Mergers and Acquisitions (M&A) are major corporate actions in the life of any company. While the potential for growth, diversification, and expansion is appealing, the process is complex and requires careful consideration. To direct an M&A deal smoothly, due diligence is critical to assess the health, risks, and value of the startup being acquired or merging with. 

In this article, CA Manish Mishra talks about due diligence checklist for startups considering M&A deals.

- Corporate Structure and Governance

It is very important to understand the corporate structure, which is essential to avoid future conflicts and ensure clarity on decision-making processes post-deal.

• Ownership Structure: Analyze the equity ownership and shareholder agreements. This will help determine who has control over the company and what rights are held by investors, co-founders, or employees.
• Board Composition and Governance: Review the board members, corporate governance structures, and any shareholder meetings minutes. Ensure that decision-making procedures are in place, and there is alignment between the founders, investors, and board members.
• Company Subsidiaries and Affiliates: Identify and analyze the structure of any subsidiaries or affiliated companies to determine if there are any legal or financial obligations that may impact the deal.

- Financial Records and Performance

Financial due diligence is a critical aspect of evaluating the startup’s financial health and performance.

• Financial Statements: Request and review the past 3–5 years of audited financial statements. These should include balance sheets, income statements, cash flow statements, and tax returns.
• Revenue Streams: Understand how the startup generates revenue. Scrutinize any recurring revenue models, subscription models, or other forms of consistent revenue generation.
• Debt and Liabilities: Identify any outstanding debts, loans, or credit obligations, along with repayment schedules and terms. Pay close attention to any off-balance-sheet liabilities.
• Profitability and Margins: Review profit margins, cost structures, and profitability trends to understand whether the company is on a sustainable growth path.

- Legal and Compliance Considerations

The legal aspect of M&A deals is paramount, as there may be hidden risks that could affect the deal's success.

• Corporate Documents: Verify all incorporation documents, such as Articles of Association, Shareholder Agreements, and Bylaws. Ensure that the company is compliant with all local and international regulations.
• Intellectual Property (IP): Identify all IP assets, including patents, trademarks, copyrights, and domain names. Ensure that these assets are properly registered, protected, and not under dispute.
• Contracts and Agreements: Review all significant contracts and agreements, including customer contracts, supplier agreements, and leases. Pay particular attention to clauses that may be triggered by an M&A deal, such as change-of-control provisions or termination clauses.
• Litigation and Claims: Review the company’s litigation history and potential claims that may arise post-acquisition. Any ongoing legal disputes could potentially derail the deal or result in unforeseen costs.
• Regulatory Compliance: Verify the startup’s compliance with all relevant local, state, and international laws, such as data privacy laws, environmental regulations, or industry-specific guidelines.

- Human Resources and Employment Matters

The team is one of the key drivers of a startup's value. Therefore, understanding the workforce structure and any related liabilities is important.

• Employee Agreements: Review all employment contracts, non-compete agreements, and intellectual property assignment agreements. Make sure there are no issues around the protection of proprietary information.
• Employee Benefits and Stock Options: Investigate any outstanding employee stock options or equity compensation plans. Understand the structure of employee benefits, including health insurance, pensions, and bonus schemes.
• Talent and Key Employees: Identify the key employees who drive the startup’s growth. Determine if any of them are planning to leave or are critical to the success of the company post-deal.
• Labor Issues: Identify any ongoing or past labor disputes, grievances, or employee turnover trends. High turnover can indicate deeper issues in the workplace culture.

- Technology and Products

For tech startups, technology can often be the most valuable asset. Proper due diligence in this area will protect against future integration challenges.

• Technology and Development: Review the company’s technology stack, software development lifecycle, and technology roadmap. Assess the scalability, security, and efficiency of their technology.
• Product Pipeline: Review the company’s product offerings, both current and in development. Determine whether these products have a competitive advantage and if there are potential barriers to entry.
• Product Performance and Feedback: Analyze customer feedback, user reviews, and product performance metrics. This will help assess whether the product meets market demand and has growth potential.
• Technology Partnerships: Examine any partnerships with third-party vendors, cloud providers, or technology partners. Ensure there are no dependencies that could complicate the integration post-deal.

- Market and Competitive Position

It’s essential to understand how the startup fits into its industry and its potential for growth in the future.

• Market Analysis: Review the startup’s market position, including market share, target market, and growth potential. Understand the startup's competitive edge in the market.
• Competitor Site: Identify key competitors and analyze their strengths and weaknesses. Assess how well the startup differentiates itself from the competition.
• Customer Base: Review customer demographics, churn rates, and the concentration of revenue from a small number of clients. A diversified customer base indicates lower risk.
• Sales and Marketing: Review sales strategies, marketing campaigns, and customer acquisition costs. Evaluate whether the sales model is scalable and whether marketing strategies are effective.

- Tax and Regulatory Risks

Due diligence should also focus on understanding the potential tax implications of the M&A deal.

• Tax Returns: Review the startup’s tax returns for the past 3-5 years to identify any potential tax liabilities or audit risks.
• Tax Compliance: Ensure that the startup has complied with all local, state, and international tax laws. Pay close attention to sales taxes, income taxes, VAT, and any industry-specific taxes.
• Tax Losses and Credits: Determine if the startup has any accumulated tax losses or tax credits that may be carried forward or utilized post-acquisition.

- Financial Projections and Growth Potential

It’s important to analyze the financial future of the startup to determine the long-term value and scalability of the company.

• Financial Projections: Review the startup’s projections for revenue, expenses, and profitability. Assess the assumptions behind these projections and ensure they are realistic and achievable.
• CapEx and Future Investments: Review any upcoming capital expenditures (CapEx) or major investments the company is planning. Understand how these will impact future cash flow and profitability.
• Synergies: Evaluate potential synergies that may arise from the M&A deal, such as cost savings, new revenue streams, or operational efficiencies.

- Cultural Fit and Post-Merger Integration

M&A deals often fail due to cultural mismatches between the two companies. Understanding the startup’s culture is essential for a smooth integration.

• Company Culture: Assess the startup’s culture, values, and management style. Ensure alignment with the acquirer’s culture to reduce friction during integration.
• Post-Merger Integration Plan: Review the post-merger integration plan, ensuring that roles, responsibilities, and expectations are clear. The integration should aim for smooth collaboration and retention of key talent.

GenZCFO Advice

The due diligence process is an essential step in any M&A transaction, particularly for startups looking to either acquire or merge with other companies. GenZCFO helps you by focusing on the key areas outlined in this checklist, startups can ensure that they make informed decisions and mitigate potential risks in the M&A process. Proper due diligence will provide a clear understanding of the startup’s value, allowing both parties to move forward with confidence, minimizing surprises and positioning the companies for long-term success. Contact us for more information.