During formal due diligence, which typically begins after signing the letter of intent, you gain access to in-depth information and begin taking a closer look at the acquisition target. Traditionally the primary purpose of this stage of the M&A is to identify significant risks that could impact the terms of the deal or put it in jeopardy.
However, I would advocate a broader perspective. In addition to risks, I’d encourage you to intentionally seek out hidden opportunities. I recommend sorting your due diligence findings into three data buckets – red, yellow, and green. Red bucket items are liabilities you need to keep your eye on, yellow bucket items are acceptable risks that may be good or bad, and green bucket items are integration opportunities that could add value to the deal.
Uncovering a red bucket item doesn’t mean you automatically have to walk away from the acquisition, but it may mean you need to reassess or modify the deal. There are, of course, issues that will cause the deal to fall apart. For example, I recall discovering a pattern of under the table payments — one liability where we had to walk away.
But how in principle do you know if what you’ve uncovered is a deal changer or a deal breaker?
It really comes down to risk assessment and if you think the deal is still worth it. Fortunately, you don’t have to make this decision on your own. Confer with your acquisition team, both your internal leaders and external advisors.
Let’s say you’re confronting a clear-cut red bucket item. Here are some questions to ask: Is there a way to carve out or isolate yourself from the liability? Would modifying the transaction still fit with the strategic opportunity that’s driving your interest in the deal? Is any remaining risk worth the overall strategic benefit?
Whatever the issue, be sure to have frank discussions with the seller about it. Ask for a full explanation of what happened, and why, and how it affects the business going forward.
Once you’ve taken some time to evaluate a red bucket item, it becomes a simple business decision: Do you want to proceed with the deal or not?
At the end of the day, there’s no way to completely eliminate risk from an acquisition. After all there’s no reward without risk. But by conducting thorough due diligence and taking a strategic look at red bucket items, you can minimize liabilities and protect yourself from unnecessary hazards while maximizing your opportunity.