Investment due diligence is a necessary process for both buyers and sellers to undertake to ensure the swift execution of their envisaged transaction. Although, with the stakes high, there are certain challenges that can arise throughout the process which, with careful planning and execution, can be mitigated.
Why is Due Diligence Necessary?
Due diligence is the detailed investigation that a potential investor carries out on a target business after successfully completing preliminary negotiations with its owner. Notwithstanding, the differences in scope due to different investing scenarios, there are typically four types of due diligence. These include commercial, legal, financial, and tax checks. As a result of the due diligence, the investor may come to a different or more nuanced understanding of the opportunity and seek to renegotiate the initially agreed terms or even decide to decline the investment. Due diligence commonly results in the investor negotiating additional, more detailed terms and conditions in its final agreement with the business’s owner. Caveat emptor dictates that it is a buyer’s absolute prerogative to undertake a due diligence on a potential acquisition. This was one red flag that was openly apparent within the recent example of Theranos, where investors largely forwent their checks.
What are the Types of Due Diligence?
Investment due diligence does not have a strict formulation; it should be designed to address the specific circumstances. The matters which will be investigated depend on the structure of the contemplated transaction – what the investor will receive in exchange for its investment. If the transaction is structured so that certain assets, liabilities or segments of the business are excluded, there is no reason for the investigation to cover them. The matters to be investigated also depend on the stage of maturity of the investee business or stage in the funding cycle, referred to earlier as “investing scenarios”. Certain areas of investigation which are critical in some scenarios, e.g. historical performance for M&A transactions, may not be relevant in other – in the same example, for seed/VC funding where the business does not yet have traction so that other types of historical information, such as founders’ backgrounds, are investigated instead. Notwithstanding the differences in scope due to different investing scenarios, typical due diligence will include commercial, legal, financial, and risk due diligence.
- Commercial due diligence covers the target business’s market positioning and market share, including drivers and prospects. It seeks to obtain an independent perspective on the sales forecast as the most critical component of the target’s business plan.
- Legal due diligence covers a wide scope of legal matters, including proper incorporation and ownership, contractual obligations, ownership of assets, compliance, and litigation. It seeks to confirm the validity of the rights being acquired by the investor and the absence of legal risks which could undermine the value of the investment.
- Financial due diligence has a wider perspective because it seeks to both:
- Validate the investor’s valuation assumptions by looking at historical performance, if available, and concluding on whether it is consistent with projections and
- Identify financial uncertainties and exposures which could disrupt the business, or result in additional costs to the investor.
- Risk due diligence is the process of identifying potential fraud, but reputational issues as well. Risk Due Diligence brings together a holistic picture of companies and key personnel including:
- Legal implications
- News and Media Chatter
- Social Media Behavior
- Education and License Verification
These various types of due diligence help institutional investors better understand the companies and people that they intend to build business relationships with, as well as help manage risk of the business.
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