In the United States, due diligence became a common business practice after the passage of the 1933 Securities Act. The act requires that sellers of securities provide investors with financial and other significant information before a sale. The due diligence process involves verification, audits, and investigation of an investment or business deal to confirm all relevant facts.
Before closing a deal, due diligence is essential because it provides assurances of what buyers are getting. There are many elements of due diligence. However, the main components include financial, administrative, asset, and human resource due diligence. The financial due diligence process scrutinizes the company’s financials, including financial statements, capital expenditure plans, growth projections, creditors and debtors, among others.
Administrative due diligence involves verifying items such as company facilities, offices, plants, and equipment. Asset due diligence typically includes a detailed list of fixed company assets, their locations, equipment lease agreements, real estate deeds, and mortgages. Human resources due diligence may include an analysis of total employees, current positions and salaries, employment contracts, and position vacancies.
Depending on complexity and scale, the due diligence process can take days or months. The duration depends on the time it takes to access and review all relevant documents. A period of due diligence can be included in a sales contract that allows termination of the agreement if any previously undisclosed issue has the potential to affect the success of the business.
Primarily, fund managers, individual investors, equity research firms, broker-dealers, and risk and compliance firms or analysts carry out due diligence. The process enables companies and investors to perform compliance audits to protect themselves by identifying relevant risks. Due diligence also checks the conditions and assumptions of an offer. Before acquiring a company or entering a partnership, individuals must thoroughly check to confirm that it is compliant with all regulatory bodies, ethically operated, and as profitable as claimed.
Appropriate due diligence depends on the business transaction and the level of risk. For example, in a proposed business merger in which stock shares form a major percentage of the purchase price, due diligence assumes greater significance. The value of shares may be impacted by market volatility, and if they should fall significantly, the overall value of a company could significantly shrink. Due diligence in such a case may also involve understanding stock market dynamics. Other areas of due diligence include information technology (IT) networks, sales and marketing, and research and development (RD).
In mergers and acquisitions (M&A), due diligence gives the purchaser confidence. However, the audit can also benefit the seller. For instance, going through the rigorous process of financial scrutiny may reveal that the company’s market value is more than initially assumed.
Generally, acquirers evaluate how well the target investment fits their overall strategy, plan, or vision. For example, a private equity firm considering an acquisition will want to know how well it will complement its existing portfolio. Similarly, a large company eyeing an M&A deal should consider the ease or difficulty of merging or acquiring the new company.
Because gathering information and sensitive documents in due diligence are crucial, the seller may ask the buyer to sign a nondisclosure agreement (NDA). The NDA protects sensitive information or unwarranted disclosure by the buyer or investor before and after the sale.