Due Diligence FAQs
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Due Diligence FAQs
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General F.A.Q
Due diligence is a process or effort to collect and analyze information before making a decision. It is a process often used by investors to assess risk. It involves examining a company’s numbers, comparing the numbers over time, and benchmarking them against competitors to assess an investment’s potential in terms of growth.
Due diligence is primarily a way to reduce exposure to risk. The process ensures that a party is aware of all the details of a transaction before they agree to it. For example, a broker-dealer will give an investor the results of a due diligence report so that the investor is fully informed and cannot hold the broker-dealer responsible for any losses.
Depending on its purpose, due diligence takes different forms. A company that is considering an M&A will perform a financial analysis on a target company. The due diligence might also include an analysis of future growth. The acquirer may ask questions that address the structuring of the acquisition. The acquirer is also likely to look at the current practices and policies of the target company and perform a shareholder value analysis. Due diligence can be categorized as “hard” due diligence, which is concerned with the numbers on the financial statements, and “soft” due diligence, which is concerned with the people within the company and its customer base.
A due diligence checklist is an organized way to analyze a company. The checklist will include all the areas to be analyzed, such as ownership and organization, assets and operations, the financial ratios, shareholder value, processes and policies, future growth potential, management, and human resources.
Examples of due diligence can be found in many areas of our daily lives. For example, conducting a property inspection before completing a purchase to assess the risk of the investment, an acquiring company that examines a target firm before completing a merger or acquisition, and an employer performing a background check on a potential recruit.
Other Questions
In an M&A deal, hard due diligence is the battlefield of lawyers, accountants, and negotiators. Typically, hard due diligence focuses on earnings before interest, taxes, depreciation and amortization (EBITDA), the aging of receivables, and payables, cash flow, and capital expenditures.
In sectors such as technology or manufacturing, additional focus is placed on intellectual property and physical capital.
Other examples of hard due diligence activities include:
- Reviewing and auditing financial statements
- Scrutinizing projections for future performance
- Analyzing the consumer market
- Seeking operating redundancies that can be eliminated
- Reviewing potential or ongoing litigation
- Reviewing antitrust considerations
- Evaluating subcontractor and other third-party relationships
Conducting soft due diligence is not an exact science. It should focus on how well a targeted workforce will mesh with the acquiring corporation’s culture.
Hard and soft due diligence intertwine when it comes to compensation and incentive programs. These programs are not only based on real numbers, making them easy to incorporate into post-acquisition planning, but they can also be discussed with employees and used to gauge cultural impact.
Soft due diligence is concerned with employee motivation, and compensation packages are specifically constructed to boost those motivations. It is not a panacea or a cure-all, but soft due diligence can help the acquiring firm predict whether a compensation program can be implemented to improve the success of a deal.
Soft due diligence can also concern itself with the target company’s customers. Even if the target employees accept the cultural and operational shifts from the takeover, the target customers and clients may well resent a change in service, products, or procedures. This is why many M&A analyses now include customer reviews, supplier reviews, and test market data.
When considering investing in a startup, some of the 10 steps above are appropriate while others just aren’t possible because the company doesn’t have the track record. Here are some startup-specific moves.
- Include an exit strategy. Plan a strategy to recover your money should the business fail.
- Consider entering into a partnership: Partners split the capital and risk, so they lose less if the business fails.
- Figure out the harvest strategy for your investment. Promising businesses may fail due to a change in technology, government policy, or market conditions. Be on the lookout for new trends, technologies, and brands, and get ready to harvest when you find that the business may not thrive with the changes.
- Choose a startup with promising products. Since most investments are harvested after five years, it is advisable to invest in products that have an increasing return on investment (ROI) for that period.
- In lieu of hard numbers on past performance, look at the growth plan of the business and evaluate whether it appears to be realistic.
Due diligence is required once a deal has been agreed in principle but before any contracts are signed or the deal finalized. The outcome of the due diligence period should determine if the transaction can go ahead as planned, whether any re-negotiation is required first, or if the deal should be abandoned.
Perhaps one of the most frequently asked questions, due diligence can take anything from 15 days to 6 months. The length of time will vary by company type, size and of course the complexity of the potential deal. Having the right mix of advisors and experts on the due diligence team is important to keeping timings on track.