The Board of Directors and M&A due diligence

Media reports of merger and acquisition negotiations often refer to due diligence being a condition for making a bid or closing a deal. This means that before the intending acquiror will commit finally to the deal, it wants to do due diligence on the target, the company being acquired or merged with.

Due diligence means a close examination of the target, closer than the acquiror is able to do with publicly available information. How much due diligence is needed varies, depending on whether the target is a public company or a private company. The outcome will be a decision by the acquiror on whether to do the takeover or merger, and if so, at what price.

In a private company takeover, the acquiror may have some modest amount of information on the target. The target’s financial statements, the results of observation from physical inspection of its premises and inventory, the outcome of discussions with its executives, other information on its reputation gleaned from its customers and suppliers and from credit rating agencies.

For a public company takeover, there will be detailed financial statements and other public data filings. There may also be equity analysts’ reports, and media stories that spread light on the target’s situation. And the acquiror will have all of the usual information sources that can be accessed for a private company.

Why the need for due diligence?

For a public company acquisition, the acquiror will have a wide range of information about the target, most of it reliable and trustworthy. For a private company takeover, information may be more sparse, triggering the need for a search for more and better quality intelligence about the target. In both cases, the acquiror may feel it needs to know more.

Due diligence is done for two reasons.

First, to probe for target problems that may not be apparent in public information, or may not have been disclosed by target management.

Second, to search for better and more detailed information about the target that will help confirm whether the acquiror’s confidential plans for the target are workable.

In the probe for target problems, the acquiror looks for contracts with suppliers and customers that may have unknown and unexpected terms, financing arrangements that might change in the event of control of the target changing, property rights that may be coming to an end, and key personnel who may soon be leaving.

The search for confirmation to confirm future plans for the target may concern integration of the target into the acquiror’s business, downsizing the target by divesting divisions or other assets, cutting target costs by reducing personnel, or diverting target asset to more productive uses. The information needed for this evaluation will often not be in the public domain, thus the need for due diligence. And because the acquiror will not wish to disclose its future plans to target management and shareholders, it cannot ask the target directly for the data it needs and must get it by way of the due diligence process.

Where does the Board of Directors fit in?

Neither the acquiror’s Board nor the target’s Board is likely to be closely involved in due diligence. The process involves the target making a boardroom available to the acquiror, and offering to produce any documentation the acquiror might wish to see. The acquiror asks for target correspondence, supplier and customer contracts, banking records, employment agreements and asset registers. Target personnel are made available for interview by the acquiror. The process is carried out by specialists and professionals mandated by the acquiror.

The target’s Board of Directors is keen to ensure that due diligence passes without glitches. Its worst case scenario is the uncovering of problems that it knows nothing about, and for which it may be accountable. It can only wait and see.

The acquiror’s Board will be presented by its executive management with a due diligence report. It will base its decision to approve the acquisition, or not approve it, in part on this report. If it approves the acquisition, the acquiror moves to final negotiations with the target on price and execution of the takeover.