The growth of a business often depends on the transactions it enters. Each transaction, however, requires prudent investigation and decision-making to safeguard the entity’s interests. Conducting due diligence is imperative to fend off risks related to such deals.
In this article, we’ll define due diligence, its types, and some tips on effectively performing it.
What is due diligence?
Due diligence meaning in business is the investigation and analysis of an organization before initiating a transaction — may it be with a client, vendor, or a third party. This proactive approach is employed to vet issues that can potentially affect the business, preventing major problems in the enterprise arrangement. For instance, due diligence in mergers and acquisitions means looking into pending litigation, financial stability, labor relations, and sales.
As for implementing due diligence, companies generally require written procedures and policies. This also calls for the cooperation of the company’s board of directors. Moreso, seeking outside expertise from attorneys, insurance agents, and other experts is advisable.
Who can perform due diligence?
In general, due diligence can be conducted by various parties involved in a transaction or decision-making process. Some of these parties include:
- Buyers or investors — These could be an entity or individual seeking to invest by assessing the risks, financial health, and opportunities linked to the target company.
- Sellers — Companies or individuals selling an asset or business can also perform due diligence to clearly understand potential liabilities prior to entering into a deal.
- Accountants — Certified public accountants (CPAs) and accounting firms are frequently hired to examine financial records, check the accuracy of financial statements, and identify accounting irregularities.
- Financial advisors — Financial analysts or consultants typically assist buyers and sellers with due diligence by providing their expertise in financial analysis, risk assessment, and market research.
- Legal advisors — Legal teams and lawyers particularly review contracts, identify legal risks, and ensure regulatory compliance concerning the transaction.
Such parties typically work together to analyze information, assess risks, and make informed decisions based on their findings during the due diligence process.
When to conduct due diligence?
Due diligence is typically conducted before any business transaction. The bigger and more complex the deal, the more extensive due diligence is needed. Moreso, it can be performed at various stages of the decision-making process — from pre-transaction to actual risk management. As a general rule, due diligence should be completed before the deal closes.
Is there a difference between due care and due diligence?
The answer is yes. While both concepts are imperative for risk management and compliance, they still differ in several key aspects.
Due care (DC) is about taking responsible and prudent steps to protect an asset, while due diligence (DD) is the systematic investigation of making sure things are done correctly.
But unlike due care which typically uses an informal course of action, due diligence refers to a far more intense procedure. Proper due diligence can be considered as an investigation or audit, gathering and verifying all facts and figures.
Why is due diligence important?
Performing due diligence ensures all parties involved in the arrangement are educated and informed. Such a process aims to verify the accuracy of any business information presented, which also allows both parties to consider the benefits and risks of the transaction. Its primary purpose is to contribute to smart decision-making and mitigate risks.
What happens when due diligence goes wrong? In 2023, JPMorgan Chase admitted its errors in its $175 million acquisition of student financial aid startup Frank and filed a lawsuit against its founder for ‘artificially’ inflating the startup’s value by creating 4.2 million face users.
JP Morgan Chase’s CEO, Jamie Dimon, admitted the acquisition was a “huge mistake”, as analysts questioned its accountability for the failed deal.
This oversight could mean that the bank failed to verify Frank’s user list during their due diligence — despite claiming they conducted an “extensive due diligence”. This inadequate due diligence led to analysts questioning the bank’s accountability for the failed deal, and eroded investor confidence in Chase’s deal-making abilities.
Such failure to solely rely on the information provided by the seller, instead of conducting independent verification of data points is a perfect example of inadequate due diligence. Chase’s insufficient verification of Frank’s user base resulted in costly and damaging consequences for the bank and its reputation.
By prioritizing an extensive due diligence process, corporations can prevent such pitfalls. Learn about the different types of due diligence below and which ones you should include in your process.
The Different Types of Due Diligence
As its main goal is to identify potential risks and opportunities, due diligence means checking into various business facets. The process requires a thorough evaluation of data and documents, in which some are more quantifiable than others. Remember that not every type of due diligence is necessary to utilize but will depend on the kind of business transaction. The different types of due diligence fall into these two major categories:
Hard Due Diligence
Considered the traditional approach, hard due diligence involves the collection and verification of concrete data and numbers. This category covers the majority of due diligence, focusing on the enterprise’s financial aspects, taxes, and operations.
Hard due diligence primarily looks into three things: facts about a company’s status, figures based on its financial documentation, and legal for compliance and litigation concerns. These are some of the types of hard due diligence:
Financial Due Diligence
This type is conducted to ensure the accuracy of a company’s financial records stated in its confidential information memorandum. Financial accounts, business forecasts, and inventory schedules are often investigated.
Performing financial due diligence also involves analysis of profit margins, fixed and variable cost analysis, customer account verification, and analysis of internal control procedures. Moreover, the company’s debt situation is checked, evaluating its ability to pay its outstanding debt and if needed, secure more financing.
Legal Due Diligence
Checking into legal matters can make or break a business deal. In most cases, legal due diligence impacts how or if the transaction will move forward. The deal’s structure can be influenced by issues such as pending or previous litigation, non-compete clauses, or breached contracts.
This procedure is also known to be a mandatory consideration for companies before entering an M&A. Legal due diligence requires an evaluation of all material contracts, including:
- Loan and bank financing agreements
- Licensing or franchise agreements
- Partnership agreements
- Guarantees
- Copy of Memorandum and Articles of Association
- Board meeting meetings over the past three years
Tax Due Diligence
Also known as fiscal due diligence, tax due diligence refers to the careful examination of tax liabilities. This type particularly looks into the company’s current tax structure, pending tax-related cases, and level of compliance with tax laws.
Conducting such analysis ensures that all the organization’s taxes are being reported and paid. Some documents that are subject to validation include tax audits, tax returns for the past three to five years, and agreements with tax agencies.
Operational Due Diligence
This type of due diligence covers all the operation risks and processes that can either negatively or positively impact the deal. It concentrates on the company’s operating model to identify gaps and opportunities that require development or investment. This covers areas such as company assets, products and services, technology, supply chain, sales, marketing, and any existing facilities,
Intellectual Property Due Diligence
Intellectual property (IP) refers to tangible assets that contribute to an organization’s market position and competitive advantage. IP due diligence aims to evaluate assets such as:
- Patents for technologies or inventions developed by the company
- Copyrights for business software and creative assets
- Existing trademarks that could lead to legal disputes
- Chain-of-ownership documentation
Moreover, IP due diligence also focuses on safeguarding the trade secrets of a company and ensuring confidentiality is maintained. By performing due diligence, companies can assess the value and risks associated with IP assets. Hence, avoiding legal complications as well.
Soft Due Diligence
Soft due diligence is known to be harder to conduct since it concentrates on the company’s culture fit and other facets related to human capital. Or, to put it simply, it investigates the elements related to how people work or fit into the organization’s culture.
Human Resources Due Diligence
Human resources due diligence focuses on the most valuable asset within a company: the employees. This process is considered to be as extensive as financial due diligence, and involves the analysis of the following:
- Current positions and vacancies
- Current salaries of employees during the last three years
- Benefit and retirement packages
- HR policies for annual and sick leaves
- Employee issues, such as alleged discrimination, harassment, or wrongful termination
Employment contracts, from nondisclosure to non-competition agreements
HR due diligence can help identify any people-based risks before making a deal, and get a complete picture of the organization’s culture. In short, this process covers the workforce’s entire spectrum and all documentation related to it.
Administrative Due Diligence
This form of due diligence entails the verification of any administrative-related elements, including business facilities, occupancy rates, and workstations. Such aspects and their costs are closely connected to a company’s financials. Administrative due diligence aims to verify the properties a company owns and determine whether operational expenditures are declared in the financials.
ESG Due Diligence
Environmental, social, and governance (ESG) due diligence focuses on the target company’s adherence to ethical, sustainable, and well-governed policies. It aims to uncover material ESG risks, liabilities, and opportunities related to a transactional target or a portfolio company.
ESG due diligence places significance on non-financial factors that affect an enterprise’s reputation, financial performance, and regulatory standing. It also helps uncover a company’s ESG policies and risk factors, enabling ethical investment decisions, mergers, and acquisitions.
Commercial Due Diligence
In this type, a company’s ecosystem is examined to determine its position in the market. Commercial due diligence looks into market conditions, trends, and competition. For instance, in a merger and acquisition, this process can help the buyer understand the company based on its market and how is it likely to change in the coming years.
How to Perform Due Diligence: Best Practices
Doing due diligence can be a daunting process. Doing it ineffectively, however, can leave your company open to risks. The goal is to carefully evaluate the affairs of the target company to make an informed decision to proceed with the deal. Read on to learn how you can perform due diligence properly.
1. Establish a due diligence team
Regardless if it’s a small or huge transaction, assembling a qualified due diligence team can be beneficial. Building the right team should be focused on experience and competencies. It is ideal to have experts in relevant fields, including finance and accounting, operations, law, and risk management. Some roles you can consider are:
- Financial analysts — To analyze financial statements and assess financial performance.
- Legal advisors — To provide expertise in contract law, litigation matters, intellectual property rights, and other legal aspects of the transaction.
- Operational experts — To evaluate operational efficiency, production processes, and supply chain management of the target entity.
- Compliance specialists — To assess the target entity’s compliance with applicable laws and regulations, as well as contractual obligations.
While there’s no limit to the number of people to have on your team, it is crucial to have a leader or project manager to oversee the due diligence process. Your team does not have to be entirely in-house. Seeking external sources like outsourcing industry or niche-specific consultants is ideal to further ensure independent and objective investigation.
2. Gather all relevant documentation
Before you can proceed with the assessments, having the necessary documentation is critical. This will help your team prepare the diligence reports and verify whether or not the transaction is doable. Plus, this can guide you in assessing the target company’s overall viability. Here’s a checklist of some documents you’ll need:
Financial Documents
- Audited financial statements for the past 3-5 years
- Management accounts and financial projections
- Tax returns and related filings
- Bank statements and loan agreements
- Any financial agreements, such as leases or financing arrangements
Legal Documents
- Articles of Incorporation and organizational documents
- Shareholder agreements and ownership structure
- Intellectual property documents (patents, trademarks, copyrights)
- Litigation history and pending legal matters
- Environmental assessments and compliance reports
Operation Documents
- Business plans and strategic documents
- Operations manuals and standard operating procedures (SOPs)
- Quality control and assurance documents
- Supply chain information, including supplier contracts and relationships
- IT infrastructure and cybersecurity policies
Regulatory and Compliance Documents
- Regulatory filings and compliance reports
- Health and safety records
- Environmental assessments and permits
- Data protection and privacy policies
- Compliance with industry standards and certifications
3. Verify accuracy and completeness
Once you have the documents you need, it’s time to start verifying the data’s accuracy and completeness. Besides cross-referencing or reviewing supporting documents, you can perform verification through independent sources or third-party verification methods.
The easiest on the list is hiring external auditors or appraisers to validate financial, legal, and technical information. You can also obtain confirmation from counterparties or conduct background checks.
Moreover, conducting site visits and inspections is also advisable. This helps you verify the target company’s operational status, or confirm the value of assets like inventory, equipment, or real estate properties.
4. Conduct post-due diligence actions
Executing post-due diligence actions is crucial for monitoring the initial phase of the transaction. This can provide an evaluation of the target entity and if the deal is running as it should. If significant issues are identified, you can develop a remediation plan to address these concerns (e.g. renegotiating the terms and conditions, or recreating transition plants).
Additionally, monitoring the performance and integration of the acquired assets or operations should be considered. You may also conduct a post-mortem analysis to evaluate the effectiveness of the due diligence process and get insights for future transactions. This feedback loop can help improve your due diligence practices too.
Frequently Asked Questions (FAQs) on Due Diligence
Is due diligence only essential for large businesses?
No, due diligence is an important practice for organizations of all sizes. The scope, however, may vary depending on the scale of the transaction or partnership. Regardless of the business size, due diligence can be beneficial for reducing financial and operation risks and even gaining a better position for a negotiation.
What is the role of due diligence in real estate transactions?
In general, due diligence in real estate transactions plays a critical part in protecting one’s interests before finalizing a purchase or sale. The process can happen after the seller accepts an offer, but before the deal is closed. Doing due diligence on a property may also require guidance from a real estate agent, broker, or surveyor — from scouting the property’s location to the appraisal.
Skipping due diligence in real estate deals may expose buyers or sellers to financial and legal risks. These include overlooking any unpaid taxes or unsettled lawsuits related to the target property.
How can technology enhance the due diligence process?
Technology can significantly improve the due diligence process in several ways, including:
- Efficient collection and aggregation of large volumes of data, from databases, online repositories, and internal systems.
- Provide secure and centralized repositories for organizing, storing, and sharing due diligence documents. Most tools even offer features like version control, access controls, audit trails, and document indexing.
- Analyze and visualize complex datasets to identify patterns and gain insights. This may involve the use of dashboards, charts, and graphs.
- Facilitate collaboration and communication among due diligence team members and stakeholders. Many platforms like Convene can enable seamless information sharing, task assignment, progress tracking, and decision-making, regardless of users’ geographical location.
Convene: Your Due Diligence Command Center
Are you looking for a platform that ticks all the boxes above? Convene provides the perfect toolkit to streamline your entire due diligence process!
Convene’s secure virtual data room enables you to upload and organize vast amounts of sensitive due diligence information, from finance to legal documents. The platform uses multi-factor authentication for secure access controls, AES-256 encryption for data protection, and also adheres to SOC 2 & GDPR for data privacy.
Our platform also offers enhanced document collaboration with advanced features such as real-time shared and private annotations, audit trails and version control, and advanced search and filtering. Hence, making it easier for your due diligence team to review and verify documents.
Contact our team today and discover why Convene is the perfect due diligence command center for you!
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