Due Diligence Watches Your Back

 

Due diligence is used to investigate and evaluate a business opportunity. The term due diligence describes a general duty to exercise care in any transaction. As such, it spans investigation into all relevant aspects of the past, present, and predictable future of the business of a target company. Due diligence sounds impressive but ultimately it translates into basic commonsense success factors such as “thinking things through” and “doing your homework”.

There are many reasons for conducting due diligence, including the following:

  • Confirmation that the business is what it appears to be;
  • Identify potential “deal killer” defects in the target and avoid a bad business transaction;
  • Gain information that will be useful for valuing assets, defining representations and warranties, and/or negotiating price concessions;
  • Verification that the transaction complies with investment or acquisition criteria; and
  • Support financing proposals required to complete the transaction.

Lead and co-investors, corporate development staff, attorneys, accountants, investment bankers, loan officers and other professionals involved in a transaction may have a need or an obligation to conduct independent due diligence. Target management typically assists these parties in obtaining due diligence information but because it is unwise to totally rely on management, third party investigators such as Kan & Company are often brought in to conduct due diligence.

HOW IT’S DONE 

The parties conducting due diligence generally create a checklist of needed information. Management of the target company prepares some of the information. Financial statements, business plans and other documents are reviewed. In addition, interviews and site visits are conducted. Finally, thorough research is conducted with external sources — including customers, suppliers, industry experts, trade organizations, market research firms, and others.

Initial data collection and evaluation commences when a business opportunity first arises and continues throughout the talks. Thorough detailed due diligence is typically conducted after the parties involved in a proposed transaction have agreed in principle that a deal should be pursued and after a preliminary understanding has been reached, but prior to the signing of a binding contract.

 

HOW FAR TO GO

The amount of due diligence required depends on the nature of the transaction. The amount of due diligence you conduct is based on many factors, including prior experiences, the size of the transaction, the likelihood of closing a transaction, tolerance for risk, time constraints, cost factors, and resource availability. It is impossible to learn everything about a business but it is important to learn enough such that you lower your risks to the appropriate level and make good, informed business decisions.

 It is possible to overdo due diligence.  Too much due diligence can offend a target company to the point where they walk away from a deal. It can also result in “analysis paralysis” that prevents you from completing a transaction or provides time for a better competing offer to emerge. Accordingly, it is important that due diligence be prioritized and executed expeditiously. Appropriate investigation and verification into the most important issues often must be balanced by a sensible level of trust concerning lesser issues.

Every transaction will have different due diligence priorities. For example, if the main reason you are acquiring a company is to get access to a new product they are developing to accelerate your own time to market, then the highest priority task is to ensure that the product is near completion, that there are no major obstacles to completion, and that the end product will meet your business objectives. In another transaction, the highest priority might be to ensure that a major lawsuit is going to be resolved to your satisfaction.

 INVESTMENT

Due diligence costs are based on the scope and duration of the effort, which in turn are dependent on the complexity of the target business and other factors. Costs are typically viewed as an essential expense far outweighed by the anticipated benefits and the downside risks of failing to conduct adequate due diligence. The involved parties determine who will bear due diligence expense.

Time allocated for completion can vary widely with each situation. Many preliminary agreements define the timeframes in which due diligence will be conducted. Time schedules through the closing of a transaction are typically tight — parties should ensure that adequate time is allocated to due diligence.

KEEP IT DISCRETE 

Certain activities conducted during due diligence can breach confidentiality that a transaction is being contemplated. For example, contacting a customer to assess their satisfaction with the target company’s products might result in a rumour spreading that the company is up for sale. Accordingly, to maintain confidentiality, we often contact customers under the guise of being a prospective customer, journalist, or industry analyst.

SUCCESSFUL RESULTS 

 A well-run due diligence program cannot guarantee that a business transaction will be successful. It can only improve the odds. Risk cannot be totally eliminated through due diligence and success can never be guaranteed.

In this litigious world, you can be sued for just about anything and failing to conduct due diligence is no exception. Parties involved in a business transaction may find themselves being sued by their clients, investors, customers, employees, suppliers, or other third parties asserting failure to conduct proper due diligence or pursuing a liability that was overlooked or incorrectly assessed by due diligence.

Engaging an independent due diligence investigator will not ensure that no litigation will result.  However, conducting proper due diligence may serve as a strong legal defence to third-party claims after a transaction closes. Due diligence may also reduce legal issues by alerting a purchaser or investor to potential liabilities that can be mitigated in various ways prior to closing the transaction.

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