Due Diligence Best Practices: The Critical Dos & Don’ts for Software Sellers

Holding responsibility for a successful due diligence process is daunting. After all, due diligence often represents one of the final steps before a merger or acquisition is complete. Mess up here, and it could mean starting from scratch.

While the nitty-gritty of due diligence is mostly handled by legal and accounting teams, overall due diligence strategy should be a team effort with a trusted advisor. It’s too important to tackle on your own.

So what is the best approach to due diligence during M&A? What are critical areas of focus? What are critical mistakes to avoid? Let’s jump in.

What is Due Diligence?

In a typical M&A deal, due diligence is the point in the process where sellers share all relevant information about a business with a potential buyer in order to move forward with the deal. In SEG deals, the majority of information has already been shared before reaching this stage to avoid any unwanted surprises (more on the importance of this later).

For sellers, the goal is to get through due diligence without any adjustments to the price or terms of the deal. For buyers, the purpose of due diligence is to ensure all risks are accounted for and all potential value has been correctly interpreted.

Companies typically bring on lawyers, accountants, tax experts, company leaders, and others to examine company data including financial records, liability obligations, company processes, intellectual property, and more. Due diligence is arduous and involves input from all areas of a business.

When Does Due Diligence Begin?

In M&A, typically due diligence begins after an LOI (letter of intent) is signed. Due diligence is confirmatory in SEG processes, meaning that the buyer is simply making sure everything checks out and all established expectations are correct.

However, since due diligence is when all the cards are finally laid out on the table, it is the most vulnerable stage of the M&A process for a seller. It is imperative that no new information of material nature is shared at this stage of the process to avoid a re-trade.

Continuing the daily operations of a business while also conducting proper due diligence is a major challenge. Not knowing the right questions to ask, lack of expertise, and sunk costs can all add up over the due diligence process. Often, sellers experience deal fatigue when all these separate challenges compound.

Rather than going it alone, we recommend seeking out an M&A expert to navigate the new territory with you. An advocate and someone with real experience can be a lifesaver when you need it most.

The Importance of Due Diligence

Perhaps nothing illustrates the importance of due diligence more than what happens when due diligence goes wrong, as it did with HP’s acquisition of Autonomy in 2012. HP purchased Autonomy for $11.1 billion, hoping to move away from hardware and enter the more profitable arena of computer software.

However, HP committed a major due diligence oversight — failing to notice inaccurate income statements, balance sheets, cash flows, and relevant footnotes. HP was then sued by shareholders in federal court for negligence. The cost of HP’s due diligence fumble? A loss of $5 billion (almost half of the purchase price).

A good due diligence process matters. Not only does it prevent major buyer oversight like in the case of HP and Autonomy, but it also helps the seller get the best deal possible. Here are a couple of reasons why due diligence is important for all M&A transactions:

1. Due diligence helps the seller avoid a re-trade, where the buyer renegotiates the price or terms of the deal.
2. Due diligence is a win-win for both buyer and seller — the buyer feels more comfortable with the purchase, and sellers can push the deal through the finish line.

With so much at stake, a good due diligence process is critical to any M&A deal. Getting the process right, from start to finish, should be a top priority for all involved.

Sell Side Due Diligence Dos & Don’ts

Knowing where to start with due diligence can be daunting. However, these due diligence best practices will give you a proper foundation to build on throughout the M&A process. If you follow these practical “do’s and don’ts,” you’ll be sure to start off on the right foot.

Due Diligence Challenges

One of the most common reasons why M&A deals fail is underestimating the process. For software M&A, that includes underestimating how much time and effort are required to undergo the full due diligence process, the emotional toll diligence can take, and how to respond when buyers want to re-trade.

Diligence takes time
The due diligence process can take anywhere from 30, 60, or 90 days. As we’ve mentioned, timing is of the essence. Time kills deals in the due diligence portion of proceedings because it’s the part of the deal when the seller has the least leverage. By not acting in a timely manner, sellers might lose their chance altogether.

By not having due diligence documents prepared beforehand, deals can drag on and create unnecessary friction between your actual business and the process of selling it. Not only that, but not being prepared often means increased costs as companies scramble to hire accountants, lawyers, tax experts, etc., to meet their buyer’s demands.

Increased time means increased costs when it comes to due diligence.

The emotional toll of diligence
Many software founders are unprepared for the emotional and physical toll diligence can take. Getting frustrated about the process can complicate relationships, or not focusing enough on the business can lead them to miss financial projections and lose key customers. Add in a lengthy diligence process to the mix, and you’ve got a recipe for burnout and exhaustion.

Buyers want to negotiate key terms
One of the biggest challenges during diligence in a software M&A deal is that buyers are inherently at an advantage because they’ve gone through this process before. Buyers have a dedicated team of professionals in their corner running the process, and their goal will always be to purchase for the best price and terms possible.

Some common negotiation points include:

• Price
• Terms
• Deal structure
• Salaries and use tax
• Indebtedness definitions, etc.

In order to avoid death by a thousand papercuts, sellers need to make sure they’re ready to deal with buyers from the start. Waiting for it all to come to a head during diligence is an added challenge most sellers aren’t equipped to handle.

At Software Equity Group, we bring 30 years of experience in M&A services to the table. We know just how important due diligence is to get right to avoid re-trades and to ensure a deal is successful. Reach out to discuss how we can help your company through an M&A process, or check out our comprehensive due diligence checklist to learn more.