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Due Diligence – Definition

Due Diligence Definition

The due diligence process is where investors (mainly through there representatives) do a thorough inspection of the startup venture. The purpose is to verify the information supplied by the entrepreneurs and to identify any points of risk in investing in the firm. The extent of diligence varies depending on the stage of company development. In early-stage companies there is generally very little diligence, while later stage companies go through significant diligence.

A Little More on What is Due Diligence

The party selling their business venture is expected to confirm a certain thing including financial records, viable planning, legal compliance etc., before entering an agreement, this is known as due diligence. Due diligence can also refer to the seller’s investigation prior to finalizing a deal with a buyer. The seller needs to know whether the buyer has the adequate fund to complete the transaction. He would also like to confirm a certain thing which might affect the seller or purchased entity after the acquisition.

Due diligence is not always a legal obligation, rather it refers to the voluntary investigation carried out by the parties involved in a transaction.

Equity research analyst, fund managers, broker-dealers and investors perform due diligence in investment world, companies making an acquisition and venture capitalists investing in a startup are also expected to perform this investigation before finalizing the agreement. Individual investors are not legally obligated to perform due diligence but are recommended to, on the other hand broker-dealer are obligated by law to perform due diligence of a security before selling it.

In the U.S. the Securities Act of 1933 makes it mandatory for all the security dealers to disclose all the material information regarding security to a prospective buyer. Failing to do so is considered to be a criminal offense under this Act. Although, the Act also makes sure the security dealers and brokers do not face an unfair prosecution for not knowing an information about the security. They are obligated to perform due diligence before selling the equities of a company and disclose the information fully to the prospective investors, but they are not accountable for any information that they didn’t find in due diligence process.

A Due diligence meeting is a standard part of an Initial public offerings. An underwriter needs to make sure that all the pertinent material information regarding the securities are disclosed to the potential investors. The underwriters, issuer and all other concerned individuals including syndicate members and attorneys meet before issuing the final prospective to confirm that the due diligence process prescribed under state and federal securities laws, is properly followed by the issuer and underwriter.

The due diligence process includes multiple steps of investigation in order to get a complete picture before taking the final call. It involves analyzing the total valuation of the company, examining the revenue, profit and margin trends, looking into the competitors, investigating valuation multiples, balance sheet examination, analyzing stock price history, considering stock options and dilution possibilities and inspecting long and short term risks. The due diligence also looks into the management and share ownership of the company and Wallstreet analysts’ consensus for earning growth, revenue and profit estimates of the company for next two-three years.

Areas Reviewed During Due Diligence

The areas of review are:

  • Finances
  • Operations
  • Legal

While the entrepreneur and investor must be aware of the diligence matters, the actual inspection should primarily be conducted by professionals (attorneys, accountants, and technologists). These individuals can do a far superior job in identifying the potential pitfalls or areas of risk. Below will provides some key points of research into each of these ares.

Financial Due Diligence

  • Income Statement, Cash Flow Statement, and Balance Sheet – In early-stage firms, these documents can be very rudimentary. In any event the investor will verify ownership of assets and assess accounts receivable.
  • Financial Projections – An accountant will compare the revenue and cost projections with the operational requirements. The purpose is to make certain that the cost projections match the necessary operational expenses associated with growth. Often there will be company, market, and economic risks associated with the operations that must be considered. Lastly, it will focus on the expectations for funding demand and the expected sources of capital.
  • Capital Structure – What is the ownership structure and what effect does it have on the equity value of the company. This will include any debt instruments and their limitations on the company.
  • Tax & Reporting Compliance – Has the company complied with all taxation and regulatory filing requirements. Are the tax filings accurately and appropriately executed.

Operational Due Diligence

  • Product/Service Review – Review the market trends and characteristics for the product or service being delivered.
  • Customers, Suppliers, Purchasers, Partners – Review for any vulnerabilities in operational relationships.
  • Competitive Analysis – Review of the operational characteristics of the firm in comparison to competitors in the market.
  • Marketing and Sales Channels – Review of efficiency and vulnerabilities in the marketing and sales process. This may include a comparative analysis of compensation structure for internal and external sales units. This will include an analysis of the method for driving new customers/clients.
  • Research and Development – Technically proficient individuals will review the intellectual property and R&D for feasibility and potential in the market.
  • Management & Personnel – Review the corporate organization structure and the roles of individuals in the organization. This may include identifying performance of key individuals and the identification of indispensable parties. It will further outline the ownership and compensation structure of these individuals.
  • Corporate Governance Matters – Has the company complied with all corporate governance processes and procedures?
  • Litigation – What litigation is pending by or against the company?
  • Regulatory Environment & Compliance – What regulatory issues is the company facing. Most commonly, this may include tax, securities, environmental, and employee-labor compliance.
  • Intellectual Property – Are the intellectual property rights secured in the company. How strong are the intellectual property rights?
  • Insurance – What events are insured or bonded and where are the holes or risks in coverage.

Academic Research on Due Diligence

Mergers and acquisitions across European borders: National perspectives on preacquisition due diligence and the use of professional advisers, Angwin, D. (2001). Journal of World Business36(1), 32-57. This paper examines how national difference in cultural values may influence the perceptions of value regarding due diligence prior to a merger and acquisition (M&A) deal. A large scale survey provides the data, and the findings suggest that these national differences in business culture play an important role in affecting the acquirer’s perception of target companies. The authors also suggest that this difference may have an effect on the negotiation of an M&A deal, and during the post-acquisition phase.

Human due diligence., Harding, D., & Rouse, T. (2007). Harvard business review85(4), 124-31. This article details the steps involved in due diligence regarding the human assets of a company involved in a merger or acquisition. The author’s approach is structured around answering five basic questions: Who is the cultural acquirer? What kind of organization do you want? Will the two cultures mesh? Who are the people you most want to retain? And how will rank-and-file employees react to the deal? Each element is examined in detail, and the costs, benefits, and potential pitfalls of doing due diligence of the human element are fully addressed.

Shelf registration and the reduced due diligence argument: Implications of the underwriter certification and the implicit insurance hypotheses, Blackwell, D. W., Marr, M. W., & Spivey, M. F. (1990). Journal of Financial and Quantitative Analysis25(2), 245-259. This article examines the relationship between shelf registration and the cost of adequate due diligence. The findings suggest that firms with higher expected due diligence liabilities will pay a greater premium, and that shelf-registration erodes due diligence.  The authors also find that firms with higher due diligence liabilities are more likely to choose traditional registration.

Reducing M&A risk through improved due diligence, Perry, J. S., & Herd, T. J. (2004). Strategy & Leadership32(2), 12-19. This article outlines four best practices that can reduce the risk associated with mergers and acquisitions (M&A). The articles defines each of these behaviors and offers analysis and recommendations for each point. They also discuss key risk factors and risk mitigations plans as well.

Shelf registration, integrated disclosure, and underwriter due diligence: an economic analysis, Fox, M. B. (1984). Virginia Law Review, 1005-1034.

Hedge fund due diligence: A source of alpha in a hedge fund portfolio strategy, Brown, S. J., Fraser, T. L., & Liang, B. (2008). This article discusses the role of due diligence as part of hedge fund operations. The authors stress the importance of due diligence through a discussion of the results that can come from well- or poorly executed due diligence functions. The costs and scalability of due diligence processes are also considered.

When to walk away from a deal., Brauner, H. U., Strauch, J., & Knauer, T. (2002). In this article the authors provide real-world examples of companies that had varying levels of success when making deals, helping to illustrate the importance of thorough and effective due diligence. The authors propose four questions that should always be answered prior to making a deal: What are we really buying? What is the target’s stand-alone value? Where are the synergies–and the skeletons? And what’s our walk-away price? Case studies are used to back up these proposed questions, and the authors assertions in general.

Talent acquisition due diligence leading to high employee engagement: case of Motorola India MDB, Srivastava, P., & Bhatnagar, J. (2008). Industrial and Commercial Training40(5), 253-260. This article takes a look at some of the more innovative recruitment practices that firms are undertaking in order to find individuals with the necessary skill sets to help them achieve their goals. A case study involving Motorola Mobile – India provides the data used in this article. The findings show that holistic attitudes toward human resources and employee engagement help create a workplace where employees feel enable and invested in corporate success.

Underwriter certification and the effect of shelf registration on due diligence, Sherman, A. E. (1999). Financial Management, 5-19. This article argues that the general lack of due diligence investigation when certifying underwriters is a drawback to shelf registration. By comparing forecasts of the author’s model to existing empirical evidence, the author concludes that shelf registration leads to increased underwriter competition and reduced due diligence.

Beyond traditional due diligence for mergers an acquisitions in the 21st century, Harvey, M., Price, M. P., & Lusch, R. F. (1998). Review of Business19(3), 17-22. This article outlines the importance of executing due diligence in the process of mergers and acquisitions (M&A). Written in the late 1990s after a period in which the market witnessed a number of M&A failures, the author clearly expresses the dangers of not performing due diligence, as well as the value that can be increased in the combined entity when M&A due diligence is accurately undertaken.

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