Due diligence is an investigation, audit, or review performed to confirm the facts and details of a matter under consideration. This can require an examination of financial records, a systematic review and mitigation of risk from the business side, and an analysis of any future business. In the case of an individual investor, due diligence can refer to an examination of a stock or security using readily available public information. Due diligence strategies can be used in various types of investments. A due diligence process can also take place in the context of commercial real estate, which includes a fact-finding process by purchasers to ensure the soundness of the investment, as above, and includes physical inspections of the property.
Due diligence is performed by equity research analysts, fund managers, broker-dealers, individual investors, and companies that are considering the acquisition or investment in other companies. For an individual, due diligence is considered voluntary, although broker-dealers are legally obligated to conduct due diligence on a security before selling it.
Due diligence is performed by any of these individual entities to gain a much more detailed understanding of the business and confirm whether an acquisition or transaction is a good idea. It allows entities to test their expectations and uncover any risks or concerns. The vendor, in this case, provides comprehensive commercial, financial, legal, and other information to help the potential buyer understand how the business works.
The term due diligence has been in use since at least the mid-fifteenth century in the literal sense of giving requisite effort. It would, in later centuries, develop a legal meaning that generally suggests "the care that a reasonable person takes to avoid harm to other persons or their property," which is synonymous with the legal term ordinary care. The term has extended into business contexts, where due diligence has come to signify the research a company or individual performs before engaging in a financial transaction.
Due diligence became a common practice (and term) in the United States with the passage of the Securities Act of 1933. With the law, securities dealers and brokers were made responsible for disclosing material information about the instruments sold. Failing to disclose to potential investors opened dealers and brokers to criminal liability. However, the act recognized full disclosure and left dealers and brokers vulnerable for failing to disclose a material fact they did not possess. The act included a legal defense that stated that as long as dealers and brokers exercised "due diligence" when investigating the company's equities they sold and fully disclosed those results, they could not be held liable for the information.
The three common types of due diligence that tend to be required for many types of transactions are commercial, financial, and legal. Depending on the transaction, a buyer may choose to focus on one type of due diligence more deeply, and they may extend to other types of due diligence to answer context-specific questions.
Commercial due diligence works to understand how a target company makes money, its competitive environment, and its future goals and strategy. This can include the company's business model and strategic plan; the market landscape and trends affecting the company; key customers, suppliers, and employees; significant risks; and the company's corporate social responsibility record.
In commercial due diligence, it can be important for a potential buyer to understand customer concentration, including understanding who customers are and what percentage of the portion of sales any individual customer makes. For example, in the case of an individual customer making a large portion of a business's sales, that customer leaving for a competitor could place the purchased business at risk. This can also provide a purchaser with information about a business's customer history and expectations for the future.
Similar to knowing about customer concentration, understanding the supply chain of a company can be telling. For example, if a company relies on a single supplier, that represents a high risk to the business. Part of the due diligence process can include meeting key suppliers, working to verify the vendor's information, and better understanding their relationship with their suppliers. It can also help a potential purchaser build a relationship with those suppliers and work to improve that relationship.
Part of understanding the business can be using commercial due diligence to better understand the business model of the business a party is interested in. This business model can provide an understanding of any and all risks posed by technology advancements and the potential for disruption to the specific market.
During commercial due diligence, it can be important for the potential buyers to meet key employees and get more information about their roles and where they see themselves at the company going forward and post-purchase. This can also be a time to start building a relationship with them to increase or ensure post-transaction retention.
Another critical step in due diligence is financial due diligence, which an accountant typically undertakes. It requires a series of documents to achieve the analysis, including an accountant-prepared, year-end financial statement for at least the past three years, interim year-to-date statements and statements from comparable periods from prior year or years, trial balances, financial forecasts, tax returns, bank statements, budgets, and records on product margins, inventory turnover, accounts receivable turnover, employee turnover, major assets, and any other information needed to understand the numbers and any assumptions behind them.
Performing this analysis, the accountant and other due diligence parties should be looking for anything that could impact the future finances of the business and any other red flags. This could include the following:
- Tax liabilities
- Poor product margins
- Needed equipment repairs or investments
- Slow-paying customers
- Operational inefficiencies
- High employee turnover
- Sluggish inventory turnover
- Working capital levels
- Financial ratios
- Owner compensation
- Impact of required normalization
The last major part of any due diligence process is legal due diligence. This works to understand and review any legal issues affecting the business, which can include ongoing, pending, or threatened litigation; past lawsuits that may have affected the business; employment contracts; leases; customer and supplier agreements and warranties; laws and regulations affecting the company; licenses and permits; real estate and intellectual property issues; corporate documents, such as certificates of incorporation, company bylaws, and shareholder agreements.
Due diligence can be separated into "hard" and "soft" due diligence, based on the approach used. An entity performing its due diligence will engage in a mixture of both hard and soft due diligence. Hard due diligence can be described as focusing on numbers and data from a business, also considered a quantitative approach. Whereas soft due diligence tends to focus on the people involved in and behind the business, such as management, employees, and customers. It is often considered a qualitative approach.
Hard due diligence is largely encapsulated in the above process; it is concerned with the numbers and data found on financial statements, like balance sheets and income statements. The hard due diligence process can include fundamental analysis and the use of financial ratios to understand a company's financial position and to make projections on the company's future. This type of due diligence can also uncover accounting inconsistencies and other red flags. However, some consider the focus of hard due diligence on mathematics and legalities to be susceptible to rosy interpretations by eager salespeople, which can be counterbalanced by soft due diligence.
Soft due diligence works to balance out hard due diligence by providing a qualitative approach that inspects the aspects of a business that cannot be captured in financial and business statements. This can include the quality of a company's management group, the employees of the company and their loyalty, and the quality and diversity of a customer base and its loyalty. There are many drivers of success that cannot be captured in numbers, such as employee relationships, corporate culture, and leadership. This can also capture the sustainability and diversity goals of a business and how well they have achieved them. Many consider that when a merger and acquisition deal fails, as nearly 70 to 90 percent of them do, it is because this human element is ignored.
In mergers and acquisitions (M&A), a company considering a deal will perform a due diligence analysis of the company they wish to purchase. Much of the above framework is from the M&A due diligence process, in which the purchasing company will perform hard and soft due diligence to understand the inner workings, potential, and red flags of the company they wish to purchase. Further, the acquirer may ask the questions in such a way that the answers can help structure the acquisition terms. In traditional M&A activity, the acquiring firm deploys risk analysts who perform due diligence by studying costs, benefits, structures, assets, and liabilities, as well as undertaking the study of the company's culture, management, and other human elements.
The venture capital (VC) due diligence process is very similar to the M&A due diligence process. The potential investor does what is necessary to evaluate a potential investment opportunity while also trying to reduce the inherent risk of investments in early-stage companies. The due diligence process in this case works to select the potential winning investments, identify key risks associated with an investment, and develop a risk mitigation plan.
The areas of focus of due diligence of a VC firm may differ from an M&A analysis, but that depends on the context and market of the potential investment. However, most investigations will focus on the management team, market, product, traction, legal, and financials. Most of this—such as market, product, legal, and financials—are the same as the M&A process; while the focus on the management team and traction could be considered slightly different for early-stage companies as these can have a greater impact on the future prospects of the business than they may on the supposedly established business subject to an M&A analysis. Further, a venture capital firm needs to do a screening process; different from the M&A process, many VC firms are petitioned for financing from potential companies.
Similar to all due diligence processes, the process undertaken by venture capital firms will depend on the firm in question. Often, a lot of the necessary documentation can be provided by a company looking for funding in the screening process, and the process for VC firms tends to be smoother and faster than in M&A deals, as the company is looking for investment as much as the VC firm is looking to invest.
The screening process sees VC firms and funds review and evaluate hundreds (or more, depending on the firm) of business opportunities and use predetermined criteria to identify which opportunities to focus on as possible investments. This allows the firm to quickly identify opportunities they are interested in pursuing, meaning spending more time and money to evaluate them than those that do not fit. Most companies that do not make it through the screening process of a VC firm do not fit the firm or fund's mandate or criteria (such as the business's stage, geographic region, size of the deal, or industry sector, for example); and some funds will only review opportunities from trusted referrals to reduce the time necessary to screen companies.
Assessing the management team is important for VC firms as, especially with earlier-stage companies, the management team and its expertise and acumen can adversely impact a business without an established market position. Through this process, there are various qualitative topics that can be addressed in regard to each member of the leadership team, as the VC firm needs to know about domain expertise, total experience level and relevancy of that experience, and the individual value contribution to the company.
Similarly, a founder-market fit can be an important metric to understand, as some founders may be a good or a bad match for the problem they are tackling. The management team can also take greater importance when it comes time for a later-stage company to raise an IPO, as the wrong CFO can damage the chance of the IPO being the success a VC firm may want it to be.
Another factor for a VC's potential investment is the traction of the potential investment. Traction can be considered the measurement of how "far along" a company is, reflecting the number of customers and revenue for a company, which can explore how mature the company's offering is in the market, but also whether the company is mature enough to be raising the funding series in question. Traction also looks at a business's viability, which can include a VC to use its network and find experts in the given business space to offer expert opinions on whether a start-up may have an intriguing idea or product.
As many VC firms deal with businesses attempting to develop new business models, disrupt established business models, or try things that have otherwise not been tried previously based on new technologies, a VC firm has to assess the viability of the early-stage company's business model. This can be difficult, as traditional metrics cannot always be applied to early-stage companies, and industry-specific metrics tend to be used more commonly.
However, some of these metrics, depending on what the business in question is attempting to achieve, may not always work as well. One question that can help discern how viable the business model is can be understanding how repeatable the business model is, as a company may be taking advantage of temporary market conditions which, a removal of, could lead to the business failing in the future.
Part of this business model analysis is the timing of the business and the market they are addressing. For example, early-stage start-ups that attempt to offer solutions to problems in their target markets need to understand the issues encountered on a day-to-day basis is considered critical. Being too early to a market can result in limited market adoption, whereas entering a market at the right time can provide mass market adoption and create a better valuation for the company. But assessing the timing can be incredibly challenging, as the signs when a market is ready can be difficult, if not impossible, to see at times.
One of the other risks in a potential investment's business model can be the product they are developing—whether it is refined enough to launch, where it is in its development, and the viability of the product—and whether that product satisfies the expectations of the end-user or customer, and if it solves the problem it is intended to solve. A product can fall short of expectations and fail to deliver on the proposed value, and it can also lack a proper fit in the proposed market. Also ensuring the product offered by the company has a competitive edge and is not a clone of an already offered product without providing anything to make its value proposition makes sense. Understanding this can make or break a company, and unlike in an M&A scenario where a company tends to be well-established, a poor product-market fit can doom a start-up to failure.
For individual investors, there are steps that differ from the above frameworks for undertaking due diligence in their investments. These steps tend to be related to stock investments, where an individual investor has limits on the kind and amount of information they have access to, but can be applied to many other investments, such as bonds or real estate, to help individual investors ensure the investment they are making makes sense.
One of the first steps an individual investor can take is understanding a company's market capitalization, or the total value of the company, which can indicate how volatile the stock price is, how broad the ownership is, and the potential size of the company's target market. Large-cap and mega-cap companies tend to have stable revenue streams and large and diverse investor bases, which tends to lead to reduced volatility. Whereas, small- and mid-cap companies will typically suffer larger fluctuations in their stock prices and earnings than large corporations.
Individual investors should also work to analyze a company's income statement, which can list its revenue and net income or profit. It is also critical to monitor any trends in a company's revenue, operating expenses, profit margins, and return on equity. Analyzed over several quarters or years and then compared with companies within the same industry can offer the potential investor perspective on the company's place in the market.
When taking a perspective on where a business stands in a given market, understanding how it compares to other companies in the industry can help understand the operation of the company, perhaps put some decisions in perspective, and see the overall size of the industry. Every company is, in one way or another, defined by its competition. Due diligence includes comparing the profit of the company in question to those of its main competitors. Additional questions an investor can ask during this step can include the position the company is in its industry or specific target market and whether the industry is growing or shrinking.
To evaluate a company, many ratios and financial metrics are used, and three of the most useful include the price-to-earnings ratio, the price/earnings to growth ratio, and the price-to-sales ratio. These ratios are sometimes already calculated for the potential investor on some websites, and these websites allow the investor to quickly compare several metrics of its competitors to the main business. This can, in some cases, lead an investor to change their investment trajectory to other companies.
Understanding how a company is run, who runs the company, whether it is still run by its founders or if a board has shuffled in new faces, and the relative level of expertise and experience of the management group can be important for shoring up confidence in a company. Also important is understanding the ownership share of a company—who holds shares and who is selling shares—as a founder or management group that holds large amounts of stock can show confidence in the business, and the opposite can also be true.
A company's balance sheet will show its assets, liabilities, and available cash. Examining a company's level of debt can show how it is faring compared to the wider industry. However, debt is not inherently a negative, depending on the company's business model and industry, but debts should be highly rated by rating agencies. Typically, the more cash a company generates, the better an investment it is likely to be, as debts can be addressed and a company can continue to grow.
Investors should also research both the short-term and long-term price movements of the stock and whether the stock has been volatile or steady. This can be enriched by a comparison of profits generated historically against the price movement and seeing how it correlates. Past performance does not guarantee future price, but understanding if the price is connected to the businesses performance can be important.
Investors should be aware of how many outstanding shares a company has and how that number relates to its competition; this can include learning about whether a company plans on issuing more shares, or buying-back shares, as either action can have an impact on the future stock price.
Investors should also look at the analysis of wall street and see what, if any, consensus or opinion there is on the potential for a company's earnings growth, revenue, and profit estimates for the next two to three years. Investors should also look for discussions of long-term trends that could affect the industry, and company-specific news around partnerships, joint ventures, intellectual property, and new products or services.
This final step in an investor's due diligence works to understand both industry-wide risks and company-specific risks. This can include outstanding legal or regulator matters, unsteady management, and ensuring the investor plays devil's advocate on all issues to understand the worst-case scenarios and potential outcomes of the stock.
Another due diligence process is customer due diligence. This process is used by financial institutions to collect and evaluate relevant information about a customer or potential customer and aims to uncover any risks of the financial business doing business with an organization or individual. This due diligence is typically a formal process, part of a financial institution's Know Your Customer (KYC) standards, and depending on the country or region of a bank, can be a mandatory process. This can require customers to provide details about themselves to the financial institution, ensuring the person or organization is not on a sanction list published by a government or territory and includes an analysis of public data sources and private data sources.
