In business terms, due diligence refers to a detailed investigation of a company and its financial records, often completed by an individual or another business before they enter into a business agreement with company in question.
In most cases, the due diligence process is carried out before the purchase of a business, allowing the buyer to take reasonable steps to the assess the risk and commercial viability of a transaction.
The primary purpose is to appraise and value the business’s assets and to identify potential liabilities or financial shortcomings. Potential buyers will also assess the health of the business, the market it operates in and the strength of the companies it is competing with.
If any nasty surprises are found throughout due diligence audits, the buyer can either renegotiate or cancel the deal.
Why is due diligence important?
Before committing to any kind of business transactions, it’s important to have all the right information. Whether it’s the acquisition of a company, buying the rights to a product, or purchasing real estate, it’s crucial to get the facts straight about the deal you’re entering into.
It makes no difference if due diligence is voluntary or a legal obligation of a sale, both the purchaser and seller must follow certain procedures to ensure the process is fair and produces an accurate analysis.
The due diligence process
The due diligence process typically begins once the intent to purchase has been established, but the formal purchase agreement is not yet signed.
At this stage, a business should write a due diligence checklist that specifies all the information they need from the business owner.
Throughout the due diligence process, the purchaser should:
Spend time talking to the target company’s management and staff.
Establish what documents will verify the current state of the business.
Review any documents and data provided to ensure their integrity.
Question whether there are any potential liabilities from past or present agreements with customers, clients or contractors.
Engage an appropriately qualified practitioner to examine any ongoing or potential lawsuits, litigation, and legal issues.
Most information collected during the due diligence process is highly sensitive in nature. As a means to prevent data leaks, the target company may insist on a due diligence clause asking the other party to sign a non-disclosure agreement.
Due diligence investigations
Before purchasing a target company, many buyers will perform a full due diligence investigation (also known as a due diligence audit). This involves investigating all aspects of the business before you make a binding decision to buy.
Due diligence investigations allow you to take reasonable steps ensure you are not making risky decisions, paying too much, or breaking any regulations and rules.
When investigating a business some of the matters that may need to be reviewed include:
Past performance: Are you buying a business with a strong track record for past performance and profitability?
Market analysis: Is there demand for the company’s products or services, and how fierce is the competition?
Financial statements: Do the financial reports tally with the company’s balance sheets and internal records?
Credit issues and business disputes: Are you buying a business or buying into litigation?
Business structure and ownership: Does the person you’re dealing with actually have the right to sell the business?
Shareholder value analysis: If the value of the business grows under your ownership, how will this effect shareholder equity?
Intellectual property: Have the business’s products, services, designs, logos, and branding all been protected? Are the property rights part of the deal?
Current contracts: What is the state of any existing internal (employees/directors) and external (suppliers, clients) contacts?
Be sure to compare the information found in the investigation with what the business or individual has told you during negotiations. If the facts are inconsistent, it could be a sign of underlying problems.
When was the last time your business had a health check?
A business health check is a current and complete assessment of the components of your business. Identify any potential strengths, weaknesses and opportunities by downloading our FREE Business Health Check today!
What to include in a due diligence report
After collecting the relevant information, it is best practice to summarise all the details in a due diligence report. Ultimately, the report should conclude whether the current state of the deal is fair or not.
Depending on the kind of business deal, due diligence reports typically contain the following information:
Written profile of the company including history, business operations and model, revenue, customer base, industry competitors, past and current management.
An inventory of all equipment, facilities, and other material assets.
Past, current and future status of relationships with customers, clients, suppliers, distributors and strategic partners.
Information about the business’ financial strength and ability to grow, demonstrated by cash flow statements, balance sheets and financial forecasts.
Employment records including, but not limited to, time records, wages and pay, contracts (and variations).
Before sending the due diligence report to team members evaluating the deal, the information should be verified by qualified legal, tax and business experts.
Due diligence clauses
One of the most common clauses found in the contract of a property sale is due diligence.
A due diligence clause gives the buyer permission to conduct property searches and cancel the contract if any outstanding issues are found. Whether the property is in poor condition, infested with timber pests or the property has other liabilities – a due diligence clause allows buyers to walk away from the deal.
Some sellers dislike the sweeping rights of terminating a sale without consequence. As a response, sellers may request a time limit on how long the due diligence period can last for. If a seller makes this request, you should seek guidance from a qualified expert.
Transfer of business
When an entity buys or takes over a business or part of the business, it will often want to retain existing employees. Due diligence will assist in determining the financial costs of doing so.
Once this cost is quantified, a business is in a position to consider whether or not it is beneficial to recognise the entitlements of any existing contacts after a transfer of business. Of course, there are a number of non-financial factors that should be considered when making this decision, including the impact on employee morale and company culture.
Frequently Asked Questions
What is a target company?
A target company or target firm refers to a company that is identified as an attractive merger or acquisition option by a potential buyer.
Who pays due diligence costs?
The decision about who pays for the due diligence costs needs to be negotiated between the parties involved in a deal. In most cases, both the buyer and seller will employ and pay their own specialists, such as accountants, lawyers and investment bankers.
What is legal due diligence?
Legal due diligence is another way to assess risk and determine whether the target company is legally subservient or embroiled in disputes. Due diligence lawyers and accountants specialise in due diligence law and can help a buyer scrutinise any legal risks before closing the deal.
When you take over a business, you also take over its employer relations and health & safety policies. Want to make sure that your new acquisition is fully compliant? Call Employsure’s FREE Advice Line on 0800 568 012 to get all your questions answered.
