Due diligence
Due diligence is a systematic vetting process that individuals or companies undertake to thoroughly research potential business transactions before formalizing agreements. This process is especially crucial in corporate mergers and acquisitions, where it helps verify the legitimacy and viability of proposed deals by analyzing financial records and other pertinent information. By conducting due diligence, buyers aim to uncover potential problems, liabilities, and compatibility between merging entities, thereby protecting their interests and minimizing risks.
The due diligence process encompasses evaluating financial statements, understanding company backgrounds, cataloging products and services, and identifying legal issues. It is not simply an audit; rather, it is a broader investigation that considers both business and legal dimensions, involving accountants and lawyers to ensure all critical aspects are covered. Although primarily benefiting the buyer, sellers can also engage in due diligence to assess the buyer's capability and any implications for the future of their business.
The importance of due diligence is underscored by its potential to prevent significant financial losses and company failures, as neglecting this process can lead to poorly informed decisions. Given that a substantial percentage of mergers and acquisitions can fail, thorough due diligence serves as a vital safeguard in the complex landscape of business transactions, ultimately guiding stakeholders toward informed and strategic decision-making.
On this Page
Subject Terms
Due diligence
In business and finance, due diligence is a vetting process by which an individual or company researches a potential business transaction before entering into an agreement. Due diligence is a critical part of corporate mergers and acquisitions. People making investments and buying securities also use this process.
The purpose of due diligence is to verify the facts of the deal by analyzing financial records and other relevant information. It protects buyers and sellers, but mainly the buyer, by uncovering problems or liabilities. Due diligence activities include examining financial statements, collecting company information, cataloging products and services, determining strategic fit, and identifying legal issues.
Due diligence is vital to a transaction's success. Neglecting due diligence can result in poor financial performance, bad acquisitions, and company failures.
Background
Due diligence investigates whether the conditions that make a business deal attractive for both parties are legitimate. If due diligence is done properly, it facilitates further negotiation and the successful completion of the transaction.
The practice became standard after the Securities Act of 1933. The US law required dealers and brokers to disclose information about the stocks and securities they were selling to potential investors or face criminal prosecution. However, dealers and brokers could be held liable if they did not disclose facts they were unaware of during the sale. To protect them, the law stated dealers and brokers must exercise due diligence and reveal all their information to investors.
In business, due diligence often concerns the buying of companies. Firms rely on the process when considering a merger—when two companies combine to form a new one—or an acquisition—when one firm buys another. The process is conducted after both parties have sketched the broad terms of the deal but before an official agreement has been drawn up.
In addition to mergers and acquisitions, due diligence applies to various investment situations. Venture capitalists—investors who provide capital for small companies, such as start-ups—use due diligence when deciding to invest. Individual investors buying shares, dealers and brokers selling securities, and bankers considering loans also engage in the process. Due diligence is used in real estate transactions and property appraisals as well.
Due diligence is not an audit itself, but a broader investigation that includes elements specific to a given situation. In a merger or acquisition, due diligence centers around a business's potential for future profit. The investigation explores how well the two firms might operate together and estimates the financial benefits. The process involves the participation of the buyer or investor, accountants, and lawyers.
There are two aspects to due diligence: business and legal. The buyer's accountants oversee business due diligence, which concerns the deal's financial and strategic aspects. This includes the company's financial statements, performance, condition, and future projections, as well as the synergy among its operations, production, and distribution methods. Legal due diligence, conducted by the buyer's attorneys, includes uncovering litigation risks, questionable contracts, intellectual property issues, and other problems that could threaten the transaction.
Although due diligence typically benefits the buyer, the seller can also perform the process. The seller can investigate if the buyer has enough funds to cover the transaction and explore other factors that could affect the acquired firm after the deal is complete.
Overview
The investigative process of due diligence is necessary for a well-planned investment or acquisition. By performing research, firms and individuals can measure the benefits, costs, and risks of the potential transaction.
To conduct due diligence, buyers and investors should perform the following activities to gather enough data to make an informed decision:
- Examine financial records—Buyers and investors should review a company's financial statements and balance sheets to evaluate its performance. The most important numbers are revenue, profits, and margins. Consistent growth in revenue and profit, or net income, is favorable, but major swings are cause for concern. Margins may rise, fall, or stay the same. The financial information should also include the company's projections for the future and list any liabilities.
- Collect company information—Buyers should investigate the history of the company and its leadership. They should find out if the company is still run by its founders and if managers or institutional investors, such as insurance companies, hold most of its shares. The company is more desirable if managers hold the majority of shares, as the employees will have a personal stake in its performance.
- List products and services—Buyers and investors should have a list or catalog of the business's products and services, pricing strategies, and service availability. This includes information about the goods' competitiveness in the market. Buyers should also have access to the copyrights, patents, and trademarks owned by the company.
- Determine strategic fit—In mergers and acquisitions, buyers should consider if the company's goals are compatible with their own. The company may offer products and services that the buyers do not have. This would allow the buyers to diversify their offerings and enter a new market. Integration may be necessary, which comes with its own costs. The buyers must estimate any cost savings after the acquisition.
- Identify legal issues—Buyers and investors should look over contracts, partnership agreements, and license agreements. They should be aware of pending litigation, complaints, and other claims against the company. Buyers should explore the firm's compliance with government agencies and regulatory requirements. They should also have access to tax filings, government audits, and historical income tax liabilities, such as the failure to file.
By performing due diligence, buyers and investors can improve upon an existing deal or walk away from one that reveals too much risk. The checklist of activities ensures a fair deal.
A lack of due diligence, however, can harm the buyer, investor, or company. When the process is not adequately carried out, investors do not have all the information they need. They may enter into an insufficient deal that fails to meet expectations. The stock price may dive, the acquired company may lose money, or the buyer may default.
According to the AMA Handbook of Due Diligence, 25 to 30 percent of acquisitions and mergers end in failure. Some research indicates this percentage may be as high as 70 to 90 percent if accomplishing all agreed-upon goals is considered. As a result, the acquired firm is usually resold or liquidated within five years. Investors have also sued corporate officials over bad acquisitions.
Due diligence offers significant protection to buyers and investors during a business transaction. When done correctly, the process ensures buyers are aware of the financial matters and legal issues that can arise. It can mean the difference between a good or bad deal.
Bibliography
Barnes, Ryan. "Due Diligence in 10 Easy Steps." Investopedia, 13 Oct. 2021, www.investopedia.com/articles/stocks/08/due-diligence.asp. Accessed 10 Dec. 2024.
Crilly, William M., and Andrew J. Sherman. The AMA Handbook of Due Diligence. American Management Association, 2010.
"Due Diligence." Investopedia, www.investopedia.com/terms/d/duediligence.asp. Accessed 20 Nov. 2017.
Harroch, Richard D., and David A. Lipkin. "20 Key Due Diligence Activities in a Merger and Acquisition Transaction." Forbes, 14 Apr. 2022, www.forbes.com/sites/allbusiness/2014/12/19/20-key-due-diligence-activities-in-a-merger-and-acquisition-transaction. Accessed 10 Dec. 2024.
Howson, Peter. Checklists for Due Diligence. Routledge, 2017.
Howson, Peter. Due Diligence: The Critical Stage in Mergers and Acquisitions. Routledge, 2017.
Kenny, Graham. "Don’t Make This Common M&A Mistake." Harvard Business Review, 16 Mar. 2020, hbr.org/2020/03/dont-make-this-common-ma-mistake. Accessed 10 Dec. 2024.
Murray, Jean. "The Importance of Due Diligence When Buying a Business." The Balance, 26 Mar. 2021, www.thebalance.com/how-due-diligence-is-used-in-a-business-purchase-397778. Accessed 10 Dec. 2024.