Due diligence is crucial for businesses when engaging in different types of activities such as mergers and acquisitions, acquisition of real or movable assets, or entering into partnerships.
You may be asking, what is a due diligence?
Why should you perform one?
How does it work?
Keep reading as we have gathered exactly the information that you need!
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Table of Contents
What Is Due Diligence
In business, due diligence is a term used to refer to an audit or review of facts.
In essence, when you perform an audit, investigate facts, or review documents and records, you are performing a due diligence.
For example, in the context of a merger and acquisition deal, the acquiring firm will perform a “due diligence” on the target firm to assess the target firm’s financial position, understand its business, and assess the value of its business.
The objective of a due diligence is to ensure that you obtain and review adequate information relating to an intended transaction.
Due diligence in business is similar to performing an inspection of a home before purchasing it.
The “inspection” allows you to validate the seller’s claim, assess the quality of the property, and ensure that you consider any potential risks associated with the transaction.
An investor will perform a due diligence on a company’s financial health before purchasing stock.
A private equity firm will perform a due diligence on a startup firm to assess the startup’s growth potential.
In business, due diligence can be done in a number of ways and of different scope.
Due Diligence Types
There are different types of due diligence that you can perform allowing you to inspect different aspects of a transaction.
Let’s look at an M&A deal where the acquiring firm performs due diligence on the target.
In a typical M&A deal, the acquiring entity will perform the following due diligence:
- On the company’s capitalization
- Revenue and profitability
- Competitor analysis
- Company valuation multiples
- Company management
- Share ownership
- Financial statements
- Legal due diligence
- Intellectual property
- Long-term and short-term risks
- Operational due diligence
- Production due diligence
As you can see, depending on the complexity of the transaction, the due diligence can get quite extensive.
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Hard Due Diligence
In mergers and acquisitions, you will perform a “hard” due diligence by having your lawyers and accountands review the records of the target firm.
A hard due diligence involves assess the facts.
This can be the analysis of the target’s financial records, growth plan, management team, human resources, partnerships, competition, and so on.
Soft Due Diligence
Soft due diligence is a type of due diligence that focuses more on subjective aspects rather than hard and objective facts.
For instance, a soft due diligence is an acquiring firm’s assessment of how well the target’s workforce will integrate in the acquiring firm’s organization.
The idea is to look at how well are the employees motivated and will remain productive following the merger or acquisition.
Another aspect of a soft due diligence is to assess if the target’s customers will remain customers in the event of a chance of control.
The more the customers are loyal, the more they can potentially tolerate a change in service or procedures.
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Due Diligence Steps
Let’s look at the different steps in performing a due diligence.
Again, let’s use an M&A deal to illustrate the steps.
NDA
The first step in an M&A transaction is the execution of a non-disclosure agreement (NDA) between the acquiring firm and target firm.
The target company must ensure it enters into a robust non-disclosure agreement to ensure the acquiring firm does not use its valuable business sensitive information for any purposes other than the due diligence.
Letter of Intent
Following the entering of an NDA, the acquiringt company and target will negotiate the key terms of the transaction in a letter of intent or memorandum of understanding.
The idea is to ensure that the parties are going to engage in a potentially long and costly due diligence process having agreed on the key terms of the transaction.
Due Diligence
Once the key terms have been agreed, the due diligence will formally start.
This when the target company will provide access to different information, records, and data required by the acquiring firm.
The due diligence will typically include an overall assessment of the target firm, such as:
- Inspection of financial statements and records
- Verification of quality of assets
- Assessment of the target’s customers and accounts receivables
- Review of contracts and legal obligations
- Review of internal corporate regors
- Review of licenses and permits
- Assessment of company’s trade secrets and intellectual property
- Review of pending litigation or potential conflict
- Review of company’s sales, marketing, and pipeline
- Review of tax liability and risks
- Evaluation of human resources and key personnel
- Review of management team and their experience
Reassess Purchase Terms
Once the due diligence is completed, the can be several outcomes:
- The agreement in principle in the letter of intent is confirmed
- The parties renegotiate the terms of the purchase
- The acquirer terminates the transaction
For the acquirer to exercise these rights, it’s important to ensure that the letter of intent includes a provision allowing the acquirer to perform a due diligence, to renegotiate when material facts are discovered, or terminate if there’s a material discrepancy uncovered during the due diligence process.
Performing Due Diligence
The answer to this question is: it depends.
A due diligence can be as simple as looking up the ownership of an asset to ensure the seller effectively owns the property.
On the other hand, due diligence can involve a long process of financial and legal analysis of a company in the context of an M&A deal.
Typically, business lawyers and accountants are engaged by small businesses, large organizations, and multinationals to perform a due diligence of different magnitude.
In this context, the lawyers engaged in the due diligence process will implement the proper contractual foundation to initiate the due diligence process, such as negotiating an appropriate NDA and entering into an agreement in principle.
Then, they will have a due diligence checklist that will be submitted to the target firm who will generally have a certain period of time to furnish the information and records.
The lawyers will also ensure that the records are safely shared in a virtual data room or a physical one depending on the needs of their clients.
Finally, the lawyers will review the target company’s records and provide their client with a report on their findings.
The accountants are generally involved in the financial review and the financial aspect of the diligence.
They will work hand-in-hand with the lawyers representing the acquiring firm.
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Takeaways
So there you have it folks!
What is a due diligence in simple terms?
In essence, due diligence is the process of collecting, analyzing, and reviewing records, information, and documents on a particular matter such as an investment or a purchase.
The main objective of due diligence is to find and obtain relevant and material information so you can make an informed business decision.
If you’re looking to acquire a business or enter into a transaction, be sure to consult a business lawyer who can support you during this process.
AK-Law is a boutique law firm helping entrepreneurs, business owners, and larger businesses perform due diligence of different type and scope.
We’ll be happy to support you in this process.
