One of the least understood, yet most important, parts of the investment business is due diligence. Everybody has a different idea of what it is, why it exists, and how it should be conducted. For many entrepreneurs and brokers, due diligence is the enemy. They fear due diligence will be used and excuse to kill or renegotiate a deal. For lawyers, accountants, and many consultants, due diligence is manna from heaven. It’s the reason that they make most of their money. For investors, the desire and need for due diligence is balanced by their fear of scaring away good deals if they develop a reputation for being too difficult.
What is due diligence? Who does it help, or hurt? Here are somecliff notes on this often-misunderstood subject.
1) It’s a critical process for investors. Due diligence allows investors of various types (including lenders, institutions, angels, fund managers) to evaluate the potential investment against what they expected it to be when they first screened it. It is for verifying and checking that what the investor initially thought about the investment after further scrutiny, review, and analysis. This can include everything from background checks on management, an audit of financials, discussions with customers, market analysis, verification of intellectual property or other property rights, and review of proprietary technology, equipment, real estate, or other valuable assets.
2) One size doesn’t fit all. Sometimes due diligence is very limited and can be concluded in a few days to a couple of weeks by one to a small handful of people at a low cost. In other cases, depending on the size and complexity of the deal, it can take months and involve hundreds of people costing millions or even tens of millions of dollars. The scale and scope of due diligence is primarily determined by the size of the deal and if the investor is an institutional investor, lender, corporation, or individual. Generally, everything else being equal, individuals do the least due diligence because they don’t have a bureaucracy, they don’t want to spend as much money because it’s their money, and they feel more confident about what they’re doing. Due diligence by corporations, lenders, and other institutions is usually directly proportional to the size of the corporation, lender, or institution. Bigger organizations typically do more due diligence. This is not always true, but it is typical.
3) It’s not a scheme to renegotiate or kill the deal. Let’s be honest, due diligence can be abused by unethical investors who want to manipulate a situation for their gain. But this less-than-honest use of due diligence is the exception, not the norm. If you’re the company or seller, it may seem if you are trying to sell your asset that due diligence is the enemy, but it shouldn’t be (unless you have something to hide). The reality is that due diligence exists for a good reason. Many sellers of businesses and assets lie about things in order to get a higher value than they deserve to get from the investor or buyer. This is not just outright fraud, which is common but not nearly as widespread as simply wanting to put the best face on everything and not going out of their way to disclose things that might be viewed as negative. The bottom line is that investors who conduct serious due diligence typically make more money over the long run than investors who don’t.
4) DIY—do it yourself. If you’re an investor, you should not rely on other people to do your due diligence for you. One of the reasons people typically invest with people they know or famous people is because the involvement of those other people they know or admire makes them feel more comfortable and allows them to do less real due diligence. While it is better to invest with people you know and individuals who have been successful investors, founders, or managers in the past, that is not a substitute for doing your own due diligence. This is why the concept of crowd-sourcing or crowd-funding investments has major problems with it. It encourages a process that has a tendency to produce a herd mentality. It would seem like this would benefit company founders and only hurt the investors, but it actually hurts both sides. Instead of capital being allocated to the best fundamental investments, it gets allocated to the investments that seem “hot” or “popular.” Over the long run, this hurts productivity.
To wrap things up, remember that due diligence is absolutely critical to making any sound investment, it is not a trick or a game to renegotiate or kill a deal, and it should be something that you or your organization should do for yourselves rather than relying on the supposed wisdom of others to do it for you.
CapLinked provides tools that help companies, investors, and their advisors to navigate the due diligence process. Check out our How to Create and Share a Deal page for an overview on how to use our deal features to share information with potential investors.