Due diligence

From CEOpedia | Management online

Due diligence - it is a process of controlling a company's commercial, financial, legal and fiscal health in a multi-faceted way. Its purpose is to make a detailed assessment of the current situation of the company and to identify the current and potential risks in relation to the planned capital transaction (e. g. merger or acquisition) of the other entity. It is the last stage of the pre-transaction phase, which follows the negotiation phase.

Concept of due diligence

A procedure plays an important role in the M&A process because it aims at objectively and neutrally assessing a company. In the Anglo-Saxon system, its priority is to analyze the financial condition and cash flow of the company [1].

Financial due diligence, despite its complexity, actually boils down to the examination of tangible assets of the company. Intangible assets such as, but not limited to, logos and brand values are usually omitted. However, such an approach does not allow for a complete assessment of the condition of a given company, which very often makes them inadequate and not entirely precise. Despite this, financial due diligence aims to provide potential investors with relevant information about the company. In addition, it allows you to verify the business plan presented to them and the guaranteed benefits of the planned transaction [2]. The financial risk, which is examined during the due diligence process, is directly related to the commercial risk. According to the presented theories, the lower the commercial risk, the higher the financial risk [3].

Due diligence in M&A

Due diligence is one of the most important stages of M&A, during which the acquiring company is able to better manage the risks associated with achieving the acquisition objectives. It is best to start it (due diligence) by researching publicly available registers. The next step is to go through the next stages of due diligence [4]:

  • Preliminary due diligence;
  • Due diligence review;
  • Transactional due diligence

During preliminary due diligence, all publicly available information about a company is reviewed. In addition, they are aggregated and then compared with other companies that may be competitive to the target company [5]. During a due diligence review, the parties start the negotiation process and sign the NDA. The aim of this phase is to obtain valuable private information about the acquired company and then to negotiate appropriate terms of the acquisition. However, the most important is transactional due diligence. It is during this process that the acquiring company can obtain the most valuable and accurate information about the company. This allows, among other things, to determine the market price of the company and the value of its net assets. This is the last moment when it is possible to withdraw from closing a trade. However, if it is carried out in such a way as to enable negotiations to be closed, ownership of the company under scrutiny is ultimately acquired by the acquiring company.

Examples of Due diligence

  • A financial due diligence is a process used to analyze a company’s financial statements, such as assets, liabilities, cash flows and financial performance. It is a way to verify whether the company’s financial statements are true and accurate.
  • Legal due diligence is an examination of legal documents and records related to a company or business. It is used to verify that the company is operating in compliance with applicable laws and regulations.
  • Operational due diligence is a process used to evaluate a business’s operations and management. It includes assessing the company’s operational processes, technology, personnel and performance.
  • Tax due diligence is the process of evaluating a company’s tax position and its compliance with relevant tax laws and regulations. It is used to identify potential tax liabilities and ensure that they are addressed prior to the completion of a transaction.
  • Environmental due diligence is the process of assessing the environmental risks associated with a company or property. It is used to identify any potential environmental liabilities and ensure that they are addressed prior to the completion of a transaction.

Advantages of Due diligence

Due diligence is an important tool used to assess the potential risks associated with a company prior to a capital transaction. It can be beneficial in a number of ways:

  • It provides an accurate picture of the target company, including its financial and operational condition.
  • It helps to identify any potential liabilities and risks that may arise in the future.
  • It can help to negotiate better terms for the transaction, such as price or liabilities.
  • It can help with the valuation process by providing more accurate information on the company's assets and liabilities.
  • It can reveal any hidden costs or risks associated with the transaction.
  • It can provide a better understanding of the company's competitive position in the market.
  • It can help to identify areas of potential growth or improvement.

Limitations of Due diligence

  • Due diligence is a process of investigation and evaluation, but it has its limits.
  • Due diligence is limited by the amount and quality of the information available. Companies may not have access to all the required information to make an informed decision.
  • Companies can also be limited by the costs associated with obtaining the information, as well as the time taken to collect and analyze the data.
  • Due diligence can also be hampered by the unwillingness of the target company to share information or its ability to provide accurate information.
  • Additionally, due diligence is limited by the skills, experience, and knowledge of the people carrying out the investigation. If those carrying out the due diligence process don’t have the right expertise or resources, their investigation may be incomplete or inaccurate.
  • Finally, due diligence is limited by the amount of time allocated for the process. If the company is under pressure to complete the transaction quickly, the due diligence process may be rushed and important details overlooked.

Other approaches related to Due diligence

Apart from the traditional approach to due diligence, there are several other approaches that can be used to assess the health of a company before a planned capital transaction.

  • First, a financial due diligence approach can be used to review the financial status of the company and its assets. This includes looking at the company's balance sheet, income statement, cash flow statement, and other financial documents. Additionally, it may involve assessing the company's financial performance, accounting practices, and tax liabilities.
  • Second, a legal due diligence approach can be used to review the company’s legal documents and contracts, such as its Articles of Incorporation, employment agreements, and leases. This will help to identify any potential legal risks or liabilities that may be associated with the transaction.
  • Third, an operational due diligence approach can be used to assess the company's operations. This includes looking at the company's organizational structure, management teams, human resources, and operations. Additionally, it may involve assessing the company's customer service, pricing, and other operational practices.
  • Fourth, a strategic due diligence approach can be used to assess the company's strategic plans. This includes looking at the company's long-term goals, competitive advantages, and market position. Additionally, it may involve assessing the company's marketing strategies, product lines, and business partnerships.

In summary, there are several approaches to due diligence, including financial, legal, operational, and strategic due diligence, which can be used to assess the health of a company before a planned capital transaction.

Footnotes

  1. ↑ Howson P. 2017, p. 4-6
  2. ↑ Gleich R., Kierans G., Hasselbach T. 2012, p. 100-106
  3. ↑ Howson P. 2016, p.8
  4. ↑ Slađana S. 2013, p. 424-434.
  5. ↑ Slađana S. 2013, p. 424-434.


Due diligence — recommended articles
Statement of affairs — Vendor analysis — Investment memorandum — Reporting entity — Transaction cost theory — Project feasibility study — Valuation date — Change in accounting estimate — Request For Information

References

Author: Dominika Pałkowska

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