Why is Due Diligence Necessary?
“Due diligence is both an art and a science.” According to Investopedia, Due diligence is an investigation or audit of a potential investment or product to confirm all facts, that might include the review of financial records. Due diligence refers to the research done before entering into an agreement or a financial transaction with another party.
Because of the due diligence, your investors 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.
Types of Due Diligence
There are various types of due diligence given that every circumstance is different and there’s no formula for it. Mainly, there are four basic types of due diligence which include commercial, financial, tax and legal due diligence.
Commercial Due Diligence reports analyses company performance, the likelihood that the business will meet its targets, and highlights potential problems that may occur as a result of an acquisition. This report provides the potential buyer with in-depth knowledge of the target company and the market in which it is positioned. It is designed to enable the prospective buyer to make an informed decision, and highlight any potential risks associated with the target business.
Financial Due Diligence typically, the scope would include an analysis of the historical quality of earnings, quality of net assets, working capital requirements, capital expenditure requirements, financial debt and liabilities, and forecasted financial results. In short, it focuses solely on the financial health of the company.
Tax Due Diligence is a comprehensive examination of the different types of taxes that may be imposed upon a particular business, as well as the various taxing jurisdictions. To put it simply, it could be viewed as an extension of the financial due diligence, where the focus is on identifying potential additional tax liabilities arising from non-compliance or errors.
Legal Due Diligence covers a wide scope of legal matters, including proper incorporation and ownership, contractual obligations, ownership of assets, compliance, and litigation. It aims to confirm the validity of the rights being acquired by your investors and the absence of legal risks which could undermine the value of the investment.
How Long Does Due Diligence Take?
According to David Braun, CEO of a Capstone (they specialize in M&A) generally, on average due diligence should take between 30 and 60 days to complete. It is the optimal time to complete a thorough evaluation of the business without letting the process drag on. Why is this such a long process? Read on!
Due Diligence Process
Before the Due Diligence, gather your internal and external team of lawyers, accountants, advisors, and investors. The internal and external team will come together to discuss an opportunity, and terms of investment. Key terms discussed are usually laid out in a non-binding document such as a Term Sheet or a Cap Table. These usually are discussed through a virtual data room whereby information is typically secured hence ensuring only approved viewers get to access the confidential documents. Virtual data rooms can be created virtually and many firms provide them. Datarooms.com, Drooms, etc. are just some of the few that provide safe due diligence with information like this. Need help in generating a Cap Table? Or don’t know what to include in your Term Sheet? We got you covered!
During the Due Diligence, there is a lot, when I say a lot, I meant a lot of information requesting and receiving. So be prepared for that! That aside, there will be on-site visits at the target business by the due diligence team. During the onsite visit, the due diligence team gets to interview with various management team members from various functions; they will discuss the findings as well as draft out a report on the findings. The report is then sent to your investors and further negotiation on changes to the term could take place. Overall, since it is not a one-man show; it involves various stakeholders and hence there is no doubt due diligence process is such a long process.
To ensure a smooth due diligence process, I would advise every business to do a lot of research and do your own due diligence first, so you can answer all the questions raised by your internal and external team. Usually, a framework or checklist would come in handy when you want to do your own due diligence and they can be found here. It goes beyond the basic checks you would normally make and it’s safe to say that if you find it to be relatively straightforward, you probably didn’t do it right. On top of the checklist, follow this article on Due Diligence in 10 Easy Steps. Check out our article on What to include in an Investment Package, it will come in very handy when you do your own due diligence.
According to our experiences, some potential red flags that you should look out for when doing your own due diligence are and not limited to the following — Make sure your business’ contracts are fully disclosed, your business is not in the middle of any litigation case, and check the local laws to make sure there aren't any violations. You should always try to overcome the red flags or the difficulties faced before the actual due diligence.
No matter what, always remember that due diligence is your best opportunity for investors to understand the risks involved in your business before signing a long term relationship hence, be prepared to do everything to minimize the risk. Are you a startup seeking funding during Seed or Series A? Check us out here!
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