Although the answer may seem obvious, it is worth taking a closer look: what exactly is Due Diligence? Does this concept mean the same as auditing or examining the condition of a company? What is it done for? And, finally, who carries it out? In this article you will learn exactly what this indispensable part of every business deal consists of.
You probably already know that Due Diligence serves as an enterprise audit, which is usually requested by an investor interested in buying. It’s no secret that the investor just wants to check if the deal will be profitable for him. This type of process involves analyzing all company operations and gives an overall picture of the company to interested parties. The analysis is usually performed by external specialists: financial, tax and other, and it requires good organization and detailed knowledge so that it can work best for the benefit of all parties to the deal. Let’s see how it’s done.
What is Due Diligence?
The concept of Due Diligence is derived from the American interpretation of civil law. It was widely used in 1933 due to the adoption of the Securities Act. It is similar in meaning to the terms: legal audit, financial audit or business condition test.
Due Diligence is most often performed by the investor before making the decision of capital entry. During the investigation, the financial, commercial, legal, tax and technological condition of the enterprise is thoroughly analyzed (based on historical data) in order to objectively assess the operational situation of the company – its strengths and weaknesses. This allows to estimate the opportunities and threats arising from the transaction before negotiations start. Going further, we are able to determine potential risks affecting the value of the purchased company and what the chances of the deal success are. Due Diligence immediately precedes the negotiation stage, after which – if the talks are successful – the investment agreement is signed. Stages of a company’s sale (Mergers and Acquisitions) can be compared to a couple getting to know each other before making a wedding decision. Due Diligence is the stage of mutual “evaluation” before the engagement.
Who conducts Due Diligence?
Depending on the type of the deal, Due Diligence is carried out by lawyers, financial advisors, tax advisors, consultants, IT specialists, technical experts and other professionals. Due Diligence is probably the most important step in the merger and acquisition process for the buyer as it helps verify key information provided by the seller. According to the generally shared opinion, conducting such an investigation is a privilege of the buyer who wants to know if the subject is worth investing in. However, this process does not always brings the same results.
Obviously, the test results are of key importance to the buyer and bad results can affect the deal – let’s imagine that the buyer has identified risks and errors that have contributed to the reduction of the company’s value. Sometimes, however, Due Diligence is ultimately more important for the seller, who, by undergoing an examination, protects themselves against liability for defects in the subject of the transaction. Imagine a situation in which the seller has fulfilled their obligations by submitting to Due Diligence, provided the necessary documentation and answered all the questions asked, thanks to which they met the requirement of reliability, but the buyer incorrectly assessed the information obtained and drew conclusions unfavorable from a business perspective.
The seller can also perform such an investigation to prepare for the transaction before talking to investors. This type is called Vendor Due Diligence and allows the seller to identify potential transaction opportunities and risks (you can read more about this in our entry Vendor Due Diligence – the value of negotiation preparation).
Types of Due Diligence
Depending on the analytical perspective adopted during the investigation, several Due Diligence categories are distinguished. These analyzes are carried out by specialists in a given field, which gives a deep insight into a given area of the company’s operation and together creates a detailed picture of its overall condition. Individual studies can be carried out complementarily in order to broadly examine a given area of the company’s operation or diagnose a problem that the investor pays special attention to.
- Legal Due Diligence covers, among others, examines corporate documents to confirm their compliance with applicable law.
- Financial Due Diligence covers, among others, the analysis of company documents to obtain the necessary information about significant events that could have an impact on the financial and property situation of the Company and on tax settlements.
- Tax Due Diligence verifies, among others, compliance of the declared revenues and costs with the amounts resulting from the accounting records.
- Business Due Diligence covers the analysis of the company’s industry and market position, as well as its competition.
- Vendor Due Diligence is an analysis undertaken by the owner to identify potential transaction opportunities and risks, even before starting talks with investors.
How much time does Due Diligence take?
The investigation, its conclusion and valuation can last from a week to even several months. It all depends on the size of the company, the scope of its activity and the complexity of business processes. The time is also influenced by the need to recruit external experts, usually in a situation where the company has a niche specialization.
When should you consider Due Diligence?
The Due Diligence process begins when the buyer recognizes the potential for acquisition or when the seller decides to sell all or part of the business and is searching for investors. So, for example, Due Diligence, as a “pre-investment” operation, is most often used in the case of:
- sale of an enterprise (in its entirety or its organized part)
- sale of shares or stocks
- mergers of limited liability companies
- introducing the company to the stock exchange, the so-called IPO
- the company’s search for external investors
An individual Due Diligence process is carried out for each enterprise, depending on the entity’s situation and the owners’ expectations. It will look slightly different depending on the type of transaction, but its basic principles and mechanics will be the same for each of them. In a typical sales transaction, the company usually has 4 stages: preparation for the transaction, search for investors, proper Due Diligence and negotiations and, finally, signing the contract and closure. You can read more about this subject in the entry Due Diligence stages – selling your business step by step.
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