Due Diligence

The act of investigating any potential investment, usually through an auditor.

Due diligence is the act of investigating any potential investment, usually through an auditor or an audit process. 

Due diligence is essential to any financial process, and the purpose of it is to ensure that all facts presented (financial statements, solvency, management structure, etc.) are accurate and true. It is usually carried out by an audit firm, or by some of the junior employees in the firms involved.

Despite not being very prestigious or well thought of, it is vital to ensure safety and peace of mind for parties involved in a transaction.

This is usually done at the time of an M&A deal.

It helps to analyze and reduce the risk of a transaction as it assures the buyer that they can review the costs and benefits of the deal.

The seller knows everything about its business, and the buyer knows only what the seller shows, so the seller can hide the negative aspects and show only the positive ones. 

So, this process helps the buyer to know what he or she is getting into before the completion of the transaction.

It helps him or her to know whether they should continue with the deal or not and at what price.

It is usually done by the buyer. The seller can also perform it on the buyer if the consideration of the contract is in the form of the buyer's shares. The seller can also perform it in a cash transaction to confirm whether the buyer will be able to finance the deal or not.

Individual investors can also perform it using easily available public information.

It usually involves checking the financial figures of a company over the years and comparing them with those of the firm's competitors.

It is conducted in other contexts, too, like reviewing a product or conducting a background check on a potential employee.

So, it can be both voluntary and legal.

Performing it became common in the United States after the Securities Act 1933 came into effect. With the effect of this law, security dealers and brokers were required to fully disclose all material information about the securities they were selling, and failure to do so made them liable for criminal prosecution.

However, the lawmakers soon realized that there was a pitfall in the act as it was not necessary for them to have all the information at the time of sale. 

They made an amendment that these dealers and brokers have to conduct it at the time of sale and have to fully disclose the results. However, they were not held accountable for the information not covered in the report.

Contingent due diligence is conducted when the buyer has confirmed or is interested in a transaction. Still, the final details about whether they want to go ahead with the deal depend on the findings of their investigation.

Thus, the deal remains contingent on the findings of the buyer. It is also called an inspection contingency. 

An example of this can be found in real estate. During the due diligence period, the buyer can have the property inspected by a professional home inspector and can cancel or negotiate based on the findings of that inspection.

Importance of due diligence

It reduces the risk of transactions and thus offers a higher probability of success. It makes the information available more reliable.

Buying a business involves a great amount of money and time. 

When investors do the proper amount of research, it helps them negotiate the price confidently.

Since it is a large transaction, a buyer cannot completely trust the information provided by the seller as he or she can focus on the positives while ignoring the negatives of the firm to get a higher price.

With the help of diligence, a buyer can see the full picture and get assured of the transaction.

He or she can also know whether the deal fits with their portfolio.

Sellers also conduct due diligence before a potential transaction to know the fair value of their firm.

Reasons for using it

There are various reasons why it is conducted:

  • To authenticate the given information.

  • To identify weaknesses in the transaction and safeguard oneself from bad businesses.

  • To obtain information to know the value of the entity.

  • To make sure that the deal matches the investment criteria.

Costs of due diligence

The cost of conducting the process differs from company to company and also depends on the duration and scope of the process.

However, the costs are justifiable because they reduce the risk attached to entering into a transaction without conducting it.

The parties themselves decide on who will bear the cost of it. However, it is usually paid by both buyers and sellers to their own teams of lawyers, investment bankers, accountants, etc.

Due diligence activities in an M&A transaction

Many questions are asked during an M&A deal. Some are industry-specific, while others are more general.

Some of the common questions are:

Target Company Overview

The buyer first needs to understand why the seller is selling their business:

  • Why is the seller, i.e., the owner, selling the company, and has the owner tried to sell it before too?

  • What are the business plans and long-term strategic goals?

  • What is the complexity of the company?

  • What are the recent M&A deals that the company has entered into?

  • What is the regional structure of the firm?

Financials

The buyer examines the past financial statements of the firm and the future projected financial values.

  • Are the financial statements audited?

  • What does the financial analysis reveal about the financial status of the firm?

  • Are the profits of the entity increasing or decreasing?

  • Are the projected values reasonable?

  • What is the working capital requirement of the firm?

  • What is the CAPEX of the organization?

  • What are the liabilities of the company, and what are its terms? 

  • Does the company earn any unusual revenue?

  • Can the company cover the transaction expenses of the deal?   

Technology / Patents

The firm needs to analyze the quality of the firm's technology and intellectual property.

  • What patents and trademarks does the entity have?

  • What are copyrighted products that the company uses or owns?

  • How are trade secrets preserved?

Strategic Fit

The firm needs to understand whether the entity will be able to fit into the buyer's portfolio.

  • What synergy will be produced?

  • What products or services will it provide? 

  • Will it fit strategically?                       

Target Base

The target base of the organization needs to be understood.

  • Who are the top customers of the company?

  • What are its evident customer risks?

  • What are the warranty rules and the customer backlog?

Management / Workforce

The company's management and workforce need to be analyzed.

  • What is the current compensation structure, employee benefits, and management incentives or bonuses of the firm?

  • What are the policies of the firm?

  • A detailed background check of the entity's top executives like the CEO and CFO.    

  • What patents and trademarks does the entity have?

  • What are copyrighted products that the company uses or owns?

  • How are trade secrets preserved?

Strategic Fit

The firm needs to understand whether the entity will be able to fit into the buyer's portfolio.

  • What synergy will be produced?

  • What products or services will it provide? 

  • Will it fit strategically?                       

Target Base

The target base of the organization needs to be understood.

  • Who are the top customers of the company?

  • What are its evident customer risks?

  • What are the warranty rules and the customer backlog?

Management / Workforce

The company's management and workforce need to be analyzed.

  • What is the current compensation structure, employee benefits, and management incentives or bonuses of the firm?

  • What are the policies of the firm?

  • A detailed background check of the entity's top executives like the CEO and CFO.    

  • Are securities properly issued and in keeping with appropriate laws?

  • Are there any recapitalization or restructuring documents?

Environmental Issues

The environmental issues that the organization faces and how they are affecting it need to be identified.

  • What, if any, hazardous materials are used in the company's operations?

  • Does the firm have environmental permits?

  • Are there any environmental litigations against the company?

  • Are there any contractual obligations relating to environmental issues?

Production Capabilities

The company's production-related matters need to be assessed.

  • Who are the significant subcontractors and suppliers of the entity?

  • What materials are used in the production process?

  • What is the monthly manufacturing yield?

  • Are there any contracts related to the testing of the company's products?

Marketing Strategies

The firm's marketing strategy needs to be comprehended.

  • Does the firm have any franchise agreements?

  • What are the current marketing strategies?

  • What are the sales representatives, distributors, and agency agreements of the firm?

process: how information is gathered

This process, in the case of a formal auction, is something like this:

  • The seller or the seller's banker reaches out to various prospective buyers to determine interest in an acquisition. A targeted acquisition is one in which the seller reaches out to a small group of prospective buyers.

  • An NDA is negotiated with the potential buyers, and a confidential information memorandum (CIM) or an offering memorandum is distributed to them by the seller. It contains nonpublic information by the seller and assists the buyer in performing preliminary due diligence.

  • A potential first-round bidder must sometimes submit an expression of interest (EOI) containing the purchase price range.

  • The second round, with a narrowed buyer universe, also starts.

  • A Q&A period begins, and interested buyers hold follow-up meetings and discussions with seller management. Often, physical visits are made by the buyer and its advisors to the seller's headquarters, facilities, and plants.

  • Around this stage, the seller receives a letter of intent (LOI) from the shortlisted buyers. A Letter of intent is a written and generally non-binding agreement by the buyer to purchase the seller's business, expressing a proposed price and form of consideration.

  • Interviews are generally allowed by the receiver on a limited basis after receiving an LOI.

Due diligence basics for startup investments

Some startup-specific moves are:

  • An exit strategy to recover money should be included, considering the fact that 90% of startups fail.

  • Entering into a partnership is also a good move as partners share capital and risk, so they lose less if the business fails.

  • A harvest strategy for your investment should also be planned. Look out for new trends and technologies if the business cannot sustain the environmental changes.

  • Choose a startup with an increasing Return on Investment (ROI) for at least five years, as most investments are harvested after that period.

  • Analyze the firm's growth plans and assess whether they appear realistic.

Special considerations

In M&A, there is a distinction between "hard" and "soft" forms of due diligence (DD).

Traditionally, the acquiring firms performed the process, which was concerned only with the numbers. They studied costs, assets, liabilities, and structures. This is popularly known as hard DD.

Soft DD is concerned with the human elements of the organization. 

Hard DD is vulnerable to misleading interpretations by the seller. This is counterweighted by soft DD.

Business success cannot be fully depicted by figures. When human elements like employee relationships, corporate culture, and leadership are ignored, the chances of the failure of the deal are increased.

Hard DD is conducted by accountants, lawyers, and negotiators.

They look at all the facts to determine the company's status.

For this, they evaluate company records, existing contracts, employment agreements, business models and strategies, marketing plans, client base, etc., and identify possible weaknesses and liabilities. 

The figures of the company are also assessed using its financials like earnings before interest, taxes, depreciation and amortization (EBITDA), accounts receivables and payables days, cash flow, and capital expenditures.

The legal side of the business is also assessed, and possible problems are identified and solved.

Soft DD is not an exact science. 

It evaluates whether the employees of both organizations will be able to blend with each other and produce synergy. In other words, it analyzes whether the employees will be able to adjust to the new corporate culture.

It is regarded with employee motivation.

Many times, customer reviews, supplier reviews, and test market data are also conducted under this.

Soft DD is increasingly becoming common as more and more managers understand the fact that employees are the lifeblood of the organization, and a failure to conduct it can prove troublesome down the line.

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Researched and authored by Harveen Kaur Ahluwalia | LinkedIn

Uploaded and revised by Omair Reza Laskar | LinkedIn

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