What is Due Diligence?
A “Due Diligence” investigation is a careful and methodical investigation of a company. It is done prior to doing business with the company.
The most common reason for due diligence investigations is corporate acquisitions and mergers – investigating the company being acquired or merged. These also tend to be the most thorough types of due diligence investigations. The buyer or merger partner wants to make sure they know who they are going into bed with.
Partnerings are another time when parties will investigate of each other in conjunction with the negotiations. Here is a list of the different types of partners and partnerings where due diligence investigations are appropriate:
Strategic Alliances, Joint Ventures, Strategic Partnerships
Business Partnerships and Alliances, Partnering Agreements, Business Coalitions
Just In Time Suppliers and Relationships, Sole Source Suppliers, Outsourcing Arrangements, Suppliers and Customers
Technology and Product Licensing, Joint Development Agreements, Technology Sharing and Cross Licensing Agreements
Business Partners, Affiliates, Franchisees and Franchisers
Value Added Remarketers and Resellers, Value Added Dealers, Distribution Relationships
A Little History on the term “Due Diligence”
The term “Due Diligence” first came into common use as a result of the US Securities Act of 1933.
The Act included a defence that could be used by Broker-Dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities. As long as they conducted a “Due Diligence” investigation into the issuing company’s equity they were selling, and disclosed their findings to the investor… they would not be held liable for nondisclosure of information that failed to be uncovered in the process of that investigation.
The entire Broker-Dealer community quickly institutionalized as a standard practice, the conducting of due diligence investigations of any stock offerings in which they involved themselves. While the term “Due Diligence” was originally limited to public offerings of equity investments, over time it has come to be associated with any investigation of a company or business partner, including individuals.
Pre-Acquisition Due Diligence
How Much is a Company Worth?
Valuing a business is not an exact science. The valuation process often involves comparing several different approaches and selecting either the best method, or a combination of methods, based on the analyst’s knowledge and experience. Generally, there are several different methodologies that practitioners use to value businesses. These are:
1. Asset-based valuation;
2. Comparable transactions analysis;
3. Comparable public company method; and
4. Discounted cash flow.
In applying these methodologies to determine the value of a business, one or more of the following factors are generally reviewed and analyzed:
1. The nature of the business and its operating history;
2. The industry and economic outlook;
3. The book value and financial condition of the company;
4. The company’s earnings and dividend paying capacity;
5. The value of the company’s intangible assets;
6. Market prices of public companies engaged in similar lines of business; and
7. Transaction prices of other companies engaged in similar lines of business.
Item #5, “Intangible Assets”, can be a huge point of contention between buyers and sellers, especially in areas such as SALES.
How much is the company REALLY worth?
The valuation methodologies and factors outlined above are based primarily on historical performance information and assumptions concerning subjective value-adders. Remember, Sales is the LIFE BLOOD of every company. Many factors involving Sales can add (or detract) tremendously to the value of a business:
• What is the True Value of the SALES PIPELINE?
• What is the True Value of the existing Customer Base?
• How good is the organization’s existing Sales Force?
• How good is the Sales Management?
• Are the Salespeople truly capable of carrying out the strategies?
• Can you TRUST the Projections?
The Executive Summary and Management Overview offers a buyer comprehensive data and provide the information necessary to more accurately access the value of a company’s Forecast, Team, Pipeline and associated Sales Assets.
Post-Acquisition Due Diligence
Once you’ve consummated a transaction, you face a whole new set of challenges. The due diligence you will have done, however careful, however thorough, looked only at observable factors.
Your decisions, from this point on, have to be made with an in-depth understanding of the operating dynamics of the company. These are the organizational and interpersonal issues you can’t examine from the outside.
This activity is known as post-acquisition due diligence. Post-acquisition due diligence is as important as the pre-acquisition due diligence. If you don’t get it right, you can get the deal done, but fail to achieve the true objective… generating new post-acquisition corporate value.
This applies not only to acquisitions, but to mergers and large scale joint ventures as well.
Using Common Sense
Too much due diligence can kill the transaction, particularly on small deals. It’s not practical to investigate every possible avenue of consideration. For most transactions, to do so would be too costly and too time consuming.
Pruning the possible lines of investigation and inquiry should be done in a conscious and informed manner – not at random. That is the art of Due Diligence investigation.
We, as practitioners, do have in place checklists and menus of items from which we can choose what we want to investigate and what we will overlook. In most instances, one will investigate only a portion of the possible items the checklists highlight – some briefly and others in depth.
In general, if you are getting a great deal, good pricing, and favorable terms… you will want to move quickly and lightly. On the other hand, if you are doing a highly leveraged deal and are paying top dollar, you’ll have little or no room for error. You require a very complete due diligence, or don’t do the deal at all. When there is no room for error you tolerate no room for error.
For instance, in the process of an investigation, you may find a large number of relevant agreements that you will want to read. In the imperfect world we live in, that may be impractical – you may have to pick and choose which ones you read, which you skim, and which you pass over. How much you invest in this activity depends on how much room for error you have. It may not make sense to invest $75,000 of Due Diligence effort into a $150,000 deal, but for a $15,000,000 deal the calculus is far different.
Develop a Due Diligence Strategy
Before starting your Due Diligence investigation, develop a due diligence strategy. Consider the following factors:
• What’s important to you? What isn’t?
• Which problems will be costly? Which ones will be minor?
• What drives profits – products, technology, sales staff, contracts?
• Where are you most likely to find problems? Where are you unlikely to find problems?
• What is the type of transaction are you expecting? How large or small is the transaction? How complex? What will the investigation cost in time and in money?
• What is the risk to you if the unexpected causes the transaction to go bad?
• How much time do you have? What do you have to lose by delay? What do they have to lose? How badly do you need the deal? How badly do they?
• After the transaction is closed will you have something the other party needs or wants? Can you use this to secure warranties on the due diligence items? Can you put money into an escrow to secure warranties?
Lawyers, Accountants and Due Diligence
You can rely on lawyers and accountants to read agreements and turn numbers into stories.
Of course, you also need someone who understands the particular business and industry – an industry expert. That person will know what to look for, where to probe, and what questions to ask.
Still, no matter how thorough your checklists are, they can’t be sufficiently complete to deal with the unique issues of companies in unique industries. For example if you are doing something in an industry with special peculiarities such as telecommunications or oil, general-purpose checklists will need to be supplemented. This is where your industry expert, his industry savvy and personal contacts will be invaluable.
You will never be able to conduct a complete due diligence investigation. In most transactions you will have to exercise business judgment to assess risk versus reward – with imperfect information. This is where a practical understanding of the industry will be of great help. Knowing how to cut to the chase… knowing beforehand where the skeletons are likely to be buried, and which questions will surface areas of weakness. There is just no substitute for industry specific experience.
Other Reasons for Due Diligence Investigations
Earlier I mentioned acquisitions, mergers and partnerings as major reasons for due diligence. These aren’t the only uses for Due Diligence investigations. Here are more:
1. Selling your company.
- You want to know the financial status of the buyer. Also what is the buyer’s history of acquisitions? The buyer’s past behavior is the best indicator of how the buyer will conduct itself with you and your company.
- Will you be accepting debt from the buyer? Will you be taking shares in the seller? If so you’re really an investor. You’re investing in the buyer. You need to know what you’re investing in.
- You may conduct a due diligence check-up on yourself. It’ll prompt you to areas of inquiry. Prepare well and you’ll increase your control of the buyer’s due diligence investigation.
- Well, before putting your homestead up for sale you should spruce it up and give it a new coat of paint. An introspective review will help identify the areas of your company you need to primp.
2. Taking charge of a turnaround company.
- One of the first things to do when taking charge of a company to turn it around is collect information. The checklist is perfect for that.
3. Investing in a private company.
- Before investing in a private company you need to ask a lot of good probing questions. The checklist will help prompt you for those questions.
Interviews with Insiders
Brace up for one on one sessions with a variety of insiders.
The insiders are the ones who really know what is what. They often know more about the company than does the CEO, especially about those little details that can come back and bite you where it hurts the most. Pay special attention to those insiders with the longest history with the company. Don’t overlook the assistants of these insiders either.
Here is where to look for these people:
Members of Senior Corporate Management and Department Heads.
o The Chief Financial Officer, the Controller, the Treasurer.
o The Top Human Resources Officer
o R&D and Engineering Management.
o Sales & Marketing Management
Members of Corporate Planning and Development Department
Internal Legal Department
Internal Audit Department
Outside legal counsel
Current consultants (business, technical, other)
Typically you will not be permitted access to most of these people until after the transaction is announced, or even until after it is closed. The smaller the company, the more likely this is to be a problem.
But you will usually get early access to the CFO. Here is a trick you can use – one that we use.
When meeting with the CEO get permission to take the CFO along for an informal lunch. Then as you are leaving, with the three of you together, ask the CEO to direct the CFO to give full and complete answers to your questions. That gives the CFO cover to be open and forthright with you.
Then your job is to convince the CFO, that
(a) the deal will close and he will soon be reporting to you,
(b) you will hold in confidence anything he tells you (assure him you will find a way to discover it yourself without blame going to him), and
(c) that he doesn’t want you to discover unpleasant surprises after the transaction closes.
Ask him how to conduct your due diligence. You can learn a lot from him. It’s the CFO’s chance to ingratiate himself or herself to the new owner.
Depending on the circumstances, you may be able to use this trick with other key insiders. You most likely will only be able to use it once though!
We at 5wh Audit have the expertise to assist with Due Diligence Investigations.
© Caleb Mutsumba