What is Due Diligence?
Due diligence is an
essential process utilized by companies and private equity firms to evaluate a
potential merger or acquisition. Buyers will conduct due diligence on a target
company to confirm the accuracy of the seller's
claims, mitigate risk and garner deep insight into the operations - prior to committing to the deal. While the
investigative process is painstakingly extensive, can help prevent costly
surprises later - and
increase the chances of M&A success.
Examines general records and the business plan
to understand the corporate structure and
standing of a company. This broad
initial step sets the stage for the more in-depth and targeted due diligence
investigation.
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Articles of incorporation.
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Corporate by laws and any amendments.
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Minute book (containing ownership and board meeting
minutes).
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Certificate of Good Standing.
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List of subsidiaries
and any other entities in which the company has an equity interest
(i.e., partnerships and joint venture
agreements).
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All
jurisdictions where the company is authorized to conduct business.
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Any
documents relating to reincorporation or restructuring.
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Business plan (executive summary, market
analysis and plan, operational plan, and complete
financials).
Organization and ownership information
Delves into the structure of a company from a personnel
perspective. The organizational due diligence
phase provides perspective surrounding the ownership of the business, which
will be critical to consider
when acquiring or merging with a company.
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List of
officers and directors.
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Organization chart.
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Records surrounding issuances or grants of stock, options
and warrants.
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List of all shareholders.
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Include number of shares, dates of issuance and
type of consideration received.
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Documentation of past and
current shareholder agreements, rights, and other matters
concerning ownership.
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Copies of any voting agreements, trusts, or proxies.
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Copies of right of first offer or refusal and preemptive rights.
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Transfer restriction agreements and registration agreements.
Administrative due diligence confirms administrative information about a company, like
the business
facilities, occupancy rate and number of workstations.
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List of all business locations
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Where the company owns/leases property,
maintains employees and/or conducts business.
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Include applicable
details like the occupancy rate and number
of workstations.
This part of the due diligence stage assesses
regulatory or compliance issues with the target
company or the overall
deal. This process is particularly important in heavily regulated industries or with large parties in play. Look for any
antitrust risks the deal may present.
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Copy of the company's compliance policy
and written standards of conduct.
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Copies of any governmental licenses,
permits or consents.
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Any correspondence, citation, notice or documents relating
to any proceedings of any regulatory
agency.
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Any documents filed with the SEC or any state or
foreign securities regulatory agency (if applicable).
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Any material reports to government entities and agencies (including the EPA
and OSHA).
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Analysis of potential
antitrust issues (if
applicable).
Confirms seller's financial performance by examining both accounting and financial documentation.
The objective here is
to identify any unreported liabilities, understand the target1s current
financial position and determine
if earnings are sustainable. These activities help ensure a realistic valuation of the target and justification of the
purchase price.
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Documentation surrounding the capitalization of the company.
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Three years of annual and quarterly audited financial statements, with the auditor's reports.
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Unaudited financial statements for comparison.
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Latest interim financial information.
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Future financial projections.
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Descriptions of strategic
plans.
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Budget plan.
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Any
auditor communication to
management for the past five years.
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Schedule of accounts
receivable and accounts
payable.
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A description of depreciation and amortization methods
and changes in
accounting methods over the past
five years.
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Copy of the company's general ledger.
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Copies of any debt financing documents
(i.e., loan agreements, credit agreements, promissory notes, compliance
certificates, etc.).
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Copies of any equity
financing documents
(i.e., stock purchase agreements, subscription agreements, etc.).
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List of internal control procedures.
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Schedule of any deferred revenue.
Operational
Operational due diligence
examines the target companis systems
and processes to identify risks
arising from execution of the business function. Here, buyers assess the effectiveness of the target's operating model - including sales,
marketing, technology, supply chain and production - to determine gaps and potential areas where
investment or
development are needed. The goal is to see if the current
state of operations can support the business plan provided by the target company.
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Overview of company's operating model
showing key systems and processes (both insourced and
outsourced).
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Description of the change management process when a change to the operating model is
needed.
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Copies of any documented procedures.
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Overview of the organizational/ functional structure of the teams.
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List of company's
primary and support
activities.
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A summary any tests, evaluations,
studies, surveys, and other data regarding existing
and under development
products/services.
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Identification of
key performance indicators, value drivers and cost drivers.
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Information around
sales and marketing procedures, including research, messaging, CRM systems and processes, and lead generation practices.
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List
of all third parties in the supply
chain.
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A breakdown by manufacturing site of the products manufactured, personnel employed, number of
shifts and capacity.
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Documentation around supply chain processes (i.e., delivery times, inventory availability, transportation mode/costs,
facility costs, inventory investment, contract manufacturers, etc.).
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List of main suppliers and their discounts, terms, and credit limits.
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Details around distribution model and channels.
Delves into the target's
tax profile by analyzing tax returns and the company's tax structure. Tax examination is a highly emphasized area of due diligence, as the acquiring company will be liable for any
tax issues it inherits.
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Federal, state,
local and foreign
income tax returns
for the last three years.
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State sales tax returns
for the last three years.
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Excise tax filings for three
years.
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Employment tax filings for past three years.
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Documentation around tax structure and key tax elections.
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Any audit adjustments proposed by the IRS.
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Documentation around any tax liens or settlements.
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Copies of any audit and revenue agency reports.
Legal
Reviews the legal matters facing
a company and related risk around contracts or litigation. Legal due diligence greatly affects how, or if, a deal will move
forward. Issues like restrictive
and/or breached contracts, noncompete clauses and
past or pending litigation will influence the structure
of a deal. After all,
post-transaction, the buyer is
going to be liable for any obligations, contingencies, and restrictions.
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Any
pending or threatened litigation against or initiated by the company.
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Any
settled or concluded litigation
against or initiated by the company.
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All
active litigation files.
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Any consent decrees, injunctions, judgments, settlements, or other orders.
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Copies of all contracts.
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Any loan agreements,
bank financing agreements, and lines
of credit to which company is a party.
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Licensing or franchise agreements.
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Copy of all guarantees to which the company is a party.
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Information as to any past or present governmental investigation.
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Copies
of all attorneys' responses to audit inquiries
and all attorneys' letters to auditors.
Technological
The technological
aspect of the due diligence
process examines the
company's IT assets (or lack thereof) to
assess sustainability, value, costs, scalability and evolution
capabilities, as well as how systems would integrate into the buyer's company or portfolio. People and processes need to be
proven effective and adaptable. A cybercrime proliferates, an increasingly
important focus is the vulnerability inherent in
the IT infrastructure.
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List of software used by the company and copies of any
applicable licensing agreements.
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Any
IT outsourcing agreements.
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Current system usage and age.
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A list of interfaces that link systems together.
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Documentation around
IT processes including applications
development, IT operations, disaster recovery,
IT security, and cost management.
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Information around security and controls framework.
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Details surrounding
any hack, breach or any other
cybersecurity incident.
Physical assets
Asset due diligence verifies the tangible assets possessed by the target. This involves confirming the existence, value, age, quality and
ownership of a company's real estate, fixed assets and inventory.
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List of all owned or
leased properties and applicable details (i.e., rent amount, location, dates, etc.).
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Details on all sales
and purchases of major capital
equipment in the last three years.
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Copies of all lease agreements for equipment.
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Copies of real estate deeds, appraisals, mortgages, leases, surveys,
title policies, use permits and any other relevant
documentation.
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Schedule of owned and leased fixed
assets, including description, date acquired, value and location.
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Copies of any
equipment appraisals.
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Copy of inventory listing, including item description,
item number, date, units, and cost
for the most recent year-end and month-end.
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Description of practices regarding
inventory aging, valuation, and obsolescence, and any methodology changes.
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Any UCC filings.
Intellectual property
(IP)
Particularly
in technology-driven
industries,
a target company's IP portfolio largely determines its
value and relevance to the combined company. IP due
diligence should gauge the
materiality of the IP portfolio and ensure that there are no inherent
ownership issues present.
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Schedule and copies of all intellectual property registrations and pending
application.
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Patents and patent applications.
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Trademark registrations,
trademark applications and
trade names.
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Registered and material
unregistered copyrights.
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Copies of the chain of title records.
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Documentation around any claims or threatened claims by or against the company
regarding IP.
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Copies of any IP-related agreements
(i.e., licensing, collaboration, research and development, etc.).
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List of the company's active websites and social media accounts.
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Documentation around all proprietary and/or
customized software and IT systems
utilized by the company.
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General descriptions around proprietary
know-how, trade secrets, technology
and/or processes.
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Documents detailing the
company's approach to IP protection
and enforcement (i.e.,
confidentiality and non-disclosure agreements, employment agreements around IP,
etc.}.
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A list of all licensing
revenue and expenses.
Human resources
HR due diligence analyzes the
critical people
component of the M&A transaction. It considers information like total number of employees, demographics, compensation, benefit plans, human
resource policies, contracts
and organizational structure. The data garnered
on the personnel involved will
help an acquiring company
determine key employees and an integration plan should the transaction move forward.
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Employee demographic information {age, location, title, tenure, skillset, compensation, etc.).
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Employee handbook (should cover
policies, benefits, procedures and training).
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Files containing all employee relations
matters - including any
past/current disputes or complaints.
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All employee, non-disclosure, non-solicitation and non-compete
agreements.
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Copies of all stock option and stock purchase plans.
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Resumes of key employees.
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Documentation around qualified and nonqualified retirement plans.
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Assessment of
the competencies, skillsets
and capabilities of employees.
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Performance review schedules
and structure.
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Recruiting and onboarding process.
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Copies of payroll
documents.
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Copies of any labor or employments contracts.
Commercial
Commercial due diligence
examines the target's
ecosystem to determine
its place in the market. This process
delves into market
conditions, trends, consumers,
competitors, opportunities/threats and differentiators.
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List
of products and services
offered and in development.
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Market research including size, share, trends, drivers, demand, conditions, opportunities, threats, differentiators and outlook.
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Profiles of major competitors.
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List of top customers.
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Customer analysis including customer segments, demographics,
churn rate, satisfaction, customer acquisition cost, NPS score and lifetime value.
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List
of major suppliers.
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Identification of any barriers
to entry in the marketplace.
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A summary of all complaints or warranty claims.
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Copies of long-term sales contracts.
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Agreements with distributors, value-added resellers and dealers.
Environmental
This type of due diligence identifies
environmental, health and safety issues that could directly affect the value and reputation of
the target business, and by association, the buyer's larger organization.
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Interviews with past and present owners, operators and occupants.
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Copies of any violations, complaints or requests for information regarding environmental, workplace safety and health {from private
parties or governmental authorities).
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Historical sources
of information (i.e. aerial photographs, fire insurance maps, chain of title
documents, and land use records).
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Federal, state, local and tribal government records.
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Records concerning adjoining or neighboring properties.
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Permits and records relating to
environmental matters such as
underground storage tanks, air quality, water use, solid/liquid wastes and hazardous waste storage
or disposal.
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Any records of environmental cleanup
liens.
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Listing
of hazardous substances (i.e. asbestos,
pesticides or petroleum products) and any intentional or accidental
spills/releases of the material.
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Details on workplace
safety and health programs.
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Include any instances where unsafe
working conditions have been reported/corrected.
Cultural
Cultural due diligence is more subjective in
nature. It seeks to understand the
cultural dynamics of a potential acquisition in areas like values, perceptions,
traditions and working styles.
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Documents covering company
values, mission, vision and shared
beliefs.
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External stakeholder interviews.
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Internal stakeholder interviews and focus groups.
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On-site visit for observation.
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Questionnaires and surveys of employees to gauge both culture context and sentiment towards potential merger/acquisition.
Strategic due diligence
takes an analytical view of
all other due diligence
results to determine whether the transaction in question will be
of benefit to the buyer. It seeks to
assess a target's fit within
the buyer's larger organization and whether it will maintain
its value through
and post-integration.
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List of value
drivers for the acquisition (i.e., including
the addition of technologies/products,
key personnel acquisition, market access, revenue
enhancement, cost savings, operational and financial synergies, etc.).
• Identification of marginal costs that may be generated by the acquisitions.
• Assessment of strategic fit within the larger buyer organization.
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