The term “due diligence” originated after The United States Securities Act of 1933, when brokers did not disclose information on the stocks they were recommending to investors.

It then became a term defining a process in which businesses applied to the companies they wanted to purchase.

What is Due Diligence?

In broad sense of the phrase, due diligence is a process of investigation or research into a business, statement, or agreement prior to a transaction.

For the purposes of this post, due diligence will be used to refer to the process in business, whereby a buyer or stakeholder evaluates all aspects of the company they wish to acquire before drawing up a purchase agreement or deciding to invest their money.

When is Due Diligence Exercised?

Typically, in business acquisitions, the due diligence process occurs after a buyer has expressed interest in a seller’s business (usually with a letter of intent).

Most buyers “do their homework” before jumping into any large purchase to assess the risk and benefits of their investment, and to see if it will be wise to proceed. It’s similar to performing a home inspection prior to purchasing real estate in that they are evaluating the asset to see if there are any defects before an official offer is proposed.

It’s also done to appraise the value of the seller’s business and determine if it has commercial potential.

Due Diligence as a Condition

It is common for buyers to exercise due diligence before making a formal offer in order to protect themselves from problems that could pop up during the review.

Like a home inspection, if the buyer finds an issue, this could change the terms of the deal. In business, due diligence itself is often a condition of the sale, and anything that arises during the process could affect the selling business’s valuation. Additionally, if the buyer concludes that the seller’s business is not a financially sound investment, the buyer could withdraw their interest at no risk.

Varying Degrees of Due Diligence: The Process

The degree of due diligence a buyer will use depends wholly on the company they are interested in and the buyer themselves. In large scale business deals, due diligence can take months to complete.

Other smaller investments may only require a meeting with the seller to discuss their business model, clients, and current contracts to get a feel for the business or gain enough confidence to make an offer.

Timing can also be a factor in the length of due diligence. If an existing business is going under quickly, there may not be enough time to perform formal evaluation before it’s acquired.

In most acquisitions, the process begins with the buyer expressing interest in the seller’s business by sending them a term sheet or letter of interest. At that point, if the seller agrees, the buyer controls when due diligence begins and ends.

A Seller’s Apprehension

Because a deal is in the works, the seller may not want to disclose everything to the buyer right away. In that case, due diligence may be done in phases in order to preserve sensitive information.

It is common practice for a confidentiality agreement to be drafted and signed by each party to ensure there are no loose ends and that the buyer doesn’t reveal any private information, ideas, plans, or data to the public about the seller’s business—which seems reasonable given the amount of information that the seller will have access to.

What do Buyer’s Look at?

As a research phase of acquisition, the buyer may want to review all aspects of a seller’s business.

This can include a long list of items, but usually involves everything from financial records to employee management. Here are some of the main aspects a buyer would want to review in advance.

Business Structure

The seller’s business structure, including the type of business it is, as well as its internal organization, management, employees and their positions, the day-to-day operations, workflow, and company policies, are all typically evaluated during the due diligence process.

Finance

A buyer would be interested in assessing the value of the business as is, including its past sales performance, current revenue, profit and loss breakdown, and future sales projections—essentially if the business has a steady, sustainable revenue.

Additionally a buyer may look at internal spending. For instance, employee costs, salaries, benefits, as well as maintenance, production costs, distribution costs, and more, as well as if it results in effective financial management and a favorable return on investment.

Compatibility

In an acquisition (or merger and acquisition), the buying company is interested in purchasing a business that not only adds to their current investment portfolio with matching values, industry, and direction, but also how well the two will work together once merged. This can include a review of corporate culture, including how well the teams might integrate into each other, and the chemistry of both parties in terms of their wants and goals. Essentially, an investor or buyer will be looking at the overall “fit” of its company with the selling party.

Physical and Intangible Assets

The physical assets of a business include everything from equipment and office furniture to software programs and the products that it sells. Intangible assets include the items that don’t necessarily have obvious value, such as a seller’s client list, its intellectual property, and contractual relationships.

Reputation

The reputation of a seller can bear significant weight on its value.

Due diligence in the area of reputation may encompass past and potential future legal issues, such as the protection on its products and data, affiliation with other businesses or organizations, community involvement, or simply the way consumers or the public feel towards the business.

Furthermore, the buyer might be interested in the plans a seller has to react to future hang-ups. Do they have data security, confidentiality agreements, PR managers, customer support, lawyers, patents, and solid procedures or resources to prevent a reputation crisis or rebound from one?

Plans for Growth

Future plans allow a buyer to assess the risk in acquiring the company by knowing how the seller plans to keep the company scaling at a reasonable rate, involving everything from marketing campaigns and retention strategies to ideas for expanding products or improving current ones.

Documentation

Throughout the course of due diligence, the buyer will be asking questions, examining the ins and outs of the business, and most importantly, going through statements, contracts, and other materials for evidence of each and every detail within the business, where they can confirm the validity of the audit with written documentation.

Conducting Unbiased Due Diligence – A Buyer’s Approach

It’s a strategic and smart practice to inform a purchasing decision through the process of due diligence. It can save buyers from making poor investments, or alternatively, it can reinforce making smart ones.

While there are many approaches to take when conducting due diligence, it’s best not to rely on only one type of methodology, but rather to examine a diverse and balanced collection of due diligence methods.

The more accurate, unbiased, and correct the figures are, the more likely the buyer is presented with an objective analysis, rather than small amounts of evidence that don’t give enough information to provide any true value.

Post-Due Diligence

Often, there will be back and forth between the buyer and seller throughout the due diligence process, and it is the seller’s responsibility to disclose all information that could be pertinent to the sale.

Once complete, the buyer will weigh the findings and decide on their next move. It could be that they wish to back out of the sale for whatever reason, or they would like to amend the terms and enter into negotiations until terms are agreed upon, and an agreement is drafted to reflect both parties’ wishes.

Have you ever been involved in due diligence? What advice do you have for sellers/buyers?

Posted by Kristy DeSmit

Kristy is a blogger, Twitter enthusiast, and company legalese interpreter.

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