Due Diligence in M&A: A Comprehensive Checklist

Introduction: Trust, But Verify

“In God we trust. All others must bring data.” – W. Edwards Deming

Due diligence is the investigative process by which an acquirer verifies the target company’s information before completing a transaction. It’s where assumptions are tested, risks are identified, and deal-breakers are discovered.

Inadequate due diligence has destroyed billions in shareholder value. Getting it right is essential for M&A success.

What is Due Diligence?

Definition

Due diligence is the comprehensive investigation of a target company’s business, financial, legal, and operational aspects to verify information, assess risks, and inform deal terms.

Objectives

1. Verify information – Is what they told us true?
2. Identify risks – What could go wrong?
3. Discover deal-breakers – Are there showstoppers?
4. Inform valuation – Adjust price for findings
5. Plan integration – Prepare for post-closing
6. Structure protection – Draft warranties and indemnities

Types of Due Diligence

Due Diligence Process

Phase 1: Planning

Key Activities:

• Define scope and objectives
• Assemble due diligence team
• Prepare initial request list
• Set up data room access
• Establish timeline

Request List Preparation: Comprehensive list of documents and information needed, organized by area.

Phase 2: Document Collection

Data Room: Virtual data room (VDR) where seller uploads documents.

• Indexed folder structure
• Access controls
• Audit trail of who viewed what

Common Platforms:

• Intralinks
• Merrill DataSite
• iDeals
• Firmex

Phase 3: Analysis

Activities:

• Review documents
• Conduct interviews (management presentations)
• Site visits
• Third-party verification
• Identify issues and questions

Phase 4: Reporting

Deliverables:

• Due diligence report
• Issues list (red flags)
• Valuation adjustments
• Deal terms recommendations
• Integration considerations

Financial Due Diligence

Objectives

• Verify historical financial performance
• Assess quality of earnings
• Identify normalization adjustments
• Understand working capital needs
• Evaluate financial projections

Key Areas

1. Quality of Earnings (QoE)

Purpose: Determine sustainable, repeatable earnings.

Adjustments for:

• Non-recurring items (one-time gains/losses)
• Related party transactions (at arm’s length?)
• Accounting policy changes
• Revenue recognition timing
• Expense timing

Example:

2. Revenue Analysis

Questions:

• Revenue by customer, product, geography
• Customer concentration (top 10 customers %)
• Contract vs non-contract revenue
• Recurring vs one-time
• Growth drivers and sustainability
• Pricing trends

Red Flags:

• Heavy customer concentration
• Revenue from related parties
• Accelerated recognition before period-end
• Channel stuffing

3. Working Capital

Purpose: Determine normal operating working capital.

Components:

• Accounts receivable
• Inventory
• Prepaid expenses
• Accounts payable
• Accrued expenses

Net Working Capital (NWC): $$NWC = Current\ Assets - Current\ Liabilities$$

Target NWC: Agreed level for closing, with price adjustment if actual differs.

Trends to Analyze:

• Receivable days (DSO)
• Inventory days (DIO)
• Payable days (DPO)
• Seasonality

4. Debt and Debt-Like Items

Identify:

• Bank debt
• Bonds/debentures
• Capital leases
• Pension liabilities
• Contingent liabilities
• Deferred consideration
• Related party payables

Why: These are deducted from Enterprise Value to get Equity Value.

5. Capital Expenditure

Questions:

• Maintenance vs growth CapEx
• Deferred CapEx (catching up needed?)
• Committed CapEx
• Asset condition

6. Cash and Cash Flow

Questions:

• Cash reconciliation
• Trapped cash (overseas, restricted)
• Free cash flow analysis
• Cash conversion
• Working capital trends

Financial DD Checklist

Documents Requested:

• Audited financial statements (3-5 years)
• Monthly/quarterly management accounts
• Trial balances and general ledger
• Revenue by customer, product, geography
• Aged receivables and payables
• Inventory aging
• Bank statements and reconciliations
• Debt agreements and schedules
• Capital expenditure records
• Budget vs actual analysis
• Financial projections and assumptions

Legal Due Diligence

Objectives

• Verify legal standing and structure
• Review material contracts
• Identify litigation risks
• Assess regulatory compliance
• Evaluate intellectual property

Key Areas

1. Corporate Structure

Review:

• Certificate of incorporation
• Memorandum and Articles of Association
• Share capital structure
• Shareholder agreements
• Board and shareholder minutes
• Subsidiaries and investments

2. Material Contracts

Types:

• Customer contracts
• Supplier agreements
• Distribution agreements
• License agreements
• Employment contracts
• Lease agreements
• Loan agreements

Analysis Points:

• Change of control provisions
• Termination rights
• Assignment restrictions
• Unusual terms
• Expiration dates

3. Litigation

Review:

• Pending litigation
• Threatened claims
• Regulatory proceedings
• Past significant litigation
• Insurance coverage

4. Intellectual Property

Review:

• Trademarks
• Patents
• Copyrights
• Domain names
• Trade secrets
• License agreements
• IP disputes

5. Regulatory Compliance

Areas:

• Industry-specific licenses
• Environmental permits
• Labor law compliance
• Data protection (IT Act, GDPR)
• Anti-corruption compliance
• Competition law

6. Real Estate

Review:

• Owned vs leased property
• Title documents
• Encumbrances
• Lease terms
• Environmental issues

Legal DD Checklist

Documents Requested:

• Incorporation documents
• Share registers and certificates
• Board and shareholder resolutions
• Material contracts
• Litigation files
• IP registrations
• Regulatory licenses
• Property documents
• Insurance policies
• Statutory registers

Tax Due Diligence

Objectives

• Understand tax position
• Identify tax exposures
• Evaluate tax-efficient structure
• Assess transfer pricing risks

Key Areas

1. Tax Compliance

Review:

• Tax returns (corporate tax, GST, TDS)
• Assessment orders
• Ongoing assessments/appeals
• Advance tax payments

2. Tax Exposures

Identify:

• Disputed tax demands
• Uncertain tax positions
• Statute of limitations
• Transfer pricing adjustments
• Indirect tax exposures

3. Tax Attributes

Evaluate:

• Carried forward losses
• MAT credit
• Tax holidays/exemptions
• Depreciation pools

4. Transfer Pricing

For groups:

• Inter-company transactions
• Transfer pricing documentation
• Arm’s length pricing
• APA status

Tax DD Checklist

• Tax returns (5 years)
• Assessment orders
• Demand notices and appeals
• Transfer pricing reports
• GST returns and assessments
• TDS returns and certificates
• Tax holiday certificates

Operational Due Diligence

Objectives

• Understand business operations
• Assess operational efficiency
• Identify improvement opportunities
• Plan integration

Key Areas

1. Business Model

Understand:

• How company makes money
• Value proposition
• Customer segments
• Competitive positioning

2. Operations

Review:

• Production/service delivery process
• Capacity and utilization
• Quality metrics
• Supply chain
• Key suppliers and dependencies

3. Technology

Assess:

• IT systems and infrastructure
• Technology roadmap
• Cybersecurity
• Data management
• System integration needs

4. Customers

Analyze:

• Customer base profile
• Customer satisfaction
• Churn rates
• Sales pipeline
• Reference calls

5. Management and Organization

Evaluate:

• Organization structure
• Key personnel
• Succession planning
• Culture assessment

Operational DD Checklist

• Business plan and strategy
• Operations manual/procedures
• Production/capacity data
• Customer list and analysis
• Supplier contracts
• IT systems documentation
• Quality certifications
• Organizational charts
• KPI dashboards

HR Due Diligence

Objectives

• Understand workforce
• Identify compensation liabilities
• Assess cultural fit
• Plan retention strategies

Key Areas

1. Employee Overview

Review:

• Employee count by function, level, location
• Turnover rates
• Key employees
• Vacant positions

2. Compensation and Benefits

Analyze:

• Salary structures
• Bonus plans
• ESOPs/equity plans
• Pension/gratuity liabilities
• Health insurance
• Other benefits

3. Employment Matters

Review:

• Employment contracts
• Union agreements
• Pending labor disputes
• Compliance with labor laws
• Pending claims

4. Retention and Culture

Assess:

• Key person dependency
• Retention risk
• Cultural compatibility
• Integration challenges

HR DD Checklist

• Employee census
• Organization charts
• Compensation data
• Benefit plan documents
• Employment contracts (key personnel)
• Union agreements
• HR policies
• Pending labor cases
• ESOP/equity plans
• Training programs

Red Flags in Due Diligence

Financial Red Flags

Legal Red Flags

Operational Red Flags

Managing Due Diligence

Practical Tips

1. Start with Hypotheses What do you expect to find? What are key risks?

2. Prioritize Focus on material issues, not every detail.

3. Ask “Why” Dig into unusual items, don’t accept surface explanations.

4. Talk to People Documents tell part of story; interviews reveal more.

5. Site Visits See operations firsthand.

6. Third-Party Verification Verify key information independently.

Common Mistakes

1. Checklist Mentality Going through motions without critical thinking.

2. Boiling the Ocean Trying to examine everything equally.

3. Confirmation Bias Looking for reasons to do deal, ignoring red flags.

4. Time Pressure Rushing analysis due to deal timeline.

5. Siloed Analysis Not connecting findings across workstreams.

From Due Diligence to Deal Terms

Valuation Adjustments

Findings may lead to:

• Purchase price reduction
• Working capital adjustment
• Earnout structure
• Escrow/holdback

Warranty and Indemnity

Seller Warranties: Representations about target (accuracy of financials, no undisclosed liabilities, etc.)

Buyer Indemnification: Seller compensates buyer for breaches or specific risks.

Deal Structure Changes

Based on findings:

• Asset purchase (avoid certain liabilities)
• Carve-outs (exclude problematic units)
• Conditions precedent (issues must be resolved)
• Walk away (deal-breakers found)

Key Takeaways

1. Due diligence is risk management – Identify issues before they become your problems
2. Multiple dimensions – Financial, legal, tax, operational, HR, tech
3. Verify, don’t trust – Check information independently
4. Focus on material issues – Prioritize what matters most
5. Red flags require investigation – Don’t ignore warning signs
6. Connect findings to deal terms – Adjust price, structure, protections
7. Time well spent – Better to discover problems before closing

Disclaimer

This article is for educational purposes only. Due diligence requirements vary by transaction. Engage qualified professional advisors for actual M&A transactions. This is not legal or investment advice.

Frequently Asked Questions

Q: How long does due diligence take? A: Typically 4-8 weeks for middle-market deals. Can be shorter for simple deals or longer for complex/large transactions.

Q: Who bears due diligence costs? A: Generally, each party bears its own costs. Acquirer pays its advisors; target provides information but doesn’t pay for acquirer’s investigation.

Q: What if we find problems? A: Options include renegotiating price, seeking indemnification, structuring around the issue, or walking away if too severe.

Q: How much is enough due diligence? A: Balance thoroughness with practicality. Focus on material items, risk-based approach. Perfect information is impossible; adequate assurance is the goal.

Q: Can seller limit due diligence access? A: Yes, especially for confidential information. But overly limited access is itself a red flag.

Due diligence is like a medical checkup before marriage—you want to know what you’re getting into. It won’t reveal everything, but it significantly reduces the chance of unpleasant surprises. Time and money invested in thorough due diligence is insurance against much larger losses later.