Due diligence is one of those terms that you are likely to be familiar with and understand on the surface. Beyond its textbook definition, however, it cuts across all forms of business transactions; purchasing commercial property, corporate transactions (i.e. M&As, takeovers, investments, etc.) and even day-to-day trade transactions.
Imagine you are buying groceries or other related commodities. You don’t just jump into buying because you have been looking for that product. You perform checks like reviewing expiry dates, checking the seal; making sure it not broken, some even go as far as examining the ingredients – double checking to ensure what they are allergic to is not contained therein. When you perform those actions, , you are conducting due diligence on that product (or products) before buying to avoid any possible risk that may arise from the purchase and consumption of that product.
Now let’s put this idea into practice and learn how to manage the process in a commercial transaction.
Due diligence (DD) is the care that a reasonable person exercises to avoid harm to other people or their property. In commercial transactions, due diligence is used to describe the investigation performed before executing a transaction, i.e. before purchasing another company or other property, before a merger, or before buying a company’s equity.
How due diligence is conducted
Let’s assume your company is planning to merge with or purchase another company. DD for such transactions needs to go deep to uncover financial matters and to properly account for hard-to-value items such as goodwill, inventory and existing contracts.
Before finalizing transactions, you (often with the help of professionals) will perform due diligence to find out:
- The financial status of the company – does the business have a healthy cash flow?
- By looking at the company’s financial statement or reports – can you tell where the revenue stream is coming from?
- How reliable are its financial projections and what multiple is it placing on those earnings?
- What are the company’s profit margins in comparison to the industry – are they on the high side or low?
- How big is the market for the company’s products or services – is the market growing, shrinking or stagnant?
- Are there any major new competitors in or coming into the area that could negatively impact earnings?
- What kind of online presence does the business have, and how does that compare to its competitors’?
- Does the company have physical assets – are they valued correctly and fairly?
- Are there any hidden liabilities?
- Are the company documents complete? (e.g. articles of incorporation, board meeting minutes, tax registration, etc.)
- Is the business up to date on its taxes?
- Does it lease property? If so, when does the lease end?
- What insurance information has been provided and what is covered?
- Are there complete employee files including with respect to salary and benefits?
These, amongst others, are questions to ask and facts to investigate in conducting due diligence.
Reasons why due diligence is important in commercial transactions
- Conducting DD helps in fact-finding and business planning: It ensures that the conducting party understands the detailed nature of the business. Through investigation, it unveils the nature of the commercial investment and facilitates integration and post-completion planning.
- Conducting DD helps to understand, identify and assist with risk allocation: It highlights potential problems or risks that may arise in the transaction, thereby influencing the consideration payable.
- Conducting DD assists in securing funding: Carrying out DD assists in securing financing for the transaction, both internal and external.
How to manage the due diligence process
1. What your client wants?
You must understand that each client is different just as each transaction is different. However, common themes that emerge in any transaction include:
- Relevance of scope to the issue facing the business in question: You must establish a clear scope based on the business and client’s priorities. Ensure your draft scope is considered and approved at the right (senior) level and be clear that your client (and other relying parties) is happy with reliance terms.
- Accessibility of due diligence report, and clear recommendation/action points: Your client will want to have full access to the DD report, and it should be clear, when stating facts in connection with the DD investigation, what your advice is on the transaction as well as the next steps to be taken.
- Speed of delivery, especially if competitive (i.e. a competitive bid for a takeover): Although the DD process can take time to be finalized, in circumstances such as a takeover bid that may be competitive in nature, a client will want delivery of the DD results as soon as possible showing the overall value of the target enterprise and outlining the risks related in taking it over in order to ensure a bid at the most favorable price.
- Fees and cost: Make sure this is discussed at an early stage. A client does not want fee or cost related surprises in the middle of the transaction.
2. Team Management
You must put in place a suitable team internally, which must be clearly briefed on the transaction. Therefore, a clear reporting line should be established, and the team should be provided with all relevant documentation and information. If you will be using an external specialist, do not instruct the external specialist late. Also, provide regular updates on the process to the team i.e. material developments in structure or terms, or new documents available.
In reporting, information should be refined for the client’s understanding. Definitions and numbering should be uniform and consistent. Furthermore, a skeleton of the report should be circulated to all specialists involved.
Issues raised should be drawn out clearly and comprehensively. Typos, cross-referencing errors, inconsistency may not be material to the substance of the report itself, but they undermine the client’s confidence. Therefore, review the document carefully to remove simple errors.
The purpose of the process is to identify as quickly as possible material legal issues and communicate them to both the internal team and to the client so that something can be done to avoid or mitigate any downsides related to the transaction.
At the end of the DD process, the final report should be easily accessible to the client, help them understand the issues and the steps to be taken and provide the knowledge required to effectively and thoroughly mark-up the transaction documents.