What is Due Diligence?
Due diligence is the systematic examination of a business ahead of an event such as a merger or acquisition, capital raise, IPO, or audit. It is the investigation phase that occurs prior to a financial transaction to assess the commercial and legal risks and opportunities.
Due diligence before buying involves a rigorous inspection of a company’s critical documentation and data across every area of their business. It must be conducted before a binding agreement is signed between parties to ensure that all risks have been disclosed and all opportunities are on the table before the M&A deal proceeds.
Due diligence is performed by companies looking to acquire other companies, by PE or VC investors seeking opportunities, by fund managers, by asset managers, by lawyers, and by financial analysts and advisors.
Below are some of the types of due diligence. As the process can vary by industry and by event or transaction type, this is by no means an exhaustive list, but a good starting point to understanding the depth of assessment required.
Financial due diligence
Financial due diligence is one of the most important types. It seeks to validate a company’s financials through an in-depth analysis of their financial statements, balance sheets, revenue projections, capital structure, debt, and more. Financial DD is also the main process required for a financial audit.
Through financial due diligence, work will be done to evaluate the company’s past and current financial performance and potential profit margins. It will also assess whether projected revenue forecasts are reasonable. This work will generally be done by accountants or by a financial advisory team.
Legal due diligence
Legal due diligence is equally important, as it examines any legal issues or risks the acquirer should be aware of that could impact the transaction. Legal DD plays a major role in deal negotiations, and in establishing an appropriate value that both parties can agree on. The lawyers who conduct legal DD are key players on both buy-side and sell-side deal teams.
In legal DD, all material contracts and agreements will be inspected, including joint venture or partnership agreements, licensing agreements, and loan agreements. This is to ensure the acquisition isn’t likely to lead to future legal problems.
Tax due diligence
Tax due diligence is a thorough review of all the different types of taxes that may be imposed on a company, and the tax laws the business may be subjected to under a particular jurisdiction. It covers all issues and documentation pertaining to taxes, including income taxes, property taxes, payroll and employment taxes, sales taxes and more.
Operational due diligence
Operational due diligence is performed to get a full understanding of the functional operations of a target company. It includes a review of the target’s business plan and operational facilities, and looks at ways to generate additional value by improving the operational function.
This type is of particular importance in the industrials sector, where supply chain and manufacturing operations are critical. It’s often performed by a third party specialist or professional services firm.
Intellectual property due diligence
Intellectual property due diligence is the review of a target company’s intangible assets, including any patents, copyrights, trademarks and brand names. While it is difficult to quantify intellectual property in monetary terms, it can often account for some of the company’s most valuable assets, making it an important consideration.
Commercial due diligence
While financial DD focuses on the target company’s financial health, commercial due diligence also considers external factors. It looks at broader market risks and opportunities for the products or services the business is offering.
In commercial due diligence, market size and share are evaluated, competitors are considered, and opportunity is measured in the potential for future returns, sales forecasts and projections.
Essentially, it is the exercise of validating the acquisition and assessing its likelihood of realizing value in the current economic climate. As it is mainly future focused, it is likely to be executed by a strategy team or consulting firm.
Information technology due diligence
Information technology due diligence involves the assessment of a company’s IT infrastructure and their entire tech stack, including databases, software applications and support services.
It will often include a detailed security analysis in order to ascertain how sensitive information is managed and organized. This process ensures that data is protected against security vulnerabilities – in both current and future states.
Human resources due diligence
HR due diligence is all about the people who work for the business. It carefully considers things like payroll, employee liability, employment termination costs and historical staff turnover. It also addresses aspects that are more difficult to quantify, such as the health of the business’s culture and leadership. HR due diligence is a key aspect of soft due diligence, which we’ll define further down.
Regulatory due diligence
Regulatory due diligence ascertains whether a business is compliant with all of the regulations applicable to its region or industry.
Frequent updates and changes to regulatory frameworks and laws, such as Europe’s General Data Protection Regulation (GDPR) for data privacy, make it vital to ensure that a business is fully compliant before purchasing. Significant risk could be taken on if the acquired company is in violation of any of these regulations.
Exercising due diligence requires an in-depth look at documents and data to get to the facts - but some aspects are more easily quantifiable than others. While hard due diligence is easy to ascertain in numbers and figures, soft due diligence requires a different approach.
What is hard due diligence?
Hard due diligence addresses concrete data and facts. It focuses on the financial aspects of the business, such as financial statements, expenditures and projects. This is the primary type of due diligence that is used to assess whether profit can be generated from the deal.
What is soft due diligence?
Soft due diligence is equally important, though harder to conduct. This assesses the human capital of a business, including talent, skills, culture and leadership. It aims to establish whether key staff members are likely to stay or leave in the event of the deal going through. When M&A deals fail - which is 50% of the time - it is usually because this human element is ignored (Investopedia).
In its basic form, the due diligence process consists of the purchaser asking questions of the target business, and the business answering those questions with proof that shows they have answered. The bidder is legally obligated to disclose accurate information. There is then a rigorous due diligence Q&A process to clarify anything that might need further explanation before the purchase.
Due diligence is usually conducted after you and a bidder have agreed in principle to a deal, or at least that one may be beneficial, but before any binding contract is signed.
Main things the purchaser should consider
The purchaser should consider every area of the target’s business and seek to uncover as much detail as possible about its current state of health before making their investment decision. During this process, they should spend time talking to management and key staff, understanding what documents will help confirm the viability of the transaction, and verifying the integrity of all the information that is provided.
Purchasers should also consider their integration strategy, and how the new business entity will operate as a unified whole in order to maximize synergies.
Potential warning signs for the purchaser
Potential warning signs for the purchaser include any unverified, inaccurate or missing material information that could prove to be problematic later on. This could mean the prospective bidder is hesitant to share something that could be perceived as a red flag, or that they are disorganized and don’t actually know these details about their own business.
According to Accru, other warning signs to watch are if customer numbers and/or turnover are declining, or if there are indications that the industry itself is moving into a difficult period.
Risks of conducting improper due diligence
To perform due diligence, companies and their advisors need to carefully scrutinize every aspect of a prospective bidder. If there are gaps in the documentation they gather, they risk missing critical information that could see them fail to reach a high valuation and sale price. Even worse - it could impact the future of their business.
Poor organization can result in the discovery of risks late in the process if a company has exercised due diligence improperly. This creates stress for both parties, costs time to resolve, and increases the chances that the deal will fall through.
Buying a business is a costly endeavour, so it’s important you are confident you have all the information you need to make a well-informed decision.
Ansarada’s Due Diligence Checklist lays the framework for structuring your critical information, so that you know exactly what you need to provide to progress the deal. It is a file structure that has been built from 50 million data points across 35,000 deals to help you organize your business data and ensure nothing gets missed.
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Due diligence is the ideal opportunity for you to answer any questions bidders might have about your business and the prospective deal.
During a deal, a large amount of time is spent running Q&A, so we’ve used our know-how to make this process easier than ever. Use Ansarada’s due diligence Q&A to ensure you’ve put your best foot forward and proved your business worthy of investment.