In business terms, due diligence refers to a detailed investigation of a company and its financial records, often completed by an individual or another business before they enter into a business agreement with the company in question.
In most cases, the due diligence process is carried out before the purchase of a business, allowing the buyer to take reasonable steps to assess the commercial viability and potential risks of a transaction.
The primary purpose is to appraise and value assets and to identify potential liabilities or financial shortcomings. If any nasty surprises are found throughout due diligence audits, the buyer can either renegotiate or cancel the deal.
Why is business due diligence important?
Before committing to business transactions, it’s important to have the right information – whether it’s the acquisition of a company, undertaking an important sale or purchasing real estate.
It makes no difference if the process is voluntary or part of a legal obligation, both the purchaser and vendor must follow certain guidelines and procedures to ensure the outcome is fair and avoids potential risks.
Understanding the due diligence process
Due diligence is typically carried out once the intent to purchase has been established, but the formal purchase agreement is not yet signed.
At this stage of the purchase process, a business should write a due diligence checklist that specifies all the information they need from the target company.
Throughout the due diligence process, the purchaser should consider:
- Spending time talking to management and staff.
- Understanding what documents are required to consider the viability of the transaction.
- Reviewing customer records to verify details and the integrity of the data.
- Questioning whether there are any potential liabilities from past or present agreements.
- Engaging an appropriately qualified practitioner to examine documents that relate to ongoing or potential lawsuits, litigation, and other legal issues.
Most information collected from due diligence is highly sensitive in nature. As a means to prevent data leaks, the target company may insist on a due diligence clause asking the other party to sign a non-disclosure agreement.
Due diligence investigations
Before purchasing a target company, many buyers will perform a full due diligence investigation (also known as a due diligence audit). This involves investigating all aspects of the business before you make a binding decision to buy.
Due diligence investigations allow you to take reasonable steps to make sure that you are not making risky or poor decisions, paying too much or breaking any regulations or rules.
When investigating a business some of the matters that may need to be reviewed include:
- Financials – Do the reported accounts tally with the company’s balance sheets and internal records?
- Credit issues and business disputes – Are you buying a business or buying into litigation?
- Business structure and ownership – Does the person you’re dealing with actually have the right to sell the business?
- Shareholder value analysis – If the value of the business grows under your ownership, how will this effect shareholder equity?
- Intellectual property – Have the business’s products, services, designs, logos, and branding all been protected? Are the property rights part of the deal?
- Current contracts – What is the state of any existing internal (employees/directors) and external (suppliers, clients) contacts?
Be sure to compare the information found in the investigation and what the business or individual has said during negotiations. If the facts are inconsistent, it could be a sign of underlying problems.
What to include in a due diligence report
After collecting the information, it is often useful to summarise the details in a due diligence report. The report should answer all the burning questions raised during the process and conclude whether the current state of the deal is fair or not.
Depending on the kind of business deal, due diligence reports typically contain the following information:
- Written profile of the company including history, business model, revenue model, customer base, industry competitors, past and current management.
- Contracts for all employees, equipment, facilities, property sales, leases, suppliers and clients or customers.
- Past, current and future status of relationships with customers, clients, suppliers, distributors and strategic partners.
- Information about the business’ financial strength and ability to grow including financial records, statements, revenue, profit margins and forecasts.
- Employment records including, but not limited to, time records, wages and pay, contracts (and variations).
Before sending the due diligence report to team members evaluating the deal, the information should be verified by qualified legal, tax and business experts.
Due diligence clauses
One of the most common clauses found in the contract of a property sale is due diligence.
A due diligence clause gives the buyer permission to conduct property searches and cancel the contract if any outstanding issues are found. Whether the property is in poor condition, infested with timber pests or the property has other liabilities – a due diligence clause allows buyers to walk away from the deal.
Some sellers dislike the sweeping rights of terminating a sale without consequence. As a response, sellers may request a time limit on how long the due diligence period can last for. If a seller makes this request, you should seek guidance from a qualified expert.
Transfer of business
When an entity buys or takes over a business or part of the business, it will often want to retain existing employees. Due diligence will assist in determining the financial costs of doing so.
Once this cost is quantified, a business is in a position to consider whether or not it is beneficial to recognise the entitlements of any existing contacts after a transfer of business. Of course, there are a number of non-financial factors that should be considered when making this decision, including the impact on employee morale and company culture.
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This article has been compiled on the basis of general information current at the time of publication. Changes in circumstances after publication may affect the completeness or accuracy of this information. To the maximum extent permitted by law, we disclaim all liability for any errors or omissions contained in this information, or any failure to update or correct this information.