Leaving aside the possibility that they will discover any attempts to defraud the buyer, there seems to be some common misunderstanding about the proper role of the M&A due diligence team. They are going to carry out an evaluation of the target business, but to what end? There is often an expectation that the due diligence team will recommend whether or not the investor should go ahead with the merger or acquisition of the target business… “this is a great deal, you should take advantage of it immediately”. Many of our clients seem surprised when we tell them that it is not our job to decide if it is a good investment or not. “But you’ll tell us the good, the bad and the ugly…right?” Not quite.
The role of the due diligence team is to ensure that the investor has the information they need to close a deal with their eyes wide open on the deal, allowing the investor to make an informed investment decision. The due diligence team’s job is to assess the business to discover the real facts about its past, present and future operations. Determining whether these facts are good, bad, or ugly, or whether the business will be a good investment, are decisions for the investor alone to make. The objective of the evaluation is to collect the information that will support the final decision of the investors. The investor must determine how to weigh the information based solely on their plans and strategy. The due diligence team will be more effective if it knows the objectives of the investors, but this is not always the case, nor does it need to be in order to complete its work. Knowing investors’ goals helps the team prioritize their time.
Note that legal due diligence is primarily related to the current state of the business (typically at closing), financial due diligence is typically related to the past performance of the business, and operational due diligence should focus on the capacity of the business. to support its future operations. This means that it is in due diligence where the team MUST stick strictly to the facts but where there is also the greatest tendency to stray into interpreting the facts and filtering the information they provide. This is because legal and financial due diligence records hard facts where the operations due diligence team will look at subjective data that will help identify potential risks and opportunities (depending on the investor’s objectives). An operations assessment, for example, might determine that lead flow is low and identify the cause of the drop. That should not be interpreted as a reason to recommend against investing. The risk for future sales must be reported.
Suppose the operations due diligence team discovers that a company has a poorly defined sales process as a result of a weak sales and marketing organization. Is there a risk that the business will not meet the announced projections or is this an opportunity for an investor whose strategy is to merge the target business with another business that already has a strong sales infrastructure? The evaluation team must present the facts and the investor must decide how to weigh them. This could be a great investment or a very bad one, but it is not the job of the due diligence team to decide which.
Suppose that operations due diligence reveals that a company’s management team lacks strong experience in the market they are trying to sell into. Would this be a good investment or a bad one, not worth the investment gamble? Suppose it is discovered that the president of the company has a track record of success at another company with a revolutionary product that he has patented. After realizing that the product could also be applied in a new market, had you formed the new business to re-introduce the product to that market? Would this now be a risk or an opportunity? When you’re evaluating a trading risk or opportunity, you’re looking at the potential for some event to occur. If there is any chance of failure or success, it is up to the investor, not the due diligence team, to decide if this is an acceptable bet. The due diligence team should never be willing to gamble with someone else’s money, no matter how good the odds may seem. Your job is to report the facts.
Investors who ask the due diligence team “do you think this deal is worth doing?” they are also not being realistic. It’s like going to the track and asking the guy at the betting line next to you “do you think this horse will win?” Maybe the guy next to you knows something about the horse and maybe he doesn’t. Maybe the due diligence team understands your long-term plans and investment strategy and maybe they don’t. It’s not your job to make this recommendation (and it’s not your money). His best question is “What can you tell me about this business?”
The rules shouldn’t change for big corporate takeovers, either. Instead of an individual investor, there may be a takeover committee responsible for making the final decision. While members of the procurement committee may participate in the evaluation, there must be a separation between the procurement committee and the evaluation team, even if it is only in the charter of their activities. There should be an outright separation if the acquisition team receives compensation for the acquisition due to potential conflict of interest. All participants must clearly understand the role of the due diligence team.
