Due Diligence stands as a crucial process in the world of corporate business transactions. It is an investigation, audit, or review process to confirm facts or details of a matter under consideration. In other words, it systematically analyzes and mitigates risk from a business or investment decision. In the financial marketplace world, due diligence requires an examination of financial records.
That’s before entering into a proposed transaction with another party. An individual investor can conduct due diligence on any stock using readily available public information. The same due diligence strategy will work on many other types of investments. It’s applied in many different contexts, for example, conducting a background check on a potential employee or reading product reviews.
Due Diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies considering acquiring other companies to assess an investment’s potential in terms of growth. Otherwise, due diligence by individual investors is voluntary. However, broker-dealers are legally obligated to conduct due diligence on a security before selling it.
The goal is to ensure that the purchaser, usually an investor or another business, knows exactly what it’s getting. It’s an in-depth examination of all aspects of the target – its assets and liabilities, legal commitments, internal operations, market standing, and much more. But here’s the catch: due diligence is not a one-size-fits-all process. Usually, the considerations and methods applied differ.
Understanding What Due Diligence (DD) In The Financial Marketplace Entails
One of the most important and lengthy processes in an M&A Deal is Due Diligence. The process of due diligence is something that the buyer conducts to confirm the accuracy of the seller’s claims. A potential M&A deal involves several types of due diligence. Due Diligence consists of examining a company’s numbers, comparing them over time, and benchmarking them against competitors.
It became common practice (a common term) in the United States after the Securities Act of 1933 was passed. With that law, securities dealers and brokers became responsible for fully disclosing material information about the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution. Watch and learn:
The writers of the act recognize that requiring full disclosure may leave dealers and brokers vulnerable to unfair prosecution for failing to disclose a material fact they did not possess. Or they could not have known at the time of sale. Thus, the act includes a legal defense if the dealers and brokers exercise “Due Diligence” when investigating the companies whose equities they were selling.
And if they fully disclosed the results, they could not be held liable for information not discovered during the investigation. In other words, due diligence is a process or effort to collect and analyze data before deciding. It is a process often used by investors to assess risk. It involves examining a company’s numbers, comparing them over time, and benchmarking them against competitors.
The Most Common Due Diligence Types For Potential Business Investors
For your information, Due Diligence (DD) is an extensive process undertaken by an acquiring firm to wholly and thoroughly assess the target company’s business, assets, capabilities, and financial performance. When undertaking a Due Diligence assignment, the first step is to form a mental picture or diagram of the company you’re researching. You’ll want to focus on the investment data.
You may look at the company’s market capitalization, which shows how big it is by calculating its outstanding shares’ total dollar market value. The market cap says a lot about how volatile the stock is likely to be, how broad the ownership might be, and the potential size of the company’s end markets. For example, large-cap and mega-cap companies tend to have more success rates.
They have stable revenue streams and less volatility. Mid-cap and small-cap companies, meanwhile, may only serve single areas of the market and may have more fluctuations in their stock price and earnings. At this step in performing your stock due diligence, you’re not making any pro or con judgments regarding the stock. It would help if you focus your efforts on accumulating data.
In particular, focus on information that will set the stage for everything. When you examine revenue and profit figures, the information you’ve gathered about the company’s market capitalization will give you some perspective. There may be as many as 20 or more angles of due diligence analysis. In that case, we can consider the main types of due diligence inquiries as a reference point.
- Human Resource
- Tax Returns
- Intellectual Property
- Strategic Fit
Depending on its purpose, Due Diligence takes different forms.
Context-Specific Due Diligence:
- Commercial Due Diligence considers a company’s market share and competitive positioning, including its prospects and growth opportunities. This will consider the company’s supply chain from vendors to customers, market analysis, sales pipeline, and R&D pipeline. This can also encompass a firm’s overall operations, including management, human resources, and IT.
- Legal Due Diligence ensures that a company has all its legal, regulatory, and compliance eggs in a row. This includes everything from pending litigation to intellectual property rights to ensuring the company was incorporated correctly.
- Financial Due Diligence audits a company’s financial statements and books to ensure there are no irregularities and that the company is on solid financial footing.
- Tax Due Diligence looks at the company’s tax exposure, whether it may owe any back taxes, and where it can reduce its tax burden as we advance.
Hard Versus Soft Due Diligence:
- Hard Due Diligence concerns the numbers and data on financial statements like the balance sheet and income statement. This can entail fundamental analysis and the use of financial ratios to grasp a company’s financial position and make projections for the future. This type of due diligence can also identify red flags or accounting inconsistencies; however, Hard due diligence, driven by mathematics and legalities, is susceptible to rosy interpretations by eager salespeople. Soft due diligence acts as a counterbalance when the numbers are being manipulated or overemphasized.
- Soft Due Diligence is a more qualitative approach that looks at aspects such as the quality of the management, the people within the company, and the loyalty of its customer base. There are many business success drivers that numbers cannot fully capture, such as employee relationships, corporate culture, and leadership. When M&A deals fail, as an estimated 70%-90% of them do, it is often because the human element is ignored.
In the Merger And Acquisition (M&A) world, a company considering a deal will perform a financial analysis of a target company. The due diligence might also include an analysis of future growth. Acquirers may ask questions that address the acquisition structure. They are also likely to look at the current practices and policies of the target company and perform a shareholder value analysis.
In the bustling e-commerce industry, due diligence takes on unique dimensions. Traditional brick-and-mortar assets are replaced by digital assets like domain names and proprietary software, shifting the focus dramatically. The most crucial aspect of e-commerce due diligence is scrutinizing the website’s traffic data – its sources, sustainability, and costs. Intellectual property rights, data security, and privacy policies require intense scrutiny since ambiguity may lead to costly legal issues later. E-commerce businesses rely heavily on third-party platforms for advertising, payment processing, and other services. Hence, understanding the relationships and liabilities associated with these third parties is crucial.
In the retail industry, the physical footprint takes precedence. Due Diligence often starts with assessing the condition, value, and location of stores and other real estate assets. A comprehensive audit of inventory is also imperative. However, in today’s omnichannel retail environment, it also becomes essential to understand the digital presence of a retail business. Assessing the effectiveness of the online platform and its integration with the physical stores is critical. The financial health of suppliers, reputation, and customer satisfaction also play a significant role in retail due diligence.
For manufacturing entities, due diligence tends to be more technical. The evaluation here zeroes in on the condition and value of tangible assets, such as machinery, equipment, and facilities. It also encompasses the organization’s production capabilities, testing its ability to meet demand, control quality, and adapt to technological advancements. Operational aspects like supply chain efficiency, sourcing of raw materials, and labor relationships are reviewed thoroughly. Assessing regulatory compliance in environmental and safety practices is also a non-negotiable aspect of due diligence in this industry.
A Comprehensive Approach To Help Customize Your Business Checklist
No matter the industry, financial and legal Due Diligence remain universal. This includes assessing the target’s financial health, analyzing cash flows, reviewing audited financial statements, and examining all existing legal contracts, disputes, and potential liabilities. Yet, as we’ve seen, the importance of industry-specific factors cannot be understated in the due diligence process.
Treating DD as a routine checklist can be disastrous and might lead to overlooking industry-specific risk factors. Adopting an industry-aligned approach to due diligence that caters to its unique demands will inevitably generate more accurate, actionable insights. And it’s these insights that can forge strategies capable of realizing actual value from investments and transactions.
Applying some simple steps is appropriate when considering investing in a startup, while others aren’t possible because the company doesn’t have a track record. To enumerate, most organizations use a Due Diligence Checklist in their strategic planning. This is an organized way to analyze a company. The checklist will include all the areas to be explored, such as business ownership.
As well as the organization’s profile, assets and operations, financial ratios, shareholder value, processes and policies, future growth potential, management, and human resources. DD facts can include reviewing all financial records, past company performance, and anything else deemed material. Doing Due Diligence on stock investment is voluntary but recommended for individual investors.
Some Startup-Specific Moves:
- Include an exit strategy. Plan a method to recover your money should the business fail.
- Consider entering into a partnership: Partners split the capital and risk, so they lose less if the business fails.
- Figure out the harvest strategy for your investment. Promising businesses may fail due to technological change, government policy, or market conditions.
- Be on the lookout for new trends, technologies, and brands, and get ready to harvest when you find that the business may not thrive with the changes.
- Choose a startup with promising products. Since most investments are harvested after five years, investing in products with an increasing Return On Investment (ROI) for that period is advisable.
- Instead of complex numbers on past performance, look at the business’s growth plan and evaluate whether it appears realistic.
Remember, the Due Diligence process is primarily a way to reduce financial risk exposure. The process ensures that a party is aware of all the transaction details before they agree to it. For example, a broker-dealer will give an investor the results of a due diligence report so that the investor is fully informed before deciding. They cannot hold the broker-dealer responsible for any losses.
Topmost Crucial Practices When Performing A Hard Due Diligence Process
In traditional Mergers and Acquisitions (M&A), the acquiring firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets, and liabilities. That’s known colloquially as complex or Hard Due Diligence. However, M&A deals are increasingly subject to analyzing a company’s culture, management, and other human elements through soft due diligence.
Equally important, in merger and acquisition deals, Hard Due Diligence is the battlefield of lawyers, accountants, and negotiators. Typically, complex due diligence focuses on earnings before interest, taxes, depreciation and amortization (EBITDA), the aging of receivables and payables, cash flow, and capital expenditures.
As a rule of thumb, you should consider various factors when performing DD on a stock, including company capitalization, revenue, valuations, competitors, management, and risks. Furthermore, by taking the time to perform due diligence on the stock market before making a purchase, you’ll be better equipped to make a decision that aligns with your overall strategic investment process.
In sectors such as technology or manufacturing, additional focus is placed on physical capital and intellectual property. However, there are still other examples of complex due diligence activities.
Hard Due Diligence Activities Include:
- Reviewing and auditing financial statements
- Scrutinizing projections for future performance
- Analyzing the consumer market
- Seeking operating redundancies that can be eliminated
- Reviewing potential or ongoing litigation
- Reviewing antitrust considerations
- Evaluating subcontractor and other third-party relationships
Acquirers are also very careful about exercising due diligence regarding evaluating how well the target company fits in with the buyer’s overall strategic business plan. For example, a private equity firm considering a new acquisition will ask how well the proposed target will complement the firm’s existing portfolio of companies. Think of a large corporation eyeing a possible M&A.
In a proposed merger or a situation where shares of stock in the acquiring company constitute a significant part of the purchase transaction, the target company may look to perform its due diligence on the acquirer. Such a company may think how easy or difficult it is likely to be to successfully merge the target company into the buyer’s total corporate organization.
Some Recommended Practices When Performing A Soft Due Diligence Process
Of course, conducting soft due diligence is not an exact science. It should focus on how well a targeted workforce will mesh with the acquiring corporation’s culture. Usually, hard and soft due diligence intertwines regarding compensation and incentive programs. These programs are not only based on actual numbers, making them easy to incorporate into post-acquisition planning.
They can also be discussed with employees and used to gauge cultural impact. Soft due diligence concerns employee motivation, and compensation packages are designed to boost those motivations. It is not a panacea or a cure-all, but Soft Due Diligence can help the acquiring firm predict whether a compensation program can be implemented to improve the success of a deal.
Soft due diligence can also concern itself with the target company’s customers. Even if the target employees accept the cultural and operational shifts from the takeover, the target customers and clients may resent a change in service, products, or procedures. This is why many M&A analyses now include customer reviews, supplier reviews, and test market data.
Due Diligence (DD) is more an art than a set of business procedures. Knowing what to look for, where to look for it, and how to look for it requires a keen eye for detail, meticulous preparation, and a deep understanding of the specific industry. Only then will due diligence function as it should, as the essential lighthouse preventing one’s ship from straying into rocky waters.
Other areas of due diligence research include IT networks, issues of stocks and bonds, research and development (R&D), and sales and marketing. In other words, conducting thorough due diligence is critical to any successful acquisition. Without complete and intimate knowledge of the target company, making the best-informed decisions on mergers and acquisitions is impossible.