In the business and financial sectors, particularly in the milieu of M&As and related types of transactions, two terms that are commonly used are “due care” and “due diligence.” Although similar sounding, these two phrases are not interchangeable, and knowing the difference between them is paramount.
In the course of corporate work in the M&A and LBO world, knowing the difference between these terms (and all areas they entail) is critical to making sound business decisions.
What Is Due Care?
Due care is the process that any reasonable party makes to correct something. Although this may sound like a broad, overreaching term, in the business and financial world, it is an important concept. In short, due care is what an ordinary, prudent and reasonable person would do in a situation where similar circumstances were presented to them. Unlike due diligence, due care is more of an informal course of action. It’s a way to correct something that could have a negative impact on the entire process if left unchecked.
What Is Due Diligence?
Performing due diligence is a far more intense process than due care in the majority of situations. It’s best to think of due diligence as more of an audit, or investigation. The goal is to confirm (or discover) all the facts, figures and details of the matter under consideration.
For example, in the financial world, it’s a mandatory method of examining all the financial, legal and corporate records of any company you’re dealing with. In short, it’s a higher-level way of “doing your homework.”
The point of due diligence is to fully analyze and mitigate risk in any business dealing you’re engaged in. It involves examining a company’s balance sheets and other financial records, as well as all other corporate and legal documentation, including historical records and future projections. So, whether it’s performing a background check on a new employee, researching a stock for investment purposes or gleaning information on a target company for a merger or acquisition, performing due diligence is absolutely a required step in the process.
What Does Due Diligence Entail?
Performing due diligence on a company means more than simply looking at the easy-to-find numbers, such as the market cap. Sure, the market cap is an extremely important figure in any financial transaction, but to perform meaningful due diligence, a deeper dive is required. Things to scrutinize include the following.
- Revenue, profit and margin trends: A company’s revenue and net profit data is highly important. Also, researching the historical data of those trends, and comparing it to its competitors is a vital factor in performing due diligence. This is where investigating the balance sheets comes in handy.
- Its industry and competitors: Due diligence means not only looking at the company in question but at its competitors and the industry it’s in. It includes looking at the profit margins of other companies in the same field and following the trends in the industry. Do things look sunny for the future for the company? How about the industry as a whole? Learning about others in the same field will reveal a lot about the target company.
- Valuation multiples: There are loads of financial metrics used to gauge the health and vitality of a company, and knowing all of these are key to performing thorough due diligence. These include the price-to-earnings (P/E) ratio, which indicates how much future results are reflected in a company’s stock price, the price-to-book (P/B) ratio, which measures the valuation of a company in relation to a series of other figures (debt, annual revenue and balance sheet), and the price/earnings growth (PEG) ratio, which is a projection of future growth and revenues.
- Management and other ownership of shares: This is looking into the structure of the company and its people. Are the founders still in the driver’s seat, or have some new faces appeared on the board? And how much of the stock do these people hold? Have large amounts been sold by the founders or executives lately? All good questions to ask.
- Other issues and concerns: In addition to the examples listed above, there are lots of other issues that need to be examined. These include stock history, the possibility of stock dilution, scenarios for long- and short-term risks and any other factors that could impact the company, or its industry in general.
Due Care vs. Due Diligence
After reading the explanations above, you can see that it’s obvious that due care and due diligence are two different (though related) concepts. Both are important processes to work with when dealing with a business or financial transaction, no matter how large or small it is. Due care is more focused on “doing the right thing” and making sure those safeguards are in place. Due diligence is more than just a simple fix; it’s a deep dive into all areas of the company you’re dealing with and finding the answers to your questions.
Understand that what you find during the due diligence process may not be wholly kosher, but that’s the entire point of performing it. Knowing what to look for, what underlying issues exist, and either fixing them or factoring those flaws into your final decision is of paramount importance.
Employing a Virtual Data Room in Your Due Diligence Process
In order to facilitate and expedite your M&A process, employing a virtual data room (VDR) is a critical cog in the wheel. A trusted third-party VDR provider gives you peace of mind when it comes to these transactions. A VDR delivers a secure, online vault for storing and sharing documents, and its controls provide access privileges for the legal, financial and other parties involved in the transaction.
CapLinked is an industry leader in the VDR space, providing workspaces that are as simple to manage as they are secure. Sign up for CapLinked’s free trial of its secure VDR, complete with document control and management features, collaboration tools, customizable permissions and more.
Chris Capelle is a technology expert, writer and instructor. For over 25 years, he has worked in the publishing, advertising and consumer products industries.