In the world of business, companies are constantly buying, selling and merging with each other, all which fall under the heading of mergers and acquisitions (M&As). One of the standard terms that is an important part of the M&A lexicon is “due diligence,” which is something that occurs in virtually every transaction. Knowing what business due diligence is, the various types of it, and how it’s used is vital for every party involved in any sort of M&A (or other type of business) transaction.
About Due Diligence
Due diligence is a necessary, often intense process that involves an investigation, audit and a review to shore up assumptions and gather all the necessary details leading up to the closing of a business deal. The endgame of effective due diligence is ascertaining all the facts, figures and other details that are part of the transaction. It typically involves a deep dive into the financial, legal and corporate records of the company that you’re doing business with.
The Purpose of Due Diligence — What Does It Entail?
Preparing a sound and thorough due diligence report is far more intense than simply going over the balance sheets and tax records of a company. Of course, that information is mandatory, but there’s so much more to scrutinize. The process involves a detailed examination of the target company’s business plan, financial statements, and operational processes to identify any potential risks. The diligence process typically includes a thorough review using a diligence checklist, which covers various aspects such as legal, financial, and operational due diligence. A meaningful due diligence review involves the following information.
- Revenue, profit and margin trends: Of course, these are a major component of any company that you’re looking to do any sort of transaction with. Confirming that these numbers are accurate and that there are no jokers in the deck is important.
- Valuation multiples: There are several types of financial metrics used when conducting a business deal, but there is no better way to get to the bottom of the fiscal health of a company than knowing the valuation metrics, which includes earnings per share (EPS), price-to-earnings (P/E) ratio, price-to-book (P/B) ratio and price/earnings growth (PEG) ratio, among other metrics.
- Industry and competition: It’s not only a matter of investigating the company that you’re working with in the transaction. A proper due diligence check also requires a more holistic view of the entire industry that examines how the company in question stacks up against its peers in the industry. Learning about the entire industry as a whole will shed light on the target company you’re dealing with.
- Management and share ownership: This is about the structure of the company — the founders and other officers. Knowing how long these people have been on board, how many shares they hold and how (and when) there have been shares sold in the past is critical.
- More issues and concerns: Of course, there are scores of other issues, facts and figures and other factors that must be examined. These include stock info (history, possible dilution), risks (both long- and short-term) and any other factors that could impact either the company itself, its industry or the overall economy.
The diligence report produced at the end of the process, provides an informed decision-making tool for the potential buyer or investor highlighting any issues that might affect the valuation or future performance of the target company.
13 Types of Due Diligence in Business
Just as there are many types of businesses and business transactions, there are also multiple flavors of due diligence, some not even listed here. As you will see, all of them overlap (to some degree) with others in the list. They include the following:
1. Merger and acquisition due diligence
One of the most common types of due diligence deals with M&As, and this encompasses many of the areas in the other items on this list. These include financial items (earnings and profits, sales and revenues), human capital and technology, among many others. In the context of M&A due diligence, hard due diligence refers to the quantitative analysis of financial data, while soft due diligence looks at qualitative aspects like management quality and human resources.
2. Financial due diligence
Naturally, financial due diligance is one of the biggest types of due diligence. It includes all the company’s financial statements, tax filings, capital expenditures and audits, among many other factors. Financial due diligence encompasses many details, including analysis of customer accounts, fixed and variable cost analysis and other projections. Enhanced due diligence is often conducted in cases where there is a higher risk of money laundering or other financial crimes. This type of due diligence is common among financial institutions and involves deeper scrutiny.
3. Legal due diligence
A review of all things legal, which includes minutes of both board meetings and shareholder meetings, details about shares issued to leadership and all contracts, which include joint venture and partnership agreements, LLC or other operating agreements, intellectual property rights, licensing and franchise agreements. A good legal due diligence process reviews ongoing legal disputes as well that may reduce goodwill or affect future performance.
4. Customer due diligence
Because customers are a critical part of a company’s lifeline, due diligence into the customer base is required, along with looking at who the top customers are, any pending service agreements and/or insurance coverage and all other customer data.
5. Administrative due diligence
This type of due diligence involves verifying administrative-related details of a company. It includes all disparate facilities, occupancy rate, workstations and other important admin data. It ties in with the financials, as these costs are closely connected to the financial aspect of the process.
6. Environmental due diligence
Environmental due diligence is examining regulations and is important because violations in the environmental area can be extremely costly. It includes environment permits and licenses, proof of compliance with all current regulations and any current contingent environmental liabilities.
7. Human resource due diligence
Like financial due diligence, HR due diligence is quite extensive, and it includes the analysis of current positions and vacancies, details about future attrition, examining the contracts that involve HR, all benefit and retirement packages and policies that are part of the human resources department.
8. Asset due diligence
This type of due diligence includes details on fixed assets, lease agreements, real estate details (deeds, mortgages, title policies and use permits) and schedules of sales and purchases of major capital equipment over the past several years.
9. Intellectual property (IP) due diligence
IP due diligence includes a deep dive into schedules of patents (and patent applications), copyrights, trademarks, trade secrets and brand names, as well as any pending legal actions involving the company’s IP licenses.
10. Commercial real estate due diligence
This entails examining purchase and sales agreements, contracts and leases related to the target company, any partnership agreements (past, present and future) and purchase and sales of foreclosure properties and real estate portfolios.
11. Operational due diligence
Typically performed by the acquiring company, venture capitalists and private equity firms, operational due diligence (ODD) examines the operational risks and processes that can potentially lead to growth.
12. Technical due diligence
This type of due diligence involves a deep dive into the technical aspects of a company, which may encompass the entire organization (such as its products and services, in the case of tech firms), or the technical aspects of other types of companies (including architecture, web infrastructure, databases, security and other issues).
13. Commercial due diligence
Commercial due diligence investigates the target company’s products and/or services, along with its operations and history. This includes management structure, any legal issues, its sales and marketing, its competition and its industry as a whole.
Virtual Data Rooms for Due Diligence
Every type of transaction that involves due diligence requires the appropriate tools to keep the process moving and not break the bank, and one of those important tools is a virtual data room (VDR). A VDR is a secure online location where all sanctioned parties involved in the transaction can store, search, share and edit the documents required in the due diligence phase of a business deal. The features of a quality VDR include secure access, which includes enterprise-level encryption, multiple layers of security and user-friendly admin controls that allow you to seamlessly upload and download documents, protected by version control, while also allowing only certain parties access to documents.
CapLinked, an industry leader in the VDR space, provides virtual data rooms for companies of all types performing due diligence. The cutting-edge features of CapLinked VDRs can help you streamline the due diligence phase of any transaction. Sign up for a free trial today to see how.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.
Sources
Counting Up – What is due diligence and why is it important? | Countingup
Corporate Finance Institute – Types of Due Diligence
TDS Law – The Importance of Due Diligence
