Due diligence is an investigation that is made before investing to help make an informed, smart decision before potentially moving forward. The goal of due diligence is to verify information about an investment and to look for risks so that they can be mitigated (reduced, managed, or eliminated).
In most cases, risk cannot be entirely reduced or eliminated, but where the due diligence identifies risks that can be accepted and managed, the investment goes forward even with those risks.
It’s all about being informed — eyes wide open — before making an investment decision.
The Corporate Finance Institute (CFI) uses a due diligence template for a merger and acquisition (M&A) deal that breaks the due diligence process down into general categories. These categories can be used as part of a due diligence checklist for considering any investment, including stocks, bonds and alternative investments.
The categories along with an extensive checklist are very comprehensive. This is to make sure all the due diligence documentation is reviewed and nothing is missed. If a category does not apply to a particular investment under consideration, simply skip it.
What to Consider as Part of the Due Diligence Process
- Executives Backgrounds: Conduct a thorough investigation of the backgrounds of all people in a C-level executive or ownership position. Conduct a legal review of all employment contracts and identify any “golden parachute” provisions, which are the benefits that must be paid upon early termination of an executive.
- Financials: Conduct a financial audit of the operations for the previous three to five years, if when possible.
- Human Resources: Evaluate all employees and employment contracts. Note things like employee turnover, vacant positions, excessive payroll (over-time), and benefits. Consider the ramifications of any ongoing or potential labor disputes.
- Corporate Assets: Review the detailed schedule of assets and their valuations. Physically inspect hard assets to verify their existence and condition. Use third-party appraisers to determine the estimated value of the assets if they were sold in a scheduled liquidation. Check inventory values and look for any needed write-downs for any unsold inventory that will never sell.
- Intellectual Property: Evaluate the current status and then estimate the value of patents, trademarks, brand names, and trade secrets.
- Customers and Market Analysis: Identify the company’s best customers and those who are repeat business. Check to see if the customer base is diversified across industries and locations. Make a list of any customers that represent 5% or more of the annual sales. Conduct a market analysis to determine market share and the threat from competitors.
- Products and/or Services: Evaluate the product line(s) and/or services offered. Are the products innovative with a continual stream of new products in development or is the product line stagnant? Are the services offered, if any, in high demand. Is the demand for products and/or services expected to continue, to increase, or to decrease?
- Regulatory, Political, and Currency Exchange Risks: Examine regulatory compliance issues to look for violations of existing regulations. Consider the possibility of new regulations in the future and how they might impact the business. Consider the current and potential political circumstances and how any changes in global politics may harm a company. If a company does business internationally, consider currency exchange risk. Determine if this risk can be hedged to reduce the financial impact of currency rate changes.
- Environmental Concerns: Evaluate any environmental risk that might be experienced by the company and the compliance issues that may arise from these risks. Consider the effect of severe weather, flooding, and business interruption caused by climate change that impacts the operations of the business.
- Taxes: Conduct an audit of the tax returns for the past three to five years. Identify any IRS problems with any tax returns that are under IRS audit. Discover any unpaid tax liabilities. Estimate any penalties and interest due, if applicable. Determine the value of any net operating loss carry-forward, unused deductions, and tax credits.
- Legal: Check to see if the registration of the company is current, the business license is up-to-date, and the company is in good standing. Investigate any ongoing legal matters and lawsuits. Evaluate the potential risks of lawsuits in the future. Check for proper legal documentation of the company’s records such as the minutes of the company’s board meetings for the past three years.
- Strategic Fit: This is one area that is potentially the most important. For an M&A deal, this requires careful consideration of the culture of the company that will be acquired, especially if the operations are going to be combined. The same goes for investing in a particular asset. The numbers may look good on paper; however, if the investment is not a good fit for the investors, the real-life results may not be beneficial.
That’s the first step. But due diligence doesn’t stop there.
Here are some advanced due diligence techniques used by some of the most active and successful venture capital investors in the world.
- The Character of the Principals: For startups, there is no historical data to evaluate. The only thing an investor may evaluate is the character of the principles. If they are serial entrepreneurs who succeeded before, then this helps an investor have confidence that they might succeed again. Use this same logic when evaluating investing even in the stock of an established company.
- Use Professional Help: For any due diligence evaluation, use appropriate legal, tax, accounting, and industry experts to contribute their evaluation efforts. Ask them to make a due diligence recommendation regarding the area of their expertise.
- Insurance: Insurance should be used to reduce the risk as much as possible. For example, having business interruption insurance, which pays the bills if the company cannot operate normally due to circumstances beyond the company’s control, is an exceptional idea.
- SWOT Analysis: A SWOT analysis is an evaluation of an investment’s strength, weakness, opportunity, and threats. Sometimes a “Big Picture” analysis is the most effective.
- Industry Disruption: Think about the potential threat of industry disruption. If the business is an industry disrupter, it may have an advantage that is not seen by others.
- Worst-Case Scenario: The worst-case scenario of investing may not be just the complete loss of the money. There may be extenuating circumstances that create excessive liability for investors. These risks may extend the financial loss to an amount greater than the investment made.
This extraordinary risk should be avoided as much as possible and may be limited by how the ownership of the investment is legally held.
Some may feel that the due diligence process is tedious; however, finding an unseen and counter-intuitive risk may save an investor from a considerable loss. Therefore, it is always recommended that due diligence be thoroughly conducted for any investment.