Chapter 31Initial Due Diligence
Due diligence in various threads will likely happen simultaneously at this point. While you may have dedicated leaders handling each function inside the company, it’s best for you and cofounders to handle them yourselves instead of involving employees in the process. Or if you must, keep the privileged information circle as small as possible. Reason being, at this stage, the probability of a deal closing with this buyer is low, and getting employees involved too early may set the false expectation that a deal is imminent, which will be devastating for morale inevitably when the deal falters at a later stage or moves at a snail’s pace.
Another point on DD, answer every question asked truthfully. If there are things that you are unsure of, take it as an action item and provide the correct answer after you did your homework. Treat this as an exercise not for how much you know about things, but how seriously you take each question, and the acquirer will appreciate it when you say you don’t know and provide a precise answer later. This is a process of building rapport and trust between you and the acquirer. If there is no trust, there is no deal. In that vein, if there are changes to the company that could materially alter the deal terms, it is always better to proactively provide those updates rather than letting the acquirer find out themselves.
Let's take a look specifically at each area of due diligence. Your key point of contact (or internal champion who drives this deal) will likely attend all of these meetings, however, depending on her area of responsibility, she may ask other leaders to help drive some of these conversations that she doesn't manage.
1. People
Attendees from Acquirer: Head of HR, People Managers
Materials Under Review: Cultural Docs, Cap Table, Roster, Org Chart, Past Performance Reviews, Leveling Guideline, Compensation History, Employment Contracts
Of all the due diligence, the people one is perhaps the most straightforward. Typically if the process already has gotten to this point, there is already a good rapport and some level of cultural fit between the two companies. Nevertheless, this is an opportunity for the acquirer to spot any red flags or potential personnel issues with the company. When asked about your culture or values, be sure to provide anecdotes that back them up. The acquirer HR will also walk through your roster and ask about each employee in detail. Questions could include what this person works on day-to-day, what is her domain expertise, how critical she is for the acquisition, and likelihood of her wanting to be part of the acquisition. At the end of the meeting, the acquiring company will make an overall determination on whether the team is a potential fit, what the reporting structure would look like, and finally a list of key employees to retain, those who will be given transitional contracts, and those who will not be part of the acquisition. The hope for you as the founder is always that everybody gets retained for the acquisition, this would be the ideal case. However, for any M&A, there inevitably will be positions that are redundant or unnecessary post acquisition. Some of the most likely positions to be eliminated are your internal HRs, marketers, and support team. On the other hand, top engineers, product leaders, or design talents that are difficult to hire for even in the open job market will be highly coveted in any acquisition.
2. Financial
Attendees from Acquirer: CFO, Analysts, Third-Party Accountant/Auditor (Optional)
Materials Under Review: Past 3-5 years of Balance Sheet, P&L, Cash Flow, Bank Statements, Credit Card Statements, Tax Returns, Future Financial Projections/Forecasts, Large Customer Contracts, Large Vendor Contracts, Debt Obligations
This is the least fun due diligence of them all. I have heard people comparing the financial DD to a cavity search. Depending on how keen the acquirer is, they may bring on a third party auditor to go through all your books and ask painstakingly about every expense you had in the last three to five years. This is where having clean budgets and balanced books in the past make a world of difference. If you have a CFO or bookkeeper, this would be the only instance where it's advisable to include someone who is not a founder in the due diligence process. Again, when they get you on questions that you don't remember or don't know, take an action item and provide the answer after the meeting. Never lie, and never mislead, a deal cannot happen when there is no trust.
The acquiring company will likely ask your financial forecast for the coming quarters or year and you may be tempted to provide an optimistic figure in the hopes of getting a better deal. This would not be a wise move, as the process of closing the deal could take quarters if not a year. If you are unable to deliver on the promised forecasts, it would cast a bad light on the deal terms, and could even jeopardize the deal from closing. Hence, it's best to give conservative estimates, and over deliver on them.
Based on this information, the acquirer will model out a projection of future revenue and expenses, and use that as one of the key levers for the considerations and retention. Nevertheless, as good as this math is, M&A is more emotional than it is rational, and the projections only serve as a reference.
3. Governance / Legal
Attendees from Acquirer: General Counsel
Materials Under Review: Company Bylaws, Litigations, Cap Table, Court Orders, Incorporation Documents, Board Meeting Minutes, Fundraising Docs, Other Legal Contracts
The exercise here is to ensure that your company is properly incorporated, under good governance and there are no outstanding litigations that could derail the deal.
4. Product
Attendees from Acquirer: Product Executives, Design Executives
Materials Under Review: Access to Products, Metrics, Descriptive Materials, Roadmaps, User Interviews
Expect some white board sessions to talk product strategy, user personas, go-to-market, positioning, and integrations. Have an open-mind about what the rebranded version of your existing product may look like. The acquirer may completely scrap your brand and your logo, and instead erase everything on the internet about whether your company and your product ever existed.
Part of the DD could also involve digging deep into your metrics and understanding any trends and how they affected your product decisions. You may receive critical feedback on your existing products and ask to provide justifications on the UI/UX or feature prioritizations. Do not get defensive on any decisions, provide your rationale on the product decisions and treat it as a discussion and feel out what working together in the future may look like. The acquirer is doing this exact exercise also to vet what it's like to work with you.
5. Technology
Attendees from Acquirer: Engineering / Research Executives, Tech Leads
Materials Under Review: Access to Codebases, Engineering Dashboards, Technology Stacks, Descriptive Materials
Your CTO or VP of Engineering may be asked to present key technology stacks, engineering processes, upcoming roadmap and walk through code with the acquirer's counterparts. The acquirer wants to go through your code and commit logs to vet the level of complexity of your codebase, as well as how robust the build and deployment process is, and at the same time how clean the codebase is, who are the key contributing engineers and how productive they are. Expect the conversation to be very technical, and the discussions could take a few meetings to complete depending on the scope the acquirer would like to cover. As you prepare for this meeting, think about how to answer the "why" with each engineering process, architecture or tradeoff you instituted.
6. Miscellaneous
Depending on the specializations or certain quirks of your business, there could be other areas that are scrutinized during the due diligence process. For example, if your company has a business operation in China and generates significant revenue there, then this would likely be an area of due diligence carried out by the acquirer as it is unique to your business and may be the reason why they would like to acquire you.