What is due diligence? Definition and meaning
Due diligence refers to the detailed examination of a business and its financial records – it is carried out before committing to a business arrangement such as a merger, acquisition, or any type of important contract. It is an audit of a potential investment or arrangement to confirm all the facts before going ahead.
The term ‘due diligence’ describes the care a reasonable individual should take before undertaking a transaction or entering into an agreement with another party.
When a supplier is determining whether to offer terms of payment to a customer, he or she will carry out due diligence – analyze items that may provide information on the buyer’s ability to pay bills properly and on time.
When you carry out due diligence on another party, you want to be sure they are who they say they are, are reliable, honest, and will honor their side of the deal.
The aim is to ensure that every stakeholder associated with a financial endeavor has the information needed to assess risk accurately.
Put simply, before signing an important business contract, you check out the other party to make sure they are able to adhere to the terms – you want to confirm that you get what you believe you are paying for.
In real estate in the United States, it refers to the period of time between the acceptance of an offer and the close of escrow.
Due diligence is required when issuing a patent to make sure that the patent holder is really intent on developing a product around a patent, and is not only trying to prevent others from doing so.
According to the Financial Times Lexicon, due diligence is:
“A detailed check of the financial and operational status of an acquisition target, supplier, or other potential business partner before a deal is finalized.”
“The term is also used for when the underwriter of a new security issue, or brokers that will sell the securities onto investors, investigate the reliability of the issuer. This may involve a due diligence meeting between the issuer, the lead manager and other institutions connected to the issuer.”
In an ideal world, we would all trust each other completely and just get on with business, instead of checking each other out carefully. Unfortunately, total trust is too risky. That is why we have due diligence.
Financial due diligence
Any organization that is considering a deal must check all the assumptions it is making regarding that arrangement. Financial due diligence provides peace of mind to financial, corporate and individual buyers, by analyzing and validating all the commercial, operational, financial and strategic assumptions being made.
One party examines the other’s trading experience to form a view of the future and to make sure there are no ‘black holes’.
For any type of company acquisition, due diligence includes a complete understanding of the company’s obligations, including: pending and potential lawsuits, debts, leases, long-term customer arrangements, warranties, employment contracts, compensation arrangements, distribution agreements, and so forth.
When seeking sensitive information from another company, before releasing it that company will ask the enquirer to sign a non-disclosure agreement – a confidentiality contract.
The word ‘due’ means completing the necessary steps to accomplish something, while ‘diligence’ means to stick with something until it is done.
If you did everything you could to protect your interests in a business deal, you carried out due diligence. If you want to buy 100 acres of land and use it for farming, you should check to make sure it can be used as a farm, confer with the water company to make sure there is water, and contact the electric company to be certain that electricity is available. You might also rule out the possibility that the seller has used the land as collateral on a debt – this is all due diligence.
Henry Paulson Jr., an American Banker, chairman of the Paulson Institute at the University of Chicago, who served as the 74th Secretary of the Treasury, and was CEO of Goldman Sachs, once said: “Buying a home today is a complex process, but that in now way excuses home buyers from their obligation for due diligence.” (Image: Wikipedia)
Every merger & acquisition deal today involves varying degrees of due diligence. No shareholder or sensible company director would vote in favor of making a move without first checking out the other party thoroughly.
Due diligence by the seller
In an acquisition, it is not only the buyer who carries out due diligence – the seller does too. If you are the seller you will want to be sure that:
– The buyer has the funds to complete the transaction.
– The buyer’s stocks have a good record if part of the payment for the purchase of your company is in the form of stocks.
– The stocks are still worth something when your lockup period expires.
– They have a reputation of sticking to their commitments.
– They treat your employees properly.
– They treat your customers properly.
– The corporate cultures of the two companies are compatible.
– The ‘earn out’ component of the deal, if there is one, is realistic. Does the acquirer have a track record of successfully marketing your type of product?
– Will they be stretched too thin after this acquisition?
Charlie Munger, an American entrepreneur, investor, lawyer and philanthropist, who is Vice-Chairman of Berkshire Hathaway, a Director of Costco Wholesale Corporation, and Chairman of the Daily Journal Corporation, once said: “In the corporate world, if you have analysts, due diligence, and no horse sense, you’ve described hell.” (Image: twitter.com/mungerisms)
Due diligence in Virtual Data Rooms
Experts say that in future due diligence will be carried out increasingly online, in *Virtual Data Rooms – in fact, this is already occurring today.
* A Virtual Data Room, known commonly as a VDR, is an online repository of data that is used for storing and distributing documents.
When checking out the other party, it is vital that you get the right people and the correct information at the right time. Virtual Data Rooms allow individuals and companies to prominently display structure and categorized data which can significantly improve value by shorting deal times, minimize transactions costs, and allow for the free exchange of information.
According to duediligenceonline.com:
“This sort of combination of organized material in an online presence, was once on available to the largest deals, but now has become readily available for small to mid-sized transactions because of the web-based marketing platform.”
“This combination of accurate information and its instant availability through online deal rooms assure that the right information is getting to the right people at the right time.”
Due diligence in other languages: vérifications nécessaires (French), debida diligencia (Spanish), Due Diligence (German, Swedish, Norwegian, Portuguese), diligenza dovuta (Italian), Юридическая экспертиза (Russian), rettidig omhu (Danish), 適当な注意 (Japanese), 尽职调查 (Chinese), اجراءات لارضاء المتطلبات (Arabic), यथोचित परिश्रम (Hindi), kutokana na bidii (Swahili), and uji kelayakan (Indonesian).
Video – What is due diligence?
This Pacific M&A and Business Brokers Ltd. video explains what due diligence is, why it is so critical in the acquisition and sale of businesses, what the different segments are, and what to look for whether you are the acquirer or seller.