Due Diligence


"Due diligence" is a term used for a number of concepts, involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for an acquisition.

 

Due diligence takes different forms depending on its purpose:

1.       The examination of a potential target for merger, acquisition, privatization, or similar corporate finance transaction normally by a buyer. (This can include self due diligence or "reverse due diligence", i.e. an assessment of a company, usually by a third party on behalf of the company, prior to taking the company to market.)

2.       A reasonable investigation focusing on material future matters.

3.       An examination being achieved by asking certain key questions, including, how do we buy, how do we structure the acquisition, and how much do we pay?

4.       An investigation of current practices of process and policies.

5.       An examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis.

 

The due diligence process (framework) can be divided into nine distinct areas:

1.     Compatibility audit.

2.     Financial audit.

3.     Macro-environment audit.

4.     Legal/environmental audit.

5.     Marketing audit.

6.     Production audit.

7.     Management audit.

8.     Information systems audit.

9.     Reconciliation audit.

 

It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions.

In this regard, two new audit areas have been incorporated into the Due Diligence framework:

·         The Compatibility Audit which deals with the strategic components of the transaction and in particular the need to add shareholder value and

·         The Reconciliation audit, which links/consolidates other audit areas together via a formal valuation in order to test whether shareholder value will be added.

In business transactions, the due diligence process varies for different types of companies. The relevant areas of concern may include the financial, legal, labor, tax, IT, environment and market/commercial situation of the company. Other areas include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labor matters, immigration, and international transactions. Due diligence findings impact a number of aspects of the transaction including the purchase price, the representations and warranties negotiated in the transaction agreement, and the indemnification provided by the sellers.