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We’ve all heard the old saying: “Life punishes those who are late.” Although it’s an old saying, it hasn’t lost any of its relevance and applies to many areas of both our personal and professional lives. Now, this is, of course, a thematic newsletter from DUB.de. With that in mind, we’ll leave aside the many personal applications, especially since that could quickly come across as preachy—like a “wagging finger.” Instead, we’ll focus on the areas of M&A and business succession. In this context, being too late can mean, for example, missing out on opportunities. One reason opportunities go unused can be a lack of time. On the buyer’s side, there may be no time to engage with a potential deal. On the seller’s side, there may be no time to face the process—or, as we consultants very often experience, when the client is already in the process, missing deadlines, for example, during due diligence.
Ah yes, due diligence. Hated by many, or at least feared. Loved by no one. Generally underestimated by all parties in terms of both effort and importance.
But let’s take it step by step: What is due diligence? The term “due diligence” (or “DD”) literally means “the careful fulfillment of the duty of care required in business transactions.” In the context of a corporate acquisition, it refers to a detailed review and analysis of the so-called target company by the potential acquirer with regard to its tax, economic, and legal circumstances. One could also say that a buyer is trying to uncover the proverbial skeletons in the closet.
Various areas are examined. These are referred to as individual sub-areas, such as tax due diligence, financial due diligence, commercial due diligence, legal due diligence, technical due diligence, and so on.
As part of due diligence, “mountains of information” are sometimes gathered and analyzed by the buyer and their advisors. This makes sense: After all, the buyer is trying to counteract information asymmetry and narrow the seller’s information advantage by having their attorneys, tax advisors, auditors, and other advisors involved in the transaction review various documents. An important topic in the context of due diligence is the target company’s financial statements. A buyer wants—or must—try to ensure that the financial statements are prepared correctly, meaning the figures add up—not least because the figures contained in the financial statements are directly and indirectly relevant to the valuation. But the business model and the market are also examined and analyzed in detail.
From the buyer’s perspective, due diligence is recommended not only for these economic reasons. Legally as well, Sections 93(1), sentence 1, and 91(1) of the German Stock Corporation Act (AktG) and Sections 43(1) and (2) of the German Limited Liability Companies Act (GmbHG) impose an obligation to conduct due diligence when acquiring a company, in order to fulfill the required diligence and conscientiousness, whereby the burden of proof in the event of a breach of the duty of care lies with the executive board or management.
But back to practice: The results of the due diligence are summarized in a report. There are so-called “findings” that are so serious that they lead the buyer to terminate the transaction. These are called “deal breakers.” Minor findings are called “issues.” These issues are addressed by incorporating them into the purchase agreement, for example, in the form of guarantees and warranties provided by the seller.
You may be wondering, then, how one can prepare for due diligence. Well, it’s best not to wait until the transaction enters its critical phase. It’s best to start early. Personally, I’d even go so far as to say: always be “due diligence ready”—that is, keep all relevant information up to date and readily available at all times.
Why? A due diligence process involves going through a lot (a whole lot…) of paperwork. Fortunately, these days this is done digitally—but there’s still a great deal of information and documentation that needs to be compiled. It’s not uncommon for several people to spend weeks filling a so-called data room for due diligence. That’s time that the parties involved may not have.
What do I mean by “due diligence-ready”? It doesn’t have to be a fully populated external data room, especially since the requested documents (due diligence request list) vary from transaction to transaction anyway. However, at a minimum, the following documents should be stored in digital form and in their most recent versions within a clear, organized structure, so that they only need to be moved into a data room:
- Annual financial statements for the last five years
- Monthly financial statements for the last 18 months
- Tax assessment notices for the past five years
- Documents related to tax audits
- Shareholder resolutions and minutes of shareholder meetings, complete for the last three years
- Current extract from the commercial register, list of shareholders, copy of business registration, articles of incorporation, agreements between shareholders, etc.
- Overview of existing insurance policies
- Overview of existing interest-bearing liabilities and copies of loan agreements
- Overview of customers and suppliers with sales figures for the last 12 months (ideally updated every 6 months)
- Copies of contracts with key customers and suppliers
- Copies of rental and lease agreements
- Plan/budget for the next three fiscal years (also update every 6 to 12 months)
- Overview: Are there any change-of-control clauses in agreements with customers or suppliers, or in rental or financing agreements?
Creating this “small data room” of your own also offers entrepreneurs additional benefits: You know where to find the latest versions of all documents, and you stay focused on your business. How has Customer B’s revenue developed over the last 6 months? Why are we buying more from Supplier A, etc.? In addition, this allows you to identify so-called “deal breakers” or “deal issues” with the help of specialized advisors well in advance of a potential or planned transaction and actively address them.
A professionally prepared due diligence process is also an important tool for building trust—and what do you think is the most powerful tool for increasing transaction security? That’s right: trust! The buyer’s trust that the seller, to put it bluntly, “had their business under control.” Trust that no facts are being concealed. When deadlines are missed or the due diligence process takes an unusually long time, it creates a sense of unease on the buyer’s part. And buyers tend to penalize that uneasy feeling, for example, with valuation discounts and thus a lower purchase price for the business owner.
