Due Diligence
Due Diligence refers to the comprehensive appraisal of a business undertaken by a prospective buyer. It is the process of reviewing and documenting legal, financial, and compliance aspects of the company. The investor checks the regulatory and process compliance, specifically before an investment or funding.
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About
Due Diligence
Due diligence is an investigation, audit, or review performed to confirm the facts of a matter under consideration. In the financial world, due diligence requires an examination of financial records before entering into a proposed transaction with another party. Due diligence is usually associated with large-scale investments, the restructuring of a company, or mergers and acquisitions (M&A).
The aim of due diligence is to check the valuation of assets and liabilities, assess the risks within a business, and identify areas for further investigation; this enables an investor or purchaser to make informed investment decisions.
Reasons for Due Diligence
There are several reasons why due diligence is conducted:
Importance
Importance of Due Diligence
Transactions that undergo a due diligence process offer higher chances of success. Due diligence contributes to making informed decisions by enhancing the quality of information available to decision makers.
From a buyer’s perspective
Due diligence allows the buyer to feel more comfortable that his or her expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.
From a seller’s perspective
Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.
Due diligence undertaken in mergers and acquisitions is vigorous, time consuming, and complex. Incomplete or improper investigation is actually one of the major culprits of M&A failure. Therefore, it is critical for firms to closely investigate potential investments and understand the business’ true value. A firm may otherwise waste a great deal of their valuable assets and time completing the transaction.
Organizations exercise due diligence by:
- Researching customer reviews and the seller’s reputation
- Considering the environmental impact of the due diligence transaction
- Supplementing purchases with insurances or warranties
- Evaluating price in comparison to competitors
Expiry
What Happens when Due Diligence Expires?
Often times, the Letter of Intent (LOI) includes a Due Diligence Clause. This often defines the conduct and rights during the investigation, the parties involved, and what happens after commercial due diligence.
However, the exhaustive and intensive nature of an audit may cause issues for firms. Some cannot assemble all pertinent information while abiding by a definitive deadline. If this happens, the buyer can only use the information uncovered during investigation to decide whether to close the deal.
In some cases, if the buyer feels that their investigation was inadequate, they may request an extension from the seller. Extensions may or may not be granted. In turn, this could even frustrate the seller. The biggest takeaway here is that efficiency, productivity, and effectiveness are critical.
Areas
Areas of Due Diligence
Due diligence is typically undertaken in business due to two main types of transactions. This includes the sale or purchase of goods and services or when merging with or acquiring another corporate entity. Within each transaction, it is generally conducted in a number of areas.
The goal of investigation in general transactions is to substantiate whether the purchase is a sound decision. Items examined may include:
- Warranties
- Inventories
- Customer reviews of the seller
Enhanced due diligence in mergers and acquisitions is considerably more extensive. It audits areas such as:
- Financial records
- Business plans and practices
- The target company’s customer base
- Products or services in their pipeline
- Human resources statistics
- Sustainability and environmental impact
One high-vitality area that many businesses fail to accomplish in its entirety or even at all is a self-assessment. In a self-assessment, organizations ask themselves what their corporate needs are and what they hope to glean from the transaction. When executed properly, a self-assessment will commence integration down the right path.
Types
Types of Due Diligence
Audits should be all-encompassing, which makes it difficult to even know where to begin or what to look at. Detailed are 8 types of investigations that should be undertaken to ensure comprehensive coverage of risks and pressure points.
Financial
Financial due diligence is one of the most critical and renowned forms. In financial audit, firms investigate the accuracy of the financial records in the Confidentiality Information Memorandum (CIM). The target is gaining an understanding of overall financial performance and stability and detecting any other underlying issues.
Financial audit refers to an in-depth analysis of another company’s financial records. Firms undertake financial investigation prior to entering an agreement with another entity. This ultimately helps appraise its value and calculate potential risks. Common circumstances that require financial investigation include initiating a substantial investment, merging, or acquiring a firm.
Common questions, what are the due diligence documents that should be collected? Materials and documents analyzed during the financial due diligence are:
- Revenue, profit, and growth trends
- Stock history and options
- Short and long-term debts
- Valuation multiples and ratios in comparison to competitors and industry benchmarks
- Balance sheets, income statements, and the statement of cash flows
- The company’s forecasts and projections
- Inventory schedules.
Legal
Legal due diligence helps determine whether the target company is legally subservient or embroiled in issues. Items assessed include:
- Contracts
- Corporate documents
- Board meeting minutes
- Compliance doctrine
Human Resources
Human Resources (HR) due diligence focuses on the company’s most vital asset: their employees. HR investigation aims to understand:
- The company's organizational structure
- Compensation and benefits
- Vacancies
- Union contracts (if applicable)
- Any types of harassment disputes or wrongful terminations
Operational
Operational due diligence involves an examination of all the elements of a company’s operations. The objective is to evaluate the condition of technology, assets, and facilities and unearth any hidden risks or liabilities.
Environmental
Environmental due diligence verifies that the company’s processes, equipment, and facilities are in compliance with environmental regulations. The purpose is to negate the possibility of penalties down the line. These may span from small fines to more severe penalties such as plant closures.
Business
Business due diligence identifies who the company’s customers are and pinpoints its industry. It helps forecast the impact and associated risks that the transaction may pose on the acquiring firm’s current customers.
Strategic Fit
Strategic fit due diligence assesses whether the target company will be suitable with respect to their goals and objectives. This requires the buyer to assess:
- Potential synergies
- Benefits of the transaction
- How well the two entities would merge together
Self-Assessment
Self-assessment due diligence is often overlooked by firms. However, it is one of the most important. It should be enacted at the onset of merely considering an investment or integration. It is an inward-looking approach were firms collectively ask themselves, “what do we want or need from this transaction?” Essentially, a self-assessment is like writing a grocery list before heading to the store.
Examples
Due Diligence Examples
- Conducting thorough inspections on a property before buying it in order to make sure that it is a good investment
- An underwriter auditing an issuer’s business and operations prior to selling it
- A business exhaustively examining another to determine whether it is a sound investment prior to initiating a merger
- Consumers reading reviews online prior to purchasing an item or service
- People checking their bank accounts and credit cards frequently to ensure that there is no unusual activity
- An employer contacting an applicant’s references prior to initiating an employment offer to ensure that they are an apt candidate
- An individual testing or sampling a product out in-store before buying
Checklist
Due diligence that are generally on a due diligence checklist
Corporate structure and general matter
Taxes
Intellectual property
Strategic fit
Material assets
Contracts
Employee’s management
Litigation
Compliance and regulatory matters
Documentation
Documents required during Due Diligence of a Company.
√ Memorandum of Association.√ Articles of Association.
√ Shareholding pattern.
√ Certificate of Incorporation of the Company.
√ Financial statements including Balance sheets, Profit and Loss Accounts, Income and expense statement.
√ Bank Statements.
√ Income Tax Returns.
√ Details and Information of the Directors and management of the Company. √ Statutory Registers.
√ Utility Bills.
√ Employee records.
√ Intellectual Property Registration and other application Documents.
√ Tax Registration Certificates.
√ Property Documents.
√ Operational, Legal, other Financial Documents.
Process
Due Diligence Process
Due diligence in M&A is a lengthy and intimidating process that involves multiple parties and phases. Listed are general due diligence process steps.
Evaluate Goals of the Project
As with any project, the first step delineating corporate goals. This helps pinpoint resources required, what you need to glean, and ultimately assure alignment with the firm’s overarching strategy. This involves introspective questions revolving around what you need to gain from this investigation.
Analyze of Business Financials
This step is an exhaustive audit of financial records. It ensures that documents depicted in the Confidentiality Information Memorandum (CIM) were not fluffed. Additionally, it helps gauge the company’s asset health, asses overall financial performance and stability, and detect any red flags. Items inspected here include:
- Balance sheets and income statements
- Inventory schedules
- Future forecasts and projections
- Revenue, profit, and growth trends
- Stock history and options
- Short and long-term debts
- Tax forms and documents
- Valuation multiples and ratios in comparison to competitors and industry benchmarks
Thorough Inspection of Documents
This due diligence step begins as a two-way conversation between buyer and seller. The buyer asks for respective documents to audit, conducts interviews, or surveys with the seller, and goes on site visits. Responsiveness and organization on the seller’s end are key to expedite this process. Otherwise, it may create an arduous experience for the buyer.
Following, the buyer examines the information collected to ensure proper business practices as well as legal and environmental compliances. This is the major part of due diligence process. Overall, the buyer gains a better understanding of the firm as a whole and can better appraise long term value.
Business Plan and Model Analysis
Here, the buyer looks specifically at the target company’s business plans and model. This is to assess whether it is viable and how well the firm’s model would integrate with theirs.
Final Offering Formation
After information and documents are gathered and examined, individuals and teams collaborate to share and evaluate their findings. Analysts utilize information collected to perform valuation techniques and methods. This substantiates the final dollar you are willing to offer during negotiation.
Risk Management
Risk management is looking at the target company holistically and forecasting risks that may be associated with the transaction.
Duration
How long is Due Diligence Period?.
While road mapping, it may seem difficult to forecast how much due diligence is enough. Despite its comprehensive nature, the due diligence process should only last between 30 and 60 days. This is achievable if delegated to an efficient, dynamic team from multiple business functions. Ultimately, you want to close the deal as soon as possible, while also being thorough.
But, in reality, it is impossible to uncover all issues and potential complications during the investigation. Some items will not be uncovered until integration. However, the same idea applies to potential benefits. This reinforces the importance to be energetic and efficient while maintaining quality to meet the due diligence period deadline.
Why Due Diligence Matters
Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions.
Final Note
Due diligence is a very detailed and extremely crucial process. The output that is obtained has a high level of significance because it helps the investor make well-informed decision regarding whether the company worth investing or not. Therefore, the process must be in an extremely thorough and detailed manner so as to arrive at the best.
So, if you are planning to invest in any startups or entity and you want to examine the operations and verify the other material facts related to the entity, it is always advisable to get the due diligence done for prudence decision making.
Before entering into a shareholder’s agreement with the Company, it is appropriate to know if the legal compliances made by the Company are up to date.
Our team will guide you through the complete process of Due diligence required for your company.