Due Diligence during Company Mergers & Acquisitions

Term Paper, 2006

28 Pages, Grade: 1,0




List of Abbreviations

List of Figures

1 Some Definitions on Mergers & Acquisitions
1.1 General Types of M&A
1.2 Goals of M&A
1.2.1 Market Value oriented Strategies
1.2.2 Non-Market Value oriented Strategies
1.3 The Chronology of M&A
1.3.1 Pre Contract Phase
1.3.2 Negotiation and Closing Phase
1.3.3 Post Contract Phase
1.4 Success Measurement after M&A

2 The Due Diligence Concept
2.1 Origin of the Due Diligence Concept
2.2 Functions of a Due Diligence
2.2.1 Overcoming Information Asymmetries
2.2.2 Efficient Analysis and Evaluation
2.2.3 Groundwork for Decisions and Pricing
2.2.4 Exculpation and Warranties
2.3 A Definition of Due Diligence

3 The Due Diligence Process
3.1 Information Resources
3.2 Planning
3.3 Team
3.4 Realization
3.5 Documentation

4 Types of Due Diligence Reviews
4.1 External & Basic Due Diligence
4.2 Strategic Due Diligence
4.3 Financial Due Diligence
4.4 Legal Due Diligence
4.5 Tax Due Diligence
4.6 Marketing Due Diligence
4.7 Human Resource Due Diligence
4.8 Cultural Due Diligence
4.9 Organizational & IT Due Diligence

5 Concluding Remarks



Globalization triggers faster changes and demands within the global economy every day. With the liberalization of trade new potential markets but also new competitors arise, forcing companies to expand or even reallocate their operations.

In order to cope with this changing business environment in a fast and cost effective manner, companies often choose to grow or change through acquiring and even merging with other enterprises. The advantages are obvious: instead of undergoing an expensive and interminable developing process, existing business concepts are chosen and made use of immediately. Company mergers and acquisitions (M&A) are becoming more and more important which is fortified by the results of a current analysis published by M&A Review. It shows that 30% of the global M&A volume in 2005 had already been reached in the first quarter of 2006.1

Unfortunately 40% - 85% of company M&A still do not live up to the acquirers’ expectations or even fail completely. Studies show that the excitement of managers often causes a lack of analytical effort when they “begin to pursue a target”. It “often becomes an exercise in verifying the target’s financial statements rather than in conducting a fair analysis of the deal’s strategic logic and the acquirer’s ability to realize value from it”.2

The analytical approach of the due diligence process represents a way to overcome gaps in company analysis and evaluations. By systemizing and expanding the research and analytical effort it establishes the groundwork for thorough strategic decisions of a company which engages in M&A. This paper focuses on the idea and structure of the due diligence process and its applicability during company M&A activities.

Chapter 1 describes the basics in the process of company M&A. These range from the aspects of different M&A types to the definition of goals to be achieved by them. The strategies which are to be followed by the operational steps of M&A are also displayed and mark the initial point for the design of the due diligence process. A measurement of success in the end develops the main reasons for failures of company M&A.

An approach to apply best practices out of the financial market routine in order to overcome critical problems during the M&A process is described in chapter 2 where the history and functionality of the due diligence concept are displayed and a definition is fixated.

The different operational steps of the due diligence process can be found in chapter 3 which looks at its fundamental groundwork, the sources of information. After the planning process a suitable team needs to be created in order to ensure an effective realization of the due diligence. Chapter 3 also shows that the final documentation serves more purposes than just formulating the results of the due diligence evaluations.

Since the possible areas a due diligence review may be applied to are as numerous as the countless aspects of a company, the due diligence process is subcategorized in partial reviews. Chapter 4 displays the most commonly applied functional due diligence reviews and points out their specific attributes.

Some concluding remarks in chapter 5 focus on practical use of a due diligence as a tool as well as the risks that arise during its application.

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List of Abbreviations

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List of Figures

Figure 1: Reasons for company M&A

Figure 2: M&A volume worldwide 1995 - Q1 2006 (in USD bn.)

Figure 3: Partial Reviews and Structure of a Due Diligence

Figure 4: Market Attractiveness / Return on Capital

1 Some Definitions on Mergers & Acquisitions

The difference between company mergers and -acquisitions is that mergers “occur when one corporation is combined with and disappears into another corporation” whereas an acquisition “is the process by which the stock or assets of a corporation come to be owned by a buyer”.3

1.1 General Types of M&A

Worldwide M&A are differentiated into share deals and asset deals.4 During a share deal a company gain participation in another company’s operations by providing financial capital (e.g. by purchasing stocks of public companies or by investing venture-capital in private corporations) rather than taking over control of the whole business. Asset deals on the other hand describe the actual purchase and property transfer of material and immaterial company assets (e.g. property respective legal rights) from one company to another..

The M&A theory also distinguishes between horizontal, vertical and conglomerate as well as the concentric acquisitions5, which depend on the relation between the line of products and the type of business of the acquiring as well as the target company.

- A company within the same line of product is acquired during a horizontal M&A. The merger is supposed to strengthen the market position of the acquiring company by eliminating a competitor and by incorporating its market shares at the same time.
- A company within an allied line of product is acquired during a vertical M&A. Through this type of merger the control over the sources of supply and distribution is supposed to be expanded, resulting in the achievement of synergies along the chain of company processes.
- The acquisition of a company with a new and different line of product is defined as being conglomerate M&A. Through diversification the acquiring company tries to reduce its business risk and mediate economic fluctuations within single branches of its corporate portfolio.
- During a concentric M&A a company is bought that differs in its line of products from the acquiring company but shows similarities in its marketing and/or technology concept. Through this, the acquiring company expands its “original market with consumers which could not be reached with its products prior to the merger”.6

illustration not visible in this excerpt

Figure 1: Reasons for company M&A7

1.2 Goals of M&A

The main reason for company M&A is the long-term maximization of profits which the acquiring party expects to achieve.8 In this light it is also described as the search for potential profit advantages in every functional area of a company and their realization in a new corporate compound.9

This search’s results end up in corporate decisions regarding the interests of many entitled factions. An often discussed one of these factions is the group of capital providers also known as share holders.10 In their opinion, a company acts as an intermediary generating financial profit based on their given capital. Therefore companies are interested in increasing their market value on which the growth of share holder value is based. Literature criticizes that a concentration on the interests of shareholders neglects other parties linked to a company. These might be credit institutes, the company’s management and employees, customers, suppliers etc. also known as stake holders. It is recommended that a responsible corporate management considers the interests of both share- and stake holders.11

Hence it is possible to distinguish between market value oriented and non-market value oriented strategies which motivate a company to pursue M&A.

1.2.1 Market Value oriented Strategies

The scientific literature tries to develop market value oriented strategies by distinguishing diversification potentials within the corporate portfolio, restructuring potentials in acquirable enterprises, synergy potentials in know-how transfer as well as centralization within the corporate compound and speculation.12

- By portfolio management a company aims to shift its corporate portfolio into promising business segments. By diversifying its corporate portfolio with attractive and undervalued enterprises already lead by a competent management - which is commonly left in charge after the merger - the acquirer is also able to mediate economic fluctuations within its single business areas if these do not correlate. Risks lie within an over diversified portfolio since it may exceed the corporate management’s business competencies. Thus the grade of diversity has to be limited to a manageable extend.
- Through restructuring a target enterprise the acquiring company intends to activate potentials lying idle within it. In contrast to the role it performs during portfolio management, here the acquiring management takes an active role reorganizing the target company’s structure, processes and management which is then likely to be replaced. After the restructuring- or sanitation process either the whole corporate structure of the target or parts of it are being integrated into the corporate compound of the acquirer or split off to be sold at a profit.
- Based on Porter’s chain of value13 certain synergy potentials, such as know-how transfer and centralization, can be realized as well. In order to be effective the know-how transfer needs to take place between companies whose chains of value are sufficiently alike. Furthermore it only concerns activities that are crucial for competitive advantages and that are exclusively owned by the company so that competitors cannot imitate them. Synergies through centralization can be achieved by consolidating activities which occur in both the acquiring and the target company. The precondition to this is that these activities are identical in both their substance as well as their organization.
- Company M&A based on speculation occur when the acquiring company assumes that the current price of a target company is below its true market value or that its market value will rise in the future. These speculative M&A need to be based on thorough information in order to work out as originally intended.

1.2.2 Non-Market Value oriented Strategies

M&A Strategies that are non-market value oriented are caused by either psycho social motives or a conflict of interests within the principal agent relationship.14

- Psycho social motives for company M&A are the owner’s and management’s strive for power, growth and outrunning the competition. The company’s size becomes more important than its profitability, efficiency or market value.
- Conflicts of interest within the principal agent relationship occur if the ownership of a company (principal) is separated from its management (agent). Since the management’s remunerations are often based on a company’s size rather than on its profitability it tends to base its decisions on possibilities to enlarge its perks and not on the interests of the owner.

1.3 The Chronology of M&A

The chronological process of a company’s M&A starts with the self analysis of the company itself in which it develops an overview of its economic environment and its current position within that environment.15 Through this process the company reveals its strengths and weaknesses which in relation to its present situation enable it to shape a corporate vision for the future.16 Based on this vision a target corporate profile is defined and compared to a forecast of the corporate development under the current circumstances. Through this, strategic gaps are identified which are to be filled in order to reach the target corporate profile.

1.3.1 Pre Contract Phase

Strategic gaps lead to the question whether a company should fill them in by ‘making’ solutions itself based on existing resources or by ‘buying’ them through the acquisition of additional resources. If the decision in favor of acquiring new resources is made, an acquisition team is formed which consists of internal and/or external experts covering all relevant project issues.17 This team creates a profile of the appropriate target resources or companies corresponding to certain qualifying criteria (their line of business, size, market share, etc.). These criteria help narrowing down the list of candidates in order to lower research costs and to ease the selection process from the beginning. When the list of potential targets is developed, first contacts are established during which positions on strategies, possible synergies, company valuation, and so forth are discussed.18

1.3.2 Negotiation and Closing Phase

In case a potential target company is interested in the acquirer’s proposal, a Letter of Intent (LoI) is issued by one of the parties and confirmed by the other. This LoI states the current state of negations, which aspects are still due to be clarified and the willingness of the parties to close the contract.19 Though the LoI is not a legally binding contract it is the foundation for further negotiations by clearly defining the object to be transferred as well as taking into account aspects of care, safety, information and confidentiality both parties are to follow during the contractual process.20

During the subsequent evaluation of the target company, information on all corporate areas is collected in order to rate its financial value. From there the acquiring company is able to derive its idea of the maximum purchase price it is willing to pay.21


1 See figure 2 on page 7 of this paper

2 See Cullinan / Le Roux / Weddigen (2004), pp. 97-98

3 See Reed / Reed Lajoux (1999), p. 5

4 See Berens/Mertes/Strauch (2005), pp. 27-33

5 See Green (1982), p. 359 and Berens/Mertes/Strauch (2005), pp. 41-42

6 See Marquardt (1998), p.41

7 Based on company statements in 1991/92, see Süddeutsche Zeitung No.235 dd. 12.10.1994, p.38

8 See Wöhe (1986), p. 316

9 See Berens/Mertes/Strauch (2005), p. 41 and Wöhe (1986), pp. 316-317

10 See Rockholtz (1999), p. 7

11 See Rockholtz (1999), p. 13

12 See Rockholtz (1999), pp. 42-43; and Berens/Mertes/Strauch (2005), pp. 42-49

13 See Porter (1999), pp. 149-151

14 See Berens/Mertes/Strauch (2005), p. 49 and Holmström (1979), pp. 74-79 for further details on moral hazard within the principal agent relationship

15 See Marquardt (1998), p.66

16 See Berens/Mertes/Strauch (2005), p. 52

17 See Marquardt (1998), p.68

18 See Berens/Mertes/Strauch (2005), pp. 53-54 and Marquardt (1998), p.67

19 See Picot (2005), p. 126 and Marquardt (1998), p.76

20 See Berens/Mertes/Strauch (2005), p. 57

21 See Rockholtz (1999), pp. 36-37

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Due Diligence during Company Mergers & Acquisitions
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Diligence, Company, Mergers, Acquisitions
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Boris Beckmann (Author), 2006, Due Diligence during Company Mergers & Acquisitions, Munich, GRIN Verlag, https://www.grin.com/document/63371


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