Due Diligence: Definition, Process and Checklist

Whether you are an investor or a business founder thinking of selling her company, the due diligence process is 100% crucial. In this article we will show you exactly what due diligence is, how it works step by step, when and how it should be done, and other legal information that will help you perfectly understand how to navigate through this procedure.

What exactly is due diligence?

 

Due diligence is the process of investigation and analysis that an investor interested in acquiring or investing in a company carries out to understand the true situation of the company (whether at the operational, legal, financial, or commercial level) and to discover possible risks associated with the operation.

That is to say, it is the examination that the investor will make before disbursing the agreed economic amount to understand the real state of all the business units, thus finding any detail that could have been hidden in the previous negotiations.

Thus, basically, it aims to:

• Evaluate the investment opportunity (whether it is going to be truly profitable and to what extent)
• Find out the risks associated with the operation, and which is their nature (to determine if they would be too much of a burden for an optimal future).
• Finally, and most importantly, determine the appropriate price or valuation of the company

Although in most cases this due diligence is carried out by the buyer or investor, it is true that the entrepreneur or owner of the business to be sold can also investigate the fund or counterpart, performing the same analysis procedure. In this case, he would analyze:

• Where the investor’s funds come from
• What is her specialty (this is especially important in those investment situations where we want the new partner to advise us in the day-to-day operations of the company, benefiting from her expertise)
• Which entrepreneurs have been funded before and how did the process develop

We must also take into account that it is usual to perform a due diligence process in corporate restructurings, acquisitions, or mergers.

 

What is the purpose of due diligence?

 

On numerous occasions the entrepreneur or founder of a company finds himself selling his business idea to an investor or potential buyer.

In order to achieve this goal of receiving financing from the investor or to materialize the sale at the highest possible price, the business owner hands out a prepared sales pitch through an elaborate and persuasive presentation.

Obviously, it is always the case that all the financial projections presented show positive results, and the transmitted image of the company is very promising.

How else would someone invest in it?

Due diligence is the process that assures the investor or buyer that those “nice” numbers he has seen in the presentation or pitch are indeed true.

In other words, this “audit” helps the investor to understand the reality of the company, but this time by looking at and analyzing real numbers through internal real information and official documents.

It serves him to identify possible risks (after seeing the situation of all the departments of the company), having a more complete and true picture of where he is going to put his money. Something that, at that scale, is crucial. 

 

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How does the process work?

 

We can divide the process into three different parts.

First of all, an application or request is initiated by the future investor/buyer so he has permission to enter and perform the analysis. In other words, the first thing is to get the company’s authorization to “audit” or analyze in order to start the process.

Once the investor receives explicit acceptance, he can start the investigation.

From then on, the company is obliged to be totally transparent and provide the requested information. In case of not acting in good faith (a very recurrent term in the legal world), it may be sanctioned and forced to pay compensation.

What do we mean by not acting in good faith?

Basically hiding information, not showing any detail that may be relevant to the investor, or preventing the investor from continuing with the process in a normal manner.

After investigating and analyzing all the relevant information, the specific values that were to be investigated are extracted, usually through a detailed report (most often a financial report and another of intellectual capital, although it can also be labor, commercial, technological, legal, etc.) in order to be able to draw detailed conclusions and use them for decision making.

Of course, everything is accompanied by a confidentiality agreement by both parties. That is because the sheer depth of this research generates a situation in which the investor will end up having “insider” information which he could use for his own benefit.

 

Who actually performs the due diligence?

 

As we have just seen, at the heart of any due diligence is the hands-down job of going to the company in person to audit and conduct all relevant investigations.

But who will actually do it?

It will be the buyer or investor who designates the ones in charge.

Usually, it is lawyers (especially for the legal part), auditors (for the accounting and financial projection part), or consultants (with a much more integral and holistic profile).

Depending on the magnitude of the deal and the size and type of company, requiring one type of professional or another will be necessary.

 

How long does it last?

 

Generally speaking, due diligence can take up to 1 or 2 months maximum.

The faster the better. And this is because all the issues this procedure implies for the company being investigated.

There is no doubt that due diligence is an exhaustive analysis process, which will involve several members of the company, having to paralyze their normal day-to-day activity.

That is why the faster and shorter the process, the less interference with the normal functioning of the company, which is the main objective at all times.

 

Types of due diligence

 

What types of due diligence are there and mostly used? Generally speaking, there are many. Basically one for each of the areas of the company we want to analyze. So you could come up with tens of them.

All in themselves are important, since the hidden aspects of a company that would make the investment/purchase less valuable can be hidden inside any area.

However, those that are used the most in the purchase and sale of a company are the operational financial ones. But, in addition, we can also find:

• Fiscal
• Administrative
• Commercial
• Commercial
• Labor
• Environmental
• Real Estate

Thus, each of the types of due diligence refers to the area of the business being analyzed.

The last case in this list deserves special mention. As we have already seen in the process of buying and selling a property, due diligence in the real estate world refers to a situation report that is carried out on a property that is going to be sold (instead of a company) in which it is already reviewed and analyzed legally, from a technical and environmental point of view, in order to identify possible contingencies.

 

What do we analyze in financial due diligence?

 

The financial and operational type of due diligence deserves special mention, since in many cases it is the most relevant and most frequently used.

As we have already mentioned, there are notably extensive due diligence procedures that analyze each and every aspect of the different business units of the company in order to achieve the most realistic and complete report possible.

However, in practice, most of them focus on those aspects that are most interesting to the investor: revenues, costs, operations, and financial structuring of assets and liabilities.

What would you look at for each of these areas?

Firstly, from the point of view of income, you would analyze the current sales that the company is generating and its track record, taking into account whether the future projection is growing. In addition, in order to verify this, an audit is carried out in which the main relevant documents are analyzed: receipts, invoices, accounting, and bank statements, etc.

Then we have the whole section of costs, fundamental to understand which are the fixed and variable costs that the business needs to operate on a daily basis. This is complemented by receipts and invoices for purchases, active rental contracts, electricity and telephone bills, etc.

Finally, everything related to operations. That is to say, any detail that could prevent the company from working and continuing to operate functionally. Here we can check whether the company has the appropriate licenses and if it works within the legal framework, if the necessary know-how is available to all workers or if it is concentrated only in the hands of the CEO, etc.

Each company is a completely different world, and the specific analysis will depend on the particular case. However, these 3 pillars are always fundamental to understanding the “health” of the target company.

 

Due diligence lawyer

 

So far the functioning of the due diligence process.

It is very likely that after reading this article you will still have doubts. And, in fact, you should: it is a very important part of the buying and selling process and deserves very special attention.

That’s why having a specialized lawyer at your side can be the best alternative to avoid any problems in the future and ensure long-term success.

Therefore, our team of business lawyers is at your complete disposal to help and advise you step by step. We want to be your due diligence lawyers.

 

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