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M&A Poker

It was a textbook late-stage M&A showdown.

Buyers on one side of the table, sellers on the other, each flanked by their chosen Big 4 advisors. The room had the quiet intensity of a high-stakes poker game.

The deal was close. Very close. But close doesn’t count in M&A. A deal’s not done until the ink’s dry.

Lawyers were hovering in a side room, ready to spring into action the moment white smoke rose from our negotiations. But for now, we were deadlocked over a few “minor” balance sheet items in the closing statement.

I was the junior on the buy-side team, mostly there to observe and take notes. But I’d been told to prepare, just in case. I had a couple of talking points in my back pocket, not that I was itching to use them.

At the heart of the standoff were two issues: the accounting treatment of an inventory reserve and what we viewed as an underspend on maintenance capex.

Together, our adjustments were worth $3 million in equity value, more than 5% of the total deal. Not chump change, especially since every dollar we clawed back came straight out of the seller's pocket. And this wasn’t just any seller, it was a competitor.

At this stage of the deal, this was trench warfare: their pocket vs. ours. Forget any notion of ‘win-win’.

There was plenty of ego on display. And not just between the buyer and seller. Tension was high between the Big 4 partners. This was a technical debate, and both were determined to prove they were the smartest person in the room.

And yet, everyone knew the deal wasn’t going to fall apart over these points. Both sides were too far in. The seller had mentally spent the proceeds. We’d sunk too much into deal costs to walk away over a dispute of this size.

Still, it took hours of back-and-forth before the impasse broke. What finally moved things along? 

Our CEO.

After waiting patiently in a side room, he walked into the conference room, looked around, and said, “Are you lot still f*cking about? I’m ready to sign this in 30 minutes. If we’re not done by then, I’m going home, and I might not feel like signing tomorrow.”

That did it.

Everyone found their compromises, the papers got signed, and the tension in the room quickly lifted.

I’ve seen this charade play out on most deals I’ve worked on. Both sides reach the point where they’re grinding for the last dollar, locked in a standoff. Then, inevitably, something brings a reality check - in this case, a flippant remark from the CEO.

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Due or die

This month’s CFO Secrets Playbook is all about financial due diligence: how to sniff out the deals worth doing, and, walk away from the ones that could sink you.

What is Financial Due Diligence (FDD)?

Financial due diligence is the art and science of separating what’s real in the numbers from what’s just for show.

It’s about digging beneath the surface of a company’s numbers to understand its true financial health, identify risks, and verify the story being sold. A good CFO knows it’s not just about checking boxes, it’s about zeroing in on what could make or break the deal - and putting it to the test.

Financial due diligence (FDD) can apply to many scenarios, but it’s most common in M&A deals. This is where the stakes are highest. For that reason, we’ll explore FDD through the lens of M&A.

What FDD is NOT

Terminology is confusing in this world.

Due Diligence, Financial Due Diligence, and Quality of Earnings can all be used interchangeably. Which means it’s the fabric and scope of the work that’s more important than the name.

But for the purposes of this series, let’s try and establish some consistent terminology, shall we?

First, there’s Platform Due Diligence - the full universe of DD that goes beyond finance: i.e. legal, commercial, HR, ESG, and more.

FDD is one part of the total platform diligence. An important part, but only one. And in itself, forms a complete view of the company’s financial health.

Then there is a Quality of Earnings Review which has a narrower focus than full financial due diligence.

Let’s break it down:

Time to zoom in:

The language you hear depends a little on the part of the market, and complexity of deals you are exposed to.

In the SMB and lower mid-market space, you will mostly hear the term Quality of Earnings (QoE) Review used as a proxy for FDD. The scope normally covers the QoE plus a handful of deal-critical items in the wider FDD scope (basic tax and working capital peg).

We’ll get deeper into what a QoE review looks like next week.

In big deals (9 figures+) you are more likely to see a full suite of due diligence. It’s much easier to justify a $10m deal cost bill on a $1bn transaction, than a $100k bill on a $2m transaction. As long as you can manage the risk of a deal falling through (more on that later).

In this series we are going to focus on FDD specifically.

Why is FDD important?

At its core, it’s about knowing exactly what you’re buying and how to value it.

And even if you decide you don’t need FDD, if you are borrowing money, your lenders will likely mandate it.

When you buy a business, you are signing up to inherit a new risk and return profile. So the intention of FDD is to ensure the buyer properly understands that risk and return profile. The clearer you are on the expected future cashflows a business will generate, the easy it is to value it today.

There is a high level of focus on downside risks; the things that could make your investment a disaster.

Seeking out low probability but high impact adverse events, to ensure you can get liability coverage from the seller where appropriate.

There’s almost always a skeleton in the closet (if not many.) Identify these risks, and you can use the deal documentation to push the risk back to the seller - or at least get leverage to negotiate.

It’s what you don’t see that might kill you.

Is due diligence always essential?

You can do deals without DD, even complex ones.

Last week cloud accounting giant Bench announced they were shutting down. Three days later Employer.com announced they had bought Bench, and it would be business as usual for Bench customers.

The CEO of Employer.com announced on Twitter the deal was done from start to finish in 48 hours.

This is seriously impressive execution. But also pretty common in a distressed situation.

If it is all about risk and reward. FDD is one way of managing risk, in a thorough, methodical way. But you can also manage the downside by getting a price (and deal structuring) so favorable that the unknown risks are pre-mitigated.

If someone offered you a six-bedroom mansion in the Hamptons for $50,000, you’d take it. You wouldn’t waste time inspecting every room or checking for a fresh coat of paint. You’d confirm it exists, verify the ownership, and wire the money. Even if the plumbing’s shot and the roof leaks, it’s still a deal at that price.

Price IS your due diligence - or at least part of it.

And if not using price, you can use the terms of the deal. This is why I like a seller note in an SMB deal structure. Forget the funding advantage; it acts as a truth serum, and accelerates diligence. The seller has a stake in ensuring the buyer has a full picture of the business.

Can you DIY FDD?

Sure, you can. You can do anything, Champ. But the real question is: should you?

Doing FDD well is pretty technical. The challenge isn’t doing the work, it’s drawing the right conclusions and connecting them to the broader M&A transaction, especially the legal documents.

M&A is all about experience. By outsourcing to a specialist, you’re buying that expertise. A partner who has seen it all before.

You can build in-house capability, but how do you use it efficiently? M&A projects are binary. They are either on or off. Keeping a team busy year-round (or avoiding burn-out during busy times) is the real challenge.

Most large companies have a baseline corporate development team but still outsource peaks of work to the Big 4. Often the more technical aspects of FDD.

Serial acquirers like Apple might approach this differently. Apple reportedly makes 15 to 20 acquisitions a year, mostly bolt-ons. They can justify an in-house diligence team, but that’s Apple…

In the SMB world, DIY can be tempting, but I don’t recommend it unless you truly know what you’re doing and can spot and test risks in your deal thesis.

Focus on getting your deal under a Letter of Intent. Once you’re confident the deal will happen (Subject to no DD surprises), that is when you invest in FDD.

If you do end up discovering a nasty surprise, the money you spent on diligence just saved you from a much bigger mistake.

Finding an efficient FDD solution for smaller deals (sub-$10m) isn’t easy. If you’re in the SMB or lower mid-market space and need a Q of E provider, hit reply. I can connect you with someone I trust.

Scope vs. risk in FDD

The scope of FDD needs to match the risk. As CFO, that’s your call to make.

Remember, your favorite Big 4 transaction services partner has a profit target to hit so they’ll always try to sell you more than you need. They will scope pad.

That’s why you need to challenge them.

The risk of fee overruns is enormous when the Big 4 (or equivalent) are handling your FDD project.

There are so many variables and endless potential for scope creep. I remember one engagement where the Big 4 team initially estimated a ~$400k fee. By the time the project wrapped, they’d tacked on another $175k. Sure, the work was real, and the costs were justified on paper, but it barely added any value. It was just them ticking boxes on a checklist no one asked for. In hindsight, it was my fault. The scope wasn’t tight enough. We struck a settlement of the over-run cost in the end, but it was a hard won lesson.

Nearly every major FDD engagement I have ever run has finished with a call from the partner asking for another 25% or so of fees due to scope creep or inefficiencies. Sometimes legitimately, others not so.

Advisory charge rates are far higher than audit—and with fewer discounts. The bills add up fast. We’ll talk more about how to manage the fee risk later in the series (spoiler: fee caps are important).

And then there is the risk of burned deal costs. Nobody likes those.

You should manage this risk by breaking the work into stages each with a crystal clear scope:

• Stage 1: A light-touch review to land on assumptions for the initial valuation ahead of the first-round bid

• Stage 2: A detailed FDD review where the bulk of the work happens, completed before submitting final bids. This report will be the key document for any funders, if applicable.

• Stage 3: Confirmatory DD where you test any remaining assumptions that couldn’t be tackled in Stage 2, focusing on recent developments and trading activity in the business

This fits a typical auction process for mid-market and above transactions. It allows you to increase commitment as your deal conviction grows.

You have a clear scope for each stage, which is informed by the output of the previous stage.

Stage 2 is where the serious costs begin, so you need strong conviction and confidence in success before moving forward. By Stage 3, you should have some level of exclusivity in negotiations.

For smaller transactions, this process is simplified, and a Q of E report is typically only engaged once there’s high confidence the deal will close.

This month’s FDD Series

By the end of this series, I hope you’ll be better equipped to assess deal risk and tailor the FDD scope to match.

No two deals are the same. The FDD scopes shouldn’t be either. FDD isn’t about ticking boxes on a checklist (although this approach is surprisingly popular). The work needs to be weighted towards the specific deal risks.

The goal of this series is to share first-principles thinking for CFOs. To help you think on the fly, challenge your advisors, and nail the right scope and structure for your FDD. And evaluate the results…

A quick note before we dive in - three disclaimers for this series:

1. I am not an M&A expert or practitioner. I have never worked in an investment bank or PE fund. I’m just a CFO who’s been through a lot of M&A.

2. This series focuses on FDD in a big-company setting. I’ll highlight key differences with small-company M&A, but the primary lens is corporate transactions that rely on advisors.

3. Legal and tax structuring are out of scope. They’re geography (and situation) specific. Generic advice won’t help you here. Talk to an M&A attorney and tax advisor about your deal.

Here’s what we’ll cover throughout January:

• Part I: Introduction to Financial Due Diligence (today)

  • The scope of FDD vs risk

  • Why do FDD at all?

  • FDD vs Q of E vs Wider Due Diligence

  • Stages of FDD

• Part II: Quality of Earnings Review

  • What metrics to use & finding the base

  • Non-recurring items and reclassifications

  • Run rate adjustments

  • Pro forma adjustments

  • Overlaying recent developments

• Part III: Balance Sheet Effects

  • From Enterprise Value to Equity Value

  • Closing balance sheet vs. locked box

  • Net Working Capital (& The Peg)

  • Debt & debt like items

  • SMB deals

• Part IV: Running the Process 

  • How to set your scope

  • How to select advisors

  • Engagement Structure

  • Negotiating tactics

  • Post-closing true-ups

See you next week as we dive into how to build up a Quality of Earnings Review.

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As a reminder, there is an all new ‘Mailbag’ newsletter coming every Tuesday, starting this week. We’ve also had a bit of a facelift for 2025, hit reply and let me know what you think.

Next week we’ll get into how to build a Quality of Earnings Review.

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