Overview of Due Diligence:
Due diligence is an inquiry, audit, or study conducted to validate facts or details about a subject under consideration. Generally speaking, it is defined as "exercising caution or conducting a prudent review." However, in legal terms, and more specifically in the context of mergers and acquisitions, due diligence becomes a type of legal, operational, and financial evaluation, validating the seller's claim and the integrity of the material given. Put simply; due diligence is a study that identifies legal risks. The outcome of legal due diligence will assist in explaining the condition of the operation and highlighting its risks and structure.
Use Case of Due Diligence:
Primarily to discover potential flaws in a trade or investment opportunity, which will help avert a poor commercial transaction. Also, to ensure that the said opportunity meets the relevant criteria. Furthermore, to gather facts that will be beneficial in appraising the transaction. Finally, to confirm and verify the information presented throughout the trade or investment process.
Types of Due Diligence:
- Legal Due Diligence:
Legal due diligence includes a thorough study of all material documents, such as partnership agreements, license agreements, guarantees, loans and bank financing arrangements. It is an essential component of every transaction and must be considered before any merger or acquisition. In addition, it is a risk assessment of liabilities of the targeted corporation that may jeopardize the transaction's success.
- Financial Due Diligence:
Financial due diligence examines financial accounts, assets, debts, cash flow, and predictions to evaluate their credibility and accuracy. Therefore, allowing the party to obtain a better understanding of the corporate's key performance indicators. Additionally, it is a critical examination of the financial situation in which the corporate's past and present financial performance is evaluated. Finally, it aims to provide future projections that take into consideration all potential hazards.
- Commercial Due Diligence:
Commercial due diligence (also known as market due diligence) is crucial in strategically verifying the opportunity. This method considers the market size, market share, consumer base, rivals, and possible future returns. In addition, commercial due diligence aims to determine if a transaction is financially sustainable.
- Tax Due Diligence:
Tax due diligence aims to manage the company's tax affairs and ensure that all tax payments are paid entirely on time. In addition, tax due diligence considers how a merger would affect the tax liabilities of the new business formed by the transaction.
- Operational Due Diligence:
Operational due diligence concentrates on the firm's operations - essentially, how the company converts inputs into outputs. Consequently, this is the most forward-thinking form of due diligence.
The Due Diligence Process:
- Assessment of Project’s Objectives:
The first stage is to define the entity's goals. In turn, this helps the interested party identify the needed resources, ultimately ensuring alignment with the entity's overall plan.
- The Financial Analysis:
This stage consists of a thorough audit of financial documents. It guarantees that the records described in the Confidentiality Information Memorandum (CIM) are accurate. Furthermore, it aims to assess its asset health, financial performance, and stability and detect any red flags.
- Thorough Examination of Documents:
This stage begins with two-way communication between parties. The buyer requests relevant papers for auditing, conducts interviews or surveys with the seller, and performs site inspections.
The seller's responsiveness and organization are critical in expediting this procedure.
- Analysis of the Business Plan and Model:
During this stage, the buyer focuses on the corporate's business plans and model to determine viability and how well the firm's model would fit theirs.
- Formation of the Final Offering:
Individuals and teams collaborate to discuss and assess their results after gathering and analyzing information and documents. Therefore, analysts use the data they acquire to execute valuation procedures and methodologies.