What is the purpose of due diligence?
Due diligence is an effort or process used to gather and study information prior to making a decision. Investors often use this process to analyze risk. The process involves studying a company’s financial data, comparing information over a period of time, and comparing data against competitors to evaluate an investment’s growth potential.
Due diligence is mainly employed to reduce risk exposure. The process makes sure that a buyer is informed of all a transaction’s details prior to going through with a deal. For instance, a broker-dealer will provide an investor with the results of a report, so the investor has all the information they need. This way, the broker-dealer cannot be held accountable for any losses.
When Do Individuals Exercise Their Due Diligence?
Due diligence is typically used in business transactions such as:
- Securitization
- Mergers
- Financing important projects
- Acquisitions
- Joint ventures
Businesses also perform due diligence when they seek to:
- Hire new employees
- Add new vendors
- Buy commercial properties
- Purchase business
When making a deal, sellers and buyers need to practice due diligence after agreeing to the deal in principle but before the parties sign a binding agreement. The key is for individuals and businesses to conduct their research before any documents are signed or they are bound to a deal they are unsure of.
Therefore, businesses or people exercise this process of detailed investigation before:
- Signing a major contract
- Beginning an employment relationship
- Starting a business relationship
- Entering into a partnership
- Buying into a business
If due diligence reveals a potential problem with the relationship, for example, or a previously unseen liability, typically, the individual will investigate the situation further, call off the deal or end the hiring process.
Often, due diligence helps buyers understand the seller’s motivations. For example, let’s say an individual is selling a business because it has money problems that they cannot solve. If the buyer does not perform due diligence, they may not find this out and buy a business that saps their finances. When buyers understand exactly what is for sale, they can:
- Estimate the value of the company more accurately
- Decide if they want to follow through with the purchase
Buyers’ due diligence often includes a review of the company’s intangible and fixed assets. The scope of the due diligence depends on many factors, including the size of the company being sold, the size of the merger or deal, and the nature of the hiring process.
Why is Due Diligence Important?
Due diligence may be a simple phrase, but it conveys many important meanings. Many of us conduct research before making simple decisions. For example, before purchasing a new smartphone, an individual may spend time comparing the features and costs of different models from various carriers.
Due diligence typically grows much more complex than a simple comparison, but it is not much different. When individuals practice due diligence, they gather and analyze vital information before completing a transaction. Therefore, hiring our Los Angeles corporate attorney for performing due diligence can help prevent wasteful decisions, losses, or liabilities.
In business transactions, due diligence takes on a specialized role and is notably used by:
- Broker-dealers seeking information about transactions
- Companies that seek to buy or merge with other businesses
- Investors with concerns about risk
Understanding how due diligence works helps businesses, business owners, and entrepreneurs thrive in the corporate world. So the next time you are faced with an important business decision, be sure to collect the facts and make an intelligent, researched decision. In short, practice due diligence.
What are the different kinds of due diligence?
Due diligence can take different forms depending on its purpose.
Context-specific due diligence
- Commercial due diligence takes into account a company’s competitive positioning and market share, including its growth opportunities and future prospects. This will take into account the company’s market analysis, supply chain from vendors to buyers, R&D pipeline, and sales pipeline. This may also involve looking at the company’s management, HR, IT, and overall operations.
- Legal due diligence ensures that a company’s regulatory, compliance, and legal ducks are in a row. This also includes examining intellectual property rights, pending litigation, and making sure the company has been correctly incorporated.
- Financial due diligence takes a look at a firm’s books and financial statements to ensure there is nothing unusual and that the business is financially solid.
- Tax due diligence examines the company’s tax exposure, where it might minimize its tax burden in the future, and whether it owes any back taxes.
What is the difference between hard and soft due diligence?
Due diligence can either be ‘soft’ or ‘hard’ depending on the method employed.
- Hard due diligence is related to the data and numbers on balance sheets, income statements, and other financial documents. This can involve the employ of financial ratios and fundamental analysis to better understand a company’s financial standing and make predictions about the company’s future. This kind of due diligence can find red flags and accounting issues. That said, hard due diligence, centered around legalities and mathematics, can fall victim to overly optimistic interpretations from sales individuals. For this reason, soft due diligence serves as a balance when the data is being overemphasized or manipulated.
- Soft due diligence is a qualitative method that examines aspects like the people working in a company, the loyalty of its clients, and the quality of the management. Business success can be driven by many things that numerical data cannot capture. These include corporate culture, leadership, and employee relationships. When mergers and acquisitions fail to go through, as 70-90% do, this is usually due to the human factors being overlooked.
Below, we will go into more detail about how these different kinds of due diligence are applied when it comes to mergers and acquisitions.
What Are the Advantages Of Performing Due Diligence?
If individuals view due diligence as “completing their homework” or “conducting research,” the advantages are clear. From buying a new car or a house to starting a new job, our most important decisions rely on careful research. Yet, often, when we do not “do our homework” and leap blindly into a major life decision, the decision backfires.
Therefore, due diligence is a powerful tool used for risk management by buyers and entire companies. Performing due diligence research provides individuals with the necessary information for informed, careful decisions with no hidden surprises.
“Buyer Beware” is a commonly used expression that places the responsibility on the individual or individuals with the most to lose from the impending deal. For example, when the president of one company contemplates buying another company, they take on risk. Can they trust the seller? Is the business they are buying profitable? What were the losses the business sustained last year?
If the buyer is aware of what they are getting into and understands the risks and possible gains that may result, the buyer feels confident that they are not making a mistake and are getting what they paid for.
What Are the Disadvantages Of Due Diligence?
To an extent, due diligence is mandatory before individuals and companies complete nearly all major business transactions. One cannot overemphasize the importance of understanding the nature of an important business deal before committing to it.
Realistically, however, the due diligence process can be arduous and time-consuming. Consider that the buyer or interested party must interact with all different individuals to get their questions answered. For example, a buyer performing due diligence may have to ask questions of:
- Brokers
- Lawyers
- Accountants
- Applicants
- Company representatives
- Other parties
Once the individual review the collected information, they may not feel they have the entire picture. In this case, the process of due diligence continues as the buyer makes more requests for information. At this point, if it appears that one party is hiding details or purposefully omitting information, these acts may be evidence that the deal or party cannot be trusted.
On the other hand, when a buyer performs due diligence, it can overwhelm the seller or other party involved. As a result, it can be difficult to respond to requests for documents and information. In extreme cases, the seller can lose control of their company because they are so preoccupied.
However, buyers and sellers should be prepared for due diligence when considering any major deal. The more prepared the parties are, the less overwhelming and inhibitive the process will be.
How To Perform Due Diligence For Buying A Business?
The best sellers anticipate that the buyer will perform due diligence and prepare accordingly. Due diligence is widely performed in the business world and plays a significant role in all deals, mergers, and sales. It, therefore, makes sense to expect all buyers to exercise some degree of due diligence.
Due diligence usually begins with a request from the buyer or a series of requests. Requests typically include:
- Competitor comparisons
- Accounting and financial reports
- Market comparisons
- An analysis of intellectual property rights
- Documents about the value of the business or entity
- Additional key records and documents
The buyer or interested party receives the request and immediately begins to collect the information or appoints people to collect the information. This information is then sent back to the requesting company or person electronically or through the mail. These days, parties send most forms and documents via email or storage programs like Dropbox or WeTransfer.
Upon receipt, the buyer reviews the documents. At this point, sometimes due diligence takes longer than others. For example, if the buyer does not understand something or the information appears unclear or incomplete, they ask the seller questions. In addition, the buyer might launch private investigations to verify the other party’s claims if the information appears inaccurate.
Many people ask how long performing due diligence takes. Still, it is difficult to answer that question without understanding the nature of the transaction and the nature of the parties or businesses involved. Major transactions, for example, a merger of two companies, generally require more due diligence than selling a used car from one person to another. The extent of due diligence relies on the following:
- The type of transaction
- The perceived risks
- The needs of the party
All business people and entrepreneurs should remember that before a transaction is made, buyers have the legal right to examine specific documents. These include:
- Business records
- Assets
- Company operations
Proper due diligence should result in a detailed portrait of the seller’s company, prospective partner, or employee. Therefore, the report should clearly express every aspect of the person’s professional life and contain no secrets.
A due diligence report usually contains the following:
- Financial information
- Operational information
- Legal position
- Commercial information
Let’s take a closer look at the four categories due diligence typically encompasses:
Financial
Financial due diligence details all financial facets of the company, including:
- Profits and losses
- Debts and liabilities
- Accounts of any subsidiary companies
Buyers also should have access to visible accounts, company reports, annual returns, and other financial statements.
Operational
Operational due diligence provides a glance at the inner workings of the business, including:
- Insurance coverage
- Customer relations
- Location
- Inventories
- Procedures
- Suppliers and vendors
- Staff
- Management structure
This aspect of due diligence is vital in revealing if there are any problems with a company’s operations.
Commercial
Commercial due diligence focuses on reviewing the company’s commercial elements, including:
- Market conditions
- Goods and services
- Competitor analysis
- Compliance with local standards
Legal
When an individual or company performs legal, due diligence, they focus on the legal implications of the purchase or agreement they are considering. The report, therefore, details:
- Equipment or vehicles being used
- Property
- Contracts with clients
- Intellectual property rights
- Litigation, if ongoing
- Employment disputes
The process of due diligence relies on the fact that all information presented is honest and accurate. For example, it is against the law to present a buyer with wrongful financial information.
How do you perform due diligence for stocks?
Below, we go over the ten steps that individual investors should take when doing due diligence. The majority of the steps relate to stocks, but they can also apply to real estate, bonds, and other kinds of investments.
After going over these ten steps, we will provide some tips on how to consider investing in a startup.
All the data you require is accessible via the firm’s annual and quarterly reports, as well as in the firm profiles on discount brokerage sites and financial news.
Step 1: Study the capitalization of the company
A company’s total value, or market capitalization, shows how broad the ownership is, how volatile the stock price is, as well as the likely size of the firm’s target markets.
Mega-cap and large-cap companies typically have stable streams of revenue, as well as a diverse, large investor base. This tends to result in less volatility. Small-cap and mid-cap firms tend to endure bigger fluctuations in their earnings and stock prices as compared to larger companies.
Step 2: Profit, revenue, and margin trends
The firm’s income statement will list its net income or revenue or profit. This is the bottom line. It is crucial to keep track of trends in a company’s revenue, profit margins, operating expenses, and return on equity over time.
The company’s profit margin is determined by dividing net income by revenue. It is best to study profit margin across a period of many quarters or years, then compare this data to businesses in the same field to get some perspective.
Step 3: Industries and competitors
Once you have a sense of how big a firm is, as well as how much it makes, it is the appropriate time to examine the field in which it functions and has competition. Every firm is defined, at least partly, by its competition. Due diligence involves stacking up a company’s profit margins against a few of its competitors. For instance, some questions to pose include: Is the company’s industry growing? Is the company an industry leader or a leader in its specific markets?
By performing due diligence on a number of companies in an industry, an investor can gain significant insight into the state of the industry, as well as which companies are performing the best.
Step 4: Valuation multiples
A lot of financial metrics and ratios are employed to analyze companies. However, three of the most valuable are the price/earnings to growth (PEGs) ration, the price-to-earnings (P/E) ration, and the price-to-sales (P/S) ratio. The mentioned ratios are already determined for you on sites like Yahoo! Finance.
While you study ratios for a firm, be sure to compare a few of its competitors. You could find yourself drawn more to a competitor.
- The P/E ratio provides you with an overall idea of how much expectation is engrained in the company’s stock price. It is wise to study this ratio during a period of a few years to ensure that the current quarter is not an anomaly.
- The price-to-book (P/B) ratio, the price-to-sales (or revenue) ratio, and the enterprise multiple measure the company’s valuation in relation to its annual revenues, debt, and balance sheet. It is important to conduct peer comparison since the ranges of what is healthy vary according to industry.
- The PEG ratio suggestions investor expectations for the company’s future earnings growth, as well as how it stacks up against the current earnings multiple. Stocks that have PEG ratios around one are thought to be fairly valued in typical market conditions.
Step 5: Share ownership and management
Is the business still controlled by its founders? It could be that the board brought in a lot of new people. Younger businesses are usually led by their founders. You should research the biographies of the management to learn about their experience and amount of expertise. This information may be located on the company’s website.
Whether executives or and founders hold a large proportion of shares, as well as whether they have recently been trading shares is a major element in due diligence. It is good when there is high ownership by top managers. Low ownership would be a bad sign. Shareholders are usually best served when the operators of a company have an established interest in stock performance.
Step 6: Balance sheet
The firm’s consolidated balance sheet will reveal its liabilities and assets, in addition to how much money is accessible.
Look at the firm’s debt level, as well as how it stacks up against others in the same industry. That said, debt is not always a bad thing, though this depends on the company’s industry and business model. You should ensure, however, that those debts are rated highly by the rating agencies.
Certain companies and entire industries, such as gas and oil, are extremely capital intensive. Others demand little capital investment and few fixed assets. Figure out the debt-to-equity ratio to determine the amount of positive equity the firm has. Usually, the more cash a business creates, it is more likely to be a better investment since the company can pay its debts and still be profitable.
If the numbers for total liabilities, total assets, and stockholder’s equity change significantly every other year, you should attempt to see why that is. You can read the footnotes that come with financial statements and the management’s review in the annual and quarterly reports to see what is really occurring in a company. It could be that the company is preparing to launch a new product, accumulating retained earnings, or declining financially.
Step 7: Stock price history
Investors should study both the long-term and short-term price movements of the stock, as well as whether the stock has been steady or volatile. Compare the historical profits and see how this relates to the price movement.
Remember that past performance does not ensure future price movements. For example, if you are retired and looking for dividends, you may not want a stock price that is volatile. Continuously volatile stocks have short-term shareholders, which supplies extra risk for some investors.
Step 8: Stock dilution possibilities
Investors should be aware of how many outstanding shares the business has, as well as how that value is related to the competition. Perhaps the company is planning to issue more shares. If this is the case, the stock price may take a hit.
Step 9: Expectations
Investors should determine what the consensus is among analysts on Wall Street when it comes to revenue, earnings growth, and profit estimates over the next few years. Also, investors should look for conversations of long-term trends that affect the industry and specific news from the company related to joint ventures, partnerships, new products and services, and intellectual property.
Step 10: Examine short and long-term risks
Make sure to know company-specific risks as well as industry-wide risks. Are there any outstanding regulatory or legal matters? Is there unstable management?
Investors should always imagine the worst-case situations and their possible outcomes on the stock. Let’s say a new product does not perform well, or if a competitor introduces a new and better version, how will this impact the company? How would an increase in interest rates impact the firm?
After you have performed the steps listed above, you will have a better understanding of the company’s performance, as well as how it compares to the competition. This will enable you to make an informed decision.
How do you do due diligence on a startup?
If you are thinking about investing in a startup company, a few of the above ten steps will apply, while others will not be feasible since the company does not have an established record. These are some moves specific to startups.
- Have an exit strategy. Come up with a way to get your money back if the business does not succeed.
- Think about entering a partnership. Partners share the risk and capital, which means they do not lose as much if the business does not succeed.
- Determine your investment’s ‘harvest strategy.’ It is possible that businesses with lots of potential may not success due to technological changes, market conditions, or government policies. Make sure to keep an eye out for new technologies, brands, and trends. Be prepared to harvest when you realize that the company may not do well in the context of the changes.
- Pick a startup that has products with plenty of potential. Because the majority of investments are harvested after about five years, it is recommended that you invest in products that have a growing ROI, or return on investment, for that time span.
- Rather than hard numbers concerning past performance, examine the business’ plan for growth and assess whether it seems reasonable.
Mergers and Acquisitions Due Diligence
When it comes to mergers and acquisitions, a business that is contemplating a deal will conduct a financial analysis on a company they are targeting. The due diligence may include a future growth analysis. The buyer may pose questions that concern the structuring of the purchase. The buyer also will study the policies and current practices of the desired business and conduct an analysis of shareholder value.
With the traditional form of mergers and acquisitions, the buyer hires risk analysts to perform due diligence by assessing benefits, costs, liabilities, structures, and assets. This is known as hard due diligence.
However, mergers and acquisitions are increasingly subject to the analysis of a business’ management, human elements, and culture, which may be described as soft due diligence.
Doing hard due diligence
During a merger or acquisition, hard due diligence involves a battle of accountants, negotiators, and lawyers. Usually, hard due diligence puts a focus on taxes, earnings before interest, amortization and depreciation, cash flow, capital expenditures, and the aging of receivables and payables.
In fields like manufacturing or technology, further emphasis is placed on physical capital and intellectual property.
Examples of hard due diligence practices include:
- Studying future performance projections
- Auditing and reviewing financial statements
- Reviewing ongoing or potential litigation
- Studying the consumer market
- Evaluating third-party or subcontractor relationships
- Studying antitrust matters
Doing soft due diligence
Soft due diligence is not a precise science. The procedure should put an emphasis on how successfully a targeted company will blend with the buyer’s work culture.
Soft and hard due diligence mesh when it comes to incentive programs and compensation. Such programs are not based solely on numbers, which makes them simple to incorporate into planning after the purchase. They may be discussed with employees, as well, to study cultural impact.
Soft due diligence specifically concerns worker motivation, and benefits packages are built precisely to increase motivation. Of course, it is not a cure-all, but this kind of diligence can assist the purchasing firm with understanding whether a benefits program can help improve the deal’s chances of success.
Soft due diligence also concerns itself with the customers of the target company. The targeted clients and customers may dislike a change in service, procedures, or products, even if the employees are okay with the operational and cultural shifts involved in the takeover. For this reason, plenty of mergers and acquisitions studies include supplier reviews, test market data, and customer reviews.
What is a checklist for due diligence?
You can use a checklist to perform due diligence in an organized manner. The checklist should include the subjects to be reviewed, including assets and operations, ownership and organization, shareholder value, financial ratios, future growth potential, processes and policies, human resources, and management.
What is an example of due diligence?
Due diligence can be found everywhere in our daily lives. For instance, before buying a property, it is normal to perform a property inspection to assess the level of risk. If a buyer is contemplating purchasing a house, but the property ends up having toxic mold and a rat infestation, this would be a bad investment and the buyer should not go through with the purchase.
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