How to Respond to Due Diligence Findings - 4 Real World Examples

How confident are you in your understanding of the M&A due diligence process and the best strategies for navigating it?

While you may excel as a leader or manager, it's common not to have extensive experience in mergers and acquisitions. This is why many companies and business owners seek the support of advisors during the due diligence phase.

However, it’s important to remember that even these advisors will often look to you for final decisions on how to address specific findings. While they can provide valuable insights, they may not always offer a single, definitive solution.

So, how do you find the answers?

Some due diligence findings may clearly indicate dealbreakers, while others might appear as distant risks, leaving you uncertain about the best course of action. Ignoring a red flag can lead to sleepless nights, as the realization dawns that failing to address critical issues or misjudging the value of a target can result in significant financial consequences, potentially impacting your organization’s bottom line and long-term viability.

In fact, the solution is rarely straightforward. Depending on the situation and your priorities, there are multiple approaches to consider when managing due diligence findings. Understanding the available options is the first important step, as each has its pros and cons. You are the one that possesses insights into your needs, which also positions you to be the one to make the best judgment regarding the most appropriate course of action.

To effectively tackle these challenges, it is essential to have a robust framework for critically evaluating your advisors’ findings, ensuring that you make the most informed decisions possible.

Case Scenarios

To help you better understand and manage M&A due diligence, we will explore four illustrative scenarios today. For each scenario, we will provide background on the due diligence findings and offer strategies for addressing these issues. In some cases, we will even present multiple approaches for mitigating the associated risks.

Scenario 1: IP Consideration in a Standalone Situation

A biopharma group is selling a subsidiary focused on research and development in regenerative medicine. This subsidiary relies heavily on key intellectual property (IP) owned by its parent company, which licenses the IP to the subsidiary at no cost.

The IP associated with regenerative medicine is key to the viability of the target business. As a potential buyer, how would you approach this due diligence issue to ensure that the acquisition makes both operational and financial sense?

Here are two potential approaches.

One straightforward way is to proceed with the acquisition while maintaining the existing licensing agreement for the IP. You could negotiate with the seller to continue licensing the IP either for free or for a fee. If you opt for a fee-based license, it’s essential to incorporate this cost into your financial model to accurately reflect the total acquisition cost. This approach allows for a quicker transaction, giving you immediate access to the technology as you evaluate longer-term strategies.

However, a significant drawback of this approach is that you would remain dependent on the seller for access to essential IP, potentially limiting your control and flexibility. Ongoing negotiations regarding licensing terms could also lead to complications in the future.

A more robust solution would be to request that the seller transfer the IP rights directly to the subsidiary as part of the sale. While this transfer is feasible, the seller may hesitate to proceed with relevant arrangements until they are confident that a deal is in place.

To mitigate the risk, you could either wait until the IP transfers are finalized before signing the Sales and Purchase Agreement (SPA) or negotiate to include a condition precedent (CP) in your SPA. This CP would specify that the completion of the transaction is contingent upon the successful transfer of the IP rights, meaning that even after signing the SPA, the deal would not be finalized until the IP transfer is completed.

This approach allows you to secure the IP rights, granting you full control over the technology and enhancing the overall value of the acquisition. It also reduces future uncertainties and dependencies on the seller. However, be aware that this will require an upfront payment for the IP rights instead.

Scenario 2: Bad Debt and the Consequent Legal Actions

When doing due diligence on a toy manufacturing company, you discovered that the company has $100,000 in bad debt due to cash flow issues with a national supermarket chain. The supermarket has not made payments in over 200 days and is currently undergoing restructuring. The toy company has initiated a lawsuit against the supermarket chain to seek compensation for the outstanding amount.

Despite this situation, the supermarket is just one of many customers, allowing the toy company to continue operating without its business. As a potential buyer, how should you address this issue?

One conservative approach is to write off the bad debt on the toy company's balance sheet and reflect the full amount in your purchase price. This method simplifies the transaction by acknowledging the potential loss upfront. However, while this approach is straightforward, it may not always be necessary if there is a realistic chance of recovery, especially if there is a valuation gap between your and the seller’s expectations.

If legal analysis indicates a high probability of recovering the full amount, adjusting the purchase price downward may not be well received by the seller. In this case, you could negotiate a special indemnity related to the lawsuit.

Under this arrangement, you would agree to pay the full purchase price initially, but if any portion of the bad debt remains unrecovered, the seller would indemnify you for that amount. This structure allows the seller to maintain a favorable sale price while providing you with a safety net against potential overpayment.

In more extreme situations, if the supermarket chain issue is so critical that you would not proceed with the transaction unless the lawsuit is resolved, you might want to include closing conditions in the SPA.

This condition would stipulate that the deal cannot close until the lawsuit outcome is determined, protecting you from acquiring a company with unresolved financial risks.