The purpose of any business is to increase profits and minimise risks. In the context of business security, the concept of due diligence is fundamental. Unfortunately, it is still little understood by many entrepreneurs. In this article, we’ll try to understand what it means and what you cannot do without it.
What is due diligence: etymology and clarification of the concept
In the business environment, the idea of due diligence involves the procedure of independent verification of a particular company, creating an objective and complete view of it and obtaining comprehensive knowledge about the activities, financial condition and status of the business.
The due diligence procedure, as a rule, precedes the purchase of a company, the implementation of a merger transaction, the signing of an investment agreement, etc. Such an in-depth audit is necessary to minimise the risk of unsuccessful transactions; it is worth resorting to before any serious transaction.
The term due diligence has been used in world financial practice for almost a hundred years — it first appeared in US legislative documents in 1933. Then it was explained as “disclosure by a broker to an investor of information about a company whose shares are traded on the stock exchange.”
In its modern form, due diligence standards were developed in Switzerland in 1977. Representatives of several banks worked on them and documented a unified approach to collecting information about their customers in an agreement called “The Swiss Banks Due Diligence Agreement”. Over time, the developed principles spread to the consulting business, where they began to be used for a comprehensive analysis of the activities of companies by lawyers, auditors and financial analysts.
The concept of due diligence began to penetrate the business realities of the post-Soviet countries only in the early 2000s, and in recent years this procedure has been used more often. It is especially in demand when attracting foreign capital, the company’s entry into international markets, and during the initial public offering of shares. In the post-Soviet space, no legislative framework regulates due diligence. In most cases, this procedure is carried out by the individual requirements of the customer, guided by foreign standards.
The purpose of due diligence can be called the reduction of entrepreneurial risks, including the risk of buying shares at an inflated value, losing money or property, reputational losses, etc.
Who needs due diligence and why?
All market participants may be interested in conducting due diligence. The desire of investors to receive comprehensive information about the acquisition object, its fair value, possible risks and objective potential is quite natural.
The circle of people interested in conducting due diligence also includes the owners and shareholders of the company and its top managers who want to get an objective assessment of the success of the chosen strategy or are preparing for an important deal.
Banks also often resort to due diligence before concluding a significant loan agreement or deciding to restructure a company’s debts. In most cases, due diligence is used to assess a particular asset’s prospects objectively.
The results of due diligence can also be helpful in the case of:
- preparation for the issue of securities;
- change of top management;
- obtaining loans or sponsorship injections;
- detection of violations during a tax or other audit;
- decrease in the efficiency of the enterprise, deterioration of competitive positions;
- occurrence of internal conflicts.
Due diligence procedure: types and stages
There are no clear, generally accepted rules on how due diligence should be carried out and what activities the procedure should consist of. This may depend on the company’s scope, customer requirements, acceptable research sources and other conditions.
At the same time, most experts distinguish such types of due diligence as:
- Tax. It involves a comprehensive audit of financial and tax reporting for the last three years, identification of obvious, hidden and potential tax risks, analysis of compliance of documentation with legal requirements, etc. Tax due diligence plays a crucial role in assessing the condition and attractiveness of a potential transaction object.
- Marketing. It involves a detailed check of the business and/or products in terms of compliance with market conditions, an assessment of the adequacy of pricing, product and communication policies, and an analysis of the company’s business reputation. When conducting marketing due diligence, the competitive environment is also often assessed, the competitive advantages of the company/product are identified, and development prospects are analysed.
- Ecological. This means checking the likelihood of a negative impact on the environment as a result of certain activities of the company, calculating the harm to the environment from a future project and identifying facts of non-compliance with accepted environmental standards and obligations.
- Juridical (legal). Includes legal, due diligence of all company documentation and analysis of legal aspects of work (for example, registration of intellectual property rights, lawsuits, etc.). As part of legal, due diligence, contracts with counterparties, loan agreements, encumbrances on real estate, trademark documents and much more are checked.
- Economic (financial). It involves determining the company’s key financial indicators, its assets and liabilities, income and expenses; business prospects are analysed, and its financial stability is calculated. The quality of work of the accounting and financial services and the compliance of documentation with the regulator’s requirements are also assessed.
- Technical. It is used when concluding transactions with real estate objects, investing in construction, production facilities, etc. This refers to verifying technical documentation and estimates, physical inspection of facilities, engineering and technical consultations, etc.
In Western practice, complex due diligence is often used, which involves a comprehensive check of the company according to various parameters.
The due diligence procedure’s duration depends on the business’s complexity and can range from several weeks to one year.
Due diligence is usually carried out by a team of experts, which includes financial analysts, auditors, and lawyers. If necessary, other specialists, such as engineers, environmentalists, experts in safety, corporate ethics, etc., can be involved in the work. The audit can be performed by the investor’s employees (of course, with the proper qualification) and by representatives of an independent consulting company. Both options have their pluses and minuses.
The result of the due diligence procedure is an objective, comprehensive assessment of a particular company, summarised in the report. In some cases, each expert gives the customer his opinion upon verification, but a general summary report is often prepared with the essential information.
Sources of information for due diligence
In the process of due diligence, experts can consider any information. The study usually includes:
- legal corporate documents;
- financial statements for a certain period (usually for three years);
- all kinds of reports (results of examinations, technical reports, conclusions of various specialists, etc.);
- tangible (real estate, assets, etc.) and intangible (patents, trademarks, etc.) assets of the company;
- contracts;
- any information from open sources (published reports, product research, etc.);
- insider information (data received from company employees) and much more.
Successful work requires the ability to operate with large amounts of information and draw the correct conclusions based on them. As one of the axioms of the Harvard Business School says: “Business is the ability to make effective and efficient decisions in the face of uncertainty.” The due diligence procedure will help reduce this uncertainty, reveal information that unfair entrepreneurs could try to hide, and minimise potential transaction risks. Therefore, we can confidently say that its implementation is not a whim, not an excessive precaution, but a beneficial and even necessary practice.