M&A, remember that the details matter. For expert guidance, feel free to contact Outsiders Law.