Due diligence means investigating a company or organisation before you invest in it. This involves looking into the company's financial stability, management, products and services, competitive landscape, and other factors.
Performing due diligence is an essential part of investing wisely. By doing your homework ahead of time, you can avoid costly mistakes and ensure that you know exactly what you are investing in.
Why due diligence?
Due diligence is the process of investigating a potential business transaction in order to assess the associated risks. It allows buyers to make informed decisions and avoid surprises at the end of a deal.
Due diligence investigations are particularly important in the context of caveat emptor, or ‘let the buyer beware’. This means that it is up to the purchaser of goods to ensure that they are free from defects and fit for purpose. By conducting due diligence, buyers can verify that they are getting what they expect from a deal.
When to perform due diligence
The due diligence process is important for potential buyers to undertake when considering purchasing a private company or entering into a partnership.
Due diligence gives buyers the opportunity to examine the records, assets and operations of a target company in order to assess its suitability as an investment. The goal of due diligence is to gather enough information to allow the buyer to make an informed decision about whether or not to proceed with the business transactions.
The due diligence process can be time-consuming and complex, but it is essential in order to make a sound investment decision. Buyers who take the time to conduct due diligence will be in a much better position to understand the risks and opportunities involved in a proposed purchase or partnership.
What are the types of due diligence?
There are four common types of due diligence: financial, legal, commercial and reputational.
Financial due diligence
This is the process of investigating a company's financial performance in order to assess its value and potential for investment. It usually involves reviewing the company's accounting records, financial statements, tax returns and other information.
All financial aspects of the company should be outlined, including debts, profit/loss ledgers, and the accounts of any wholly-owned subsidiary company.
A potential business partner should access a business’ latest accounts, annual returns and company reports through Companies House.
It's also important to look at total assets, liabilities and long-term debt levels.
Financial due diligence will usually be undertaken by the buyer's accountant and/or solicitor as part of the pre-contract investigations. They will review all aspects of the company's financial affairs to assesses risks and liabilities, as well as its financial health and prospects. The findings of this due diligence will be used to negotiate the terms of the sale contract, including the price.
Legal due diligence
The legal due diligence process looks at a company's legal status and compliance with laws and regulations. It usually involves reviewing the company's corporate filings, contracts, and other legal documents to assess the legal risks.
It is an important due diligence step as it helps the investor or buyer to understand a company's ability to keep running smoothly after a purchase.
All information presented in a company's annual report must be accurate, or the individual directors may be exposed to criminal sanctions.
This is especially important for financial information, but applies to all information included in the report. The annual report is a public document, and as such is subject to legal scrutiny. Any inaccuracies or false statements could result in legal action being taken against the directors of the company.
As a result, it is essential that all information included in the annual report is accurate and up-to-date. This will help to protect the directors from any potential legal action and ensure that the company complies with its legal obligations.
Commercial due diligence process
This explores the target business model, market position, competitive landscape and other factors to assess its viability and potential for investment. It could involve conducting market research and understanding the nature of the market, including risks and potential for growth.
There are a number of commercial considerations that must be taken into account when entering into any business transaction.
Furthermore, it is also important to have a general understanding of the target's goods and services. This will help you to understand the market capitalisation or "market cap" of a private company.
The target company may have intangible assets such as goodwill, brand recognition and intellectual property assets like trademarks and patents.
Operation and structure
The term "operational" refers to all of the company's procedures, its location, inventories, suppliers, management structure, staff levels and skills, customer relation and specific insurance coverage.
In other words, it encompasses everything that the company does on a day-to-day basis in order to function.
Operational details are important for a number of reasons. First and foremost, they provide a clear picture of how the company is organised and how it goes about its business.
This information is essential for anyone who wants to invest in or partner with the company. It also helps to ensure that the company is run smoothly and efficiently, and that customers are satisfied with the product or service that they receive.
Operational details can help to identify potential areas of risk and liability. By understanding all of the moving parts of the business, companies can be better prepared to protect themselves against legal challenges.
Reputational due diligence
This is the process of investigating a company's reputation. It usually involves conducting media searches, social media monitoring, and interviews with past and current employees. For example does the business have a history of employee complaints and issues?
Disadvantages
The due diligence process can be lengthy and difficult. Depending on the transaction, buyers can interact with various parties (eg brokers, accountants, and lawyers) each with different levels of information, and incomplete records.
The buyer will then review the information collected, and make further requests for more information if there are questions or missing details. This can lengthen the sale process considerably.
Due diligence can also affect the seller negatively. The process can distract the seller from actually running their business in order to respond to large volumes of questions and requests for documents.
This distraction can lead to a deterioration in the business's performance during the sale process, which can ultimately affect the price that is received for the business. Consequently, while due diligence is an important part of any sale transaction, it is important to weigh the pros and cons carefully before proceeding.
Here is your due diligence checklist:
Financial statements
Request financial statements and financial records for the last three years, including tax returns, profit and loss statements, balance sheets and cash flow statements. Some of the key things to look for include:
- Up to date tax returns
- Financial statements (at least 3 years)
- Details of all loans and credit agreements
- Any company investments such as bonds or marketable securities
- How is capital structured
- Financial projections and capital budgets
- Up to date tax and pension liabilities
- Shareholder agreements and rights
- Foreign exchange reserves
- Unrecorded liabilities
- Any collateral for debt
- Details of owner withdrawals (if any)
- Revenues
- Gross margins
- Fixed/variable expenses analysis
- List of non-operational expenses
- General ledger
Contracts
Request copies of all contracts that the business is a party to, including leases, supply agreements and contracts with employees (this may also include details of employee benefits and customer contracts). Buyers should look for the following contracts:
- Customers
- Suppliers
- Joint venture and partnership agreements
- Settlement agreements
- Franchising agreements
- Accounts receivable
- Accounts payable
- Leases for equipment
- NDAs
- Non-compete contracts
- Employee contacts
- Loan, credit and guarantee agreements
Legal documents
Request copies of any official documents that are relevant to the business, such as incorporation papers and patents.
- Shareholder certificate documents
- Business licenses
- Occupational license
- Building permits documents
- Tax registration documents
- Power of attorney documents
- Any historic or outstanding legal cases
- Any other permits and licenses
- Insurance policies
Strategy and commercial documents
These help establish the sales and marketing plan of the target company.
- Overview of sales and marketing strategy
- Marketing/sales coordination
- Sales reports
- Current market share
- Where sales come from e.g direct, online
The due diligence checklist is not exhaustive, but it is a good starting point for buyers. The goal is to obtain as much all the information about the business before making a decision.
What to do with the information gathered during due diligence
After gathering all of the information, buyers will need to decide if the transaction is feasible and make a decision on how to structure the acquisition.
Buyers should consult with their accountant and lawyer to ensure that they understand all of the risks involved in the transaction. If there are any red flags, then the buyer may want to renegotiate.
How do you know when your due diligence review is complete?
The due diligence process is complete when the buyer has gathered all of the information that they need to make a decision. This will vary depending on the type of transaction and the perceived risks. Buyers should consult with their accountant and lawyer to ensure that they have all of the information they need. Once the due diligence review is complete, the buyer can proceed with confidence.
Once you have due diligence conducted you can proceed with structuring the buying of the business.
Other considerations when performing due diligence
Professional advice
Engaging with professionals like accountants, solicitors and industry experts can significantly enhance the due diligence process. These specialists have the necessary expertise and experience to delve into complex areas, ensuring a thorough investigation. They can also help identify risks and opportunities that may not be apparent to those without specialised knowledge.
Understanding Regulatory Compliance
In industries that are subject to regulations, it's essential to assess the target company's compliance with all relevant rules and standards. This review should include an examination of regulatory filings, inspections, or violations. Non-compliance may lead to legal issues, fines, or other penalties, affecting the value and feasibility of the investment or acquisition.
Environmental Due Diligence
For industries with potential environmental impacts, an environmental assessment is crucial. This includes analysing compliance with environmental laws and assessing potential liabilities related to contamination or other risks. Understanding the environmental footprint and responsibilities can prevent unexpected costs or legal issues that might arise post-acquisition, ensuring a sustainable investment.
Technology and Intellectual Property
In technology-driven businesses, evaluating intellectual property, technology assets, licences, and agreements is vital. Assessing patents, copyrights, trademarks and other intellectual assets can uncover their true value and potential risks. Thorough examination ensures that the technology aligns with strategic goals and that there are no hidden liabilities or conflicts that could undermine the investment.
Cultural Fit
Understanding the organisational culture of the target company is essential for post-acquisition success. Assessing cultural compatibility helps in predicting how seamlessly the companies can integrate. Differences in values, leadership styles, or work environment can create challenges in integration, affecting employee morale and productivity. Proper evaluation aids in planning and implementing effective change management strategies.
Privacy and Data Security
Reviewing data handling practices and compliance with privacy laws is paramount in today's digital age. Identifying how the company protects personal and sensitive information, along with any previous breaches or non-compliance, can reveal potential risks or liabilities. Adequate scrutiny helps in ensuring that the company’s practices align with legal requirements and industry best practices.
Post-Acquisition Integration Plan
Once due diligence is complete, planning for post-acquisition integration becomes essential. This includes identifying synergies, understanding how operations will combine, and planning organisational changes. An effective integration plan ensures that the transition is smooth, minimising disruptions and maximising the value and efficiency of the combined entity.
Potential Red Flags
It is vital to identify and understand potential red flags or deal-breakers in the due diligence process. These could include significant undisclosed liabilities, compliance issues, or discrepancies in financial performance. Recognising these red flags early on helps in making an informed decision, allowing for renegotiation or withdrawal from the deal if necessary.
Costs of Due Diligence
Understanding the costs involved in due diligence is crucial. The process may require considerable investment in time and resources, depending on the complexity of the transaction. A clear estimate of these costs allows for better budgeting and decision-making, ensuring that the benefits of due diligence justify the investment in the process.
Confidentiality and Ethical Considerations
Maintaining confidentiality during due diligence is paramount. Mishandling sensitive information could lead to legal challenges or loss of trust. Ethical guidelines must be adhered to, ensuring that all parties involved act with integrity and respect for privacy. A robust confidentiality agreement can set the boundaries and expectations, safeguarding the interests of all stakeholders.