What is Due Diligence? Definition, Types and Advantages

Due diligence is defined as a process of investigation where proper steps are taken to minimize the risk of an uninformed decision. It is mostly undertaken when the risk factor is excellent and the chances of making unnecessary mistakes can be easily avoided.

What is Due Diligence?

Due diligence is described as a method of systematic research to verify the accuracy of a given statement. The term is used mainly in the business world to validate financial statements. The objective of such an exercise is to ensure that the related information reaches the hands of all the stakeholders so that they can assess the risk accurately.

It is typically carried out by investment bankers, CAs, corporate lawyers, analysts working in VC and PE firms and some cases loan officers in banks depending upon the nature of the transaction. There are other people involved in the process who offer their help like accountants, operations managers, HR managers and company secretaries.

Types of due diligence

Due diligence is generally undertaken by a firm to assess the capabilities, assets, business and financial performance of a company it is set to acquire. The various types of due diligence analysis are as follows-

1. Asset due diligence 

One of the common types of due diligence is asset due diligence, and it includes

1. List of fixed assets and their locations
2. Physical verification of the fixed assets
3. Lease agreements related to equipment
4. Schedule of purchase and sales of the lease agreements for capital equipment in the last five years
5. Use permits
6. Title policies
7. Mortgages
8. Real-estate deeds

2. Financial due diligence 

One of the essential types of due diligence in the business due diligence that verifies whether the showcased financial information in the Confidentiality Information Memorandum or CIM is correct and up-to-date or not. The data offers a deeper understanding of all the financials related to the company a buyer is acquiring. It includes

1. Unaudited financial statement of the current year along with statements of last year
2. Audited financial statement of the previous three years
3. Capital expenditure plan,
4. The projections of the organisation and the basis of making those projections
5. List of creditors
6. List of debtors
7. Schedule of inventory
8. Variable and fixed cost analysis
9. Analysis of essential customer accounts
10. Examination of internal control processes
11. Analysis of profit margins
12. Inspection of the sales pipeline
13. Study of the order book of the company
14. Debt situation of the company involving information about long-term and short-term debt
15. Applicable interest rates
16. The ability of the firm to service its outstanding debts
17. The ability of the firm to secure more finance
18. Evaluation and examination of the capital structure of the company

3. Administrative due diligence 

This is a type of due diligence where related administrative items for instance occupancy rate, facilities, and number of workstations are verified under the process of due diligence.

It checks whether the seller owns the facilities and whether he has included all the operational costs in the financials or not. The method of due diligence offers a reasonable estimate of the operational cost a buyer has to incur in case of further expansion of the target company.

4. Environmental due diligence 

One of the most important due diligence is environmental audits for all the properties that a firm owns or has leased.

This is because if the company has violated any rules and regulations about environmental issues, then, it is open to legal ramifications from local authorities and it could result in shutting down of the operations. It is important to undertake due diligence of

1. List of environmental licenses and permits
2. Validation of the said licenses and permits
3. Copies of all the notices and correspondences from local and state regulatory offices or EPA
4. Verification of the fact that the disposal methods used by the company are in tandem with the set guidelines and current regulations
5. Information on whether any contingent environmental liabilities are due

5. Taxes due diligence 

The taxes due diligence is undertaken to review the various taxes that the organisation is supposed to pay. It provides the status of all the tax-related cases that are still pending with the authorities.

It also ensures that the firm has shown proper calculation and there are no under-reporting of the taxes in the papers. Tax compliance includes review and verification of

1. Copies of income tax for the last three to five years
2. Copies of all the other taxes like withholding and sales tax for the last three to five years
3. Information about pending tax audits of the organisation
4. Information and related documents of net operating loss or NOL or unused credit carryforwards of tax credits or deductions
5. Important correspondence with tax authorities

6. Human resources due diligence 

Human resources due diligence is carried out extensively and includes the following

1. List and analysis of salaries and bonus that is paid currently and which was paid in the last three years of service
2. List of total employees and their total years of service
3. Information about the current positions of all the employees, their service notice period and the due date of their retirement
4. List of vacancies in the company
5. Financial impact because of labour disputes, grievances procedure and requests for arbitration
6. HR policies concerning different forms of leave like sick leave and annual leave
7. Employment contracts with nondisclosures, non-competition and non-solicitation agreements between the employee and the company
8. Information about any legal cases related to former and current employees
9. An analysis of issues related to employees like discrimination, harassment and wrongful termination
10. List of all the information related to health benefits, self-funded arrangements and request for arbitration of employees
11. Schedule of grants

7. Legal due diligence 

The legal due diligence is considered very important and generally includes the review and examination of the following

1. Copy of Articles of Association
2. Copy of Memorandum
3. Franchise or licensing agreements
4. Minutes of board meetings that have been conducted for the past three years
5. Minutes of all the other meetings or actions of shareholders for the past three years
6. Copy of the guarantees to which the organization is a party
7. Copies of share certificates that have been issued to important management employees
8. All the material contracts including operating agreements or limited liability company, partnership or joint venture agreements
9. Copies of lines of credit, bank financing agreements and all loan agreements

8. Intellectual property due diligence 

Every business entity has intangible assets known as intellectual property assets. It can be used to monetise the business and includes some of the firm’s most valuable assets. The intellectual property due diligence review includes

1. List of patents and patent applications
2. List pending patents clearance documents
3. List of brand names, trademarks and copyrights
4. Any claims cases that are pending by or against the company for violation of intellectual property

9. Strategic fit due diligence 

It is imperative to find out whether the firm a buyer is thinking of purchasing will be a strategic fit or not with his existing portfolio of companies. The strategic fit due diligence will include information like

1. Does the company have employees that will prove excellent fit
2. Does the company have technology, market access or products that will prove again
3. Assessing financial and operational synergies advantages that will happen with the integration of both the companies
4. Examining the plan for the merger, time the process will take and the cost of implementing the actual process of merger
5. Finding the best employees from both the firms to manage the merger process

10. Customer due diligence 

The customer due diligence involves looking at the customer base of the company at which a buyer is looking. It also involves-

1. The top customers of the firm
2. The customers who make the largest total purchases
3. Customers who are important irrespective of their current spending
4. Customer satisfaction score
5. Service agreements and resulting insurance coverage
6. Current credit policies
7. List of the customers who have shifted allegiance away from the company

Advantages of due diligence

The advantages of due diligence are as follows

• One of the major advantages of due diligence is that it helps the buyer to confirm information about financials, customers, contract etc. of the seller
• It minimises the knowledge and information gap between the buyer and the seller
• It encourages the buyer to make informed decisions
• Sets clear expectations and creates greater awareness about expectations from the deal
• The due diligence process gives the buyer the confidence that is needed to close the deal
• The advantage of due diligence is that it gives the buyer an option of backing out if something untoward comes to light
• The decisions become better and the pricing more accurate because of due diligence
• Helps to discover unknown issues that could have a greater impact on the decision-making process

Challenges of due diligence

The process of due diligence faces several challenges which are as follows-

• It can be challenging to ensure that the party meets every regulatory and legal requirement
• It is imperative to customise every process
• In case of any international elements in the deal, it has to comply with the international accounting standards and Foreign Corrupt Practices Act
• There are more analysis and enquiry involved in the buying of a private company compared to a public company
• The buyers often face a difficult challenge when the seller is not ready to step aside even after signing the papers to close the deal
• In some cases, the deal falls through as the seller fails to prepare for the transition and does not have the required documents and information
• Companies must be recent in terms of meeting the changing regulations
• Sellers sometimes hide important information from the buyer especially if it is negative

How long does due diligence take?

Although there is no fixed timeline for due diligence approximately, it takes thirty to sixty days for the process to complete. Every deal is different and might be of shorter or longer duration as per the need of the company. It is imperative to consider the following before deciding upon a timeline

• Is the deal very complex?
• To which industry does the business belong to?
• Is the target entity massive?
• What type of merger is the buyer looking at?
• Is there any international property or law involved in the deal

The concerns of the due diligence process

The due diligence process includes looking after the following concerns

• Does the business have good cash flow?
• From where are the revenues coming?
• Is there a chance of new competitors in the market that can adversely affect your chances?
• Are the financial projections reliable?
• Does the firm have any hidden liabilities?
• Are the company documents up-to-date?
• Has the seller given all the related documents to the buyer?
• Does the business have any online presence?
• What is the market area for the products or services of the company?
• What is the position of profits? Is it green or red?
• Is the market stagnant or it is still growing?
• Have the physical assets of the company appropriately been and fairly valued
• Are the taxes up-to-date?
• Has the seller offered any information about the insurance and what does it cover?
• Has the seller offered all information related to its employees?