The Due Diligence Process Demystified

Due diligence is a key part of any mergers and acquisitions (M&A) process. It enables a buyer to be as well-informed as possible when making an offer to purchase a company, while empowering a seller to best represent the company with the aim of maximizing his or her assets.

For purchasers or sellers, first-time entrants into this market may have a hard time understanding the M&A process because they haven’t experienced it first-hand. M&A activities are a serious and labor-intensive process – one that can involve the exchange of significant financial capital and a process that can impact the future direction of each enterprise involved. Due diligence is a critical piece of any M&A planning – which aims to uncover any risks or costs to the purchaser of the target organization.  

Our team at Cuesta is often engaged with first-time M&A entrants across the market and see several common questions arise time and time again. In this article, we answer these to help you to better understand the process and provide you with a solid foundational understanding – in the simplest of terms. So, let’s dive in… 

What is due diligence?

Due diligence is a thorough process of verification and audit of a potential deal or investment to confirm key facts and financial information. This process occurs before completing a transaction to provide an acquirer with an assurance of what they’re getting. Transactions that undergo due diligence usually net higher chances of success – and it contributes to making well-informed decisions by enhancing the quality of information available to the buyer. 

It is important to note that is also a very important and beneficial step for a potential seller, as going through a rigorous financial examination can help ensure fair market value for the company (or even uncover more value than was initially forecasted). Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions. 

In simplest of terms, the due diligence process helps investors and companies understand the full nature of any deal, the risks involved, and whether the deal fits within their portfolio.  

To help you gain a simple, yet comprehensive understanding of what’s involved, we have demystified M&A by describing the process through the lens of a real estate transaction. Many people have experienced going through the process of buying a house, and it turns out that the processes aren’t that different.

Key players in the transaction process 

  1. The asset being bought and sold
    • Real Estate Term: The House
    • M&A Player: The Target (of the transaction)
  2. The person or entity looking to sell their asset
    • Real Estate Term: The Homeowner
    • M&A Player: Seller (note: This can be a founder, a majority shareholder, or investor)
  3. The person/firm who represents the seller’s interests; an advisor to the seller; is responsible for marketing the asset, finding prospective buyers, and getting the highest price possible in exchange for a percent of transaction (“The Sell Side”)
    • Real Estate Term: The Seller’s Real Estate Agent
    • M&A Player: Investment Bank (IB) (note: An investment bank is involved in most of our private equity transactions. Sometimes the seller doesn’t have an IB, and this functions like a “for sale by owner” real estate transaction.The investment bank acts as an advisor to the seller, marketing the asset, facilitating interactions with potential buyers, and supporting the process.)
  4. The person/firm who represents the buyer(s); acts on behalf of the buyer(s); is responsible for sourcing quality investment opportunities and acting in the buyer’s best interest through the process (“The Buy Side”)
    • Real Estate Term: The Buyer’s Real Estate Agent
    • M&A Player: The Private Equity Firm. (note: The PE firm is acting in the interest of its investors, sourcing investments, conducting due diligence, and ensuring its investors see maximal return on their investment.) A PE firm will often have a designated “deal team” made up of financial experts in the industry of the asset. This team is responsible for conducting analysis that informs the investment thesis – how the PE firm will see a return on its investment. The investment thesis is then presented to the PE firm’s Investment Committee which determines whether to proceed with the deal.
  5. The people/firms responsible for inspecting and verifying the quality of the asset on behalf of the buy-side
    • Real Estate Term: Home Inspector
    • M&A Player: Third-Party Advisors (note: A PE firm will engage a variety of advisors to conduct due diligence on an asset as a part of different workstreams. These commonly include financial due diligence, tax due diligence, legal due diligence, IT due diligence (or ITDD), etc. Often each due diligence is conducted by a different firm that specializes in this area.)

Key components to a successful due diligence

Several areas and processes are especially essential to running an effective due diligence program – and ensuring clear outcomes for all parties involved. These core principles ring true for diligence work across pretty much any industry, and for deals of all sizes.   

  • Access to the right players – In order to get high quality information, there must be thorough access to the right resources on the sell-side. While a senior executive may be able to provide a high-level overview, the details that really matter when it comes to risks and opportunities may live with someone more junior or operational focused. In the case that those key individuals are not yet aware of the potential transaction (or not yet “under the tent” of the deal), our team often finds success in talking to these individuals under the auspices of a third-party assessment, rather than a pre-transaction due diligence.  
  • Understanding of the investment thesis – It’s important for a third-party advisor to have a firm understanding of why the buyer is interested in an asset. This is because the time allocated for due diligence is limited, and, with that limited time, third-party advisors need to choose where to focus their investigation. Often times companies are multi-faceted, perhaps providing both products and services, for example. If the investment thesis centers around the company’s product, it’s prudent for the due diligence to focus primarily on the product, with a reduced emphasis on the services part of the business.  
  • Identifying and answering the key questions – Often times, a third-party advisor is brought in to conduct due diligence is because the buyer doesn’t have the level of knowledge or expertise necessary to answer the questions they have about the asset. A strong due diligence partner will identify those questions with the buy-side ahead of time and ensure everything gets answered through the diligence sessions and in the resulting report.  

Benefits of a third-party due diligence partner

Having a strong due diligence partner is essential for the right outcomes, as articulated above.  The right partner should bring to the process deep experience and expertise in the space. For example, at Cuesta we leverage teams with decades of experience as engineers, consultants, and technology leaders. An ideal partner will bring that collective experience into each deal and use that expertise to inform recommendations, call out risks, and identify opportunities for cost savings and efficiencies.  

For a well-credentialed partner, they should bring a repeatable process that is both comprehensive and efficient, which requires less time from the sell-side and ensures that no key aspects are overlooked. Finally, the right partner will bring a rich understanding of the space, which brings important benefits for all parties involved.  

Our team at Cuesta is made up of technologists, so we’re able to empathize with the sell-side and seek to not only understand what technology choices they’ve made but why they’ve made them. Rather than running through a bunch of yes/no checklists, it’s important a partner can appropriately contextualize the company’s technology landscape and compare it against best practices for companies in that industry and of that size and maturity. 

Insights and value creation at the core

While every due diligence report is wide-sweeping, touching on every component of a target’s tech stack, often the most valuable part of a given engagement is the deal-specific qualitative and quantitative insights that are produced. Some recent highlights of Cuesta’s due diligence engagements include:  

  • Identifying $2M in synergies related to tech personnel for merging entities.  
  • Creating a go-forward ERP consolidation plan for a $5B merged entity with 27 ERP instances.  
  • Estimating line item-level costs for both upgrading EOL infrastructure and performing a lift-and-shift to the cloud. 
  • Designing a stand-alone cost model for a divested entity across all technology domains and personnel for a manufacturing/aerospace firm. 
  • Outlining the go-forward systems architecture of a $500M merger of EdTech companies. 

I hope you’ve found the approach and overview here interesting, and I look forward to your thoughts and questions on this exciting topic! 

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