Due diligence is a program of critical analysis that companies undertake prior to making business decisions in such areas as corporate mergers/acquisitions or major product purchases/sales. The due diligence process, whether outsourced or executed in-house, is in essence an attempt to provide business owners and managers with reliable and complete background information on proposed business deals, whether the deal in question is a proposed acquisition of another company or a partnership with an international distributor, so that they can make informed decisions about whether to go forward with the business action. "The [due diligence] process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers, and key developers," wrote Lee Copeland in Computerworld. The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business action under consideration.
Many companies undertake the due diligence process with insufficient vigor. In some cases, the prevailing culture views it as a perfunctory exercise to be checked off quickly. In other instances, the out-come of the due diligence process may be tainted (either consciously or unconsciously) by owners, managers, and researchers who stand to benefit personally or professionally from the proposed activity. Businesses should be vigilant against letting such casual or flawed attitudes impact their own processes, for an efficient due diligence process can save companies from making costly mistakes that may have profound consequences for the firm's other operational areas and/or its corporate reputation.
The due diligence process is applied in two basic business situations: 1) transactions involving sale and purchase of products or services, and 2) transactions involving mergers, acquisitions, and partnerships of corporate entities. In the former instance, purchase and sales agreements include a series of exhibits that, taken in their entirety, form due diligence of the purchase. These include actual sales contracts, rental contracts, employment contracts, inventory lists, customer lists, and equipment lists. These various "representations" and "warranties" are presented to back up the financial claims of both the buyer and seller. The importance of this kind of due diligence has been heightened in recent years with the emergence of the Internet and other transformative technologies. Indeed, due diligence is a vital tool when a company is confronted with major purchasing decisions in the realm of information technology. "A due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a high-end system," said Copeland.
In cases of potential mergers and acquisitions, due diligence is a more comprehensive undertaking. "The track track record of past operations and the future prospects of the company are needed to know where the company has been and where its potential may carry it," explained William Leonard in Ohio CPA Journal. In addition, observers note that the dramatic increase in information technology (IT) in recent years has complicated the task of due diligence for many companies, especially those engaged in negotiations to buy or merge with another company. After all, system incompabilities can require huge amounts of time, money, and personnel resources to integrate.
Leonard notes that traditional due diligence practices in acquisition/merger scenarios called for detailed examination of financial statements, accounts receivable, inventories, workers compensation, employment practices and employee benefits, pending and potential litigation, tax situation, and intellectual property prior to signing on the dotted line. But in this dynamic business era, other areas should be looked at as well, including (if applicable): intellectual property rights, new products in the production pipeline, status of self-funded insurance programs, compliance with pertinent ordinances and regulations, competition, environmental practices, and background of key executives/personnel.
Many business experts also caution that the due diligence process is incomplete if it does not incorporate an element of objective self-analysis. "Self-analysis is the fundamental first step to realistically determine whether the post-acquisition 'whole' will be greater than the sum of its part," wrote Aaron Lebedow in Journal of Business Strategy. A detailed assessment of the market that is the target of the proposed acquisition should also be undertaken prior to closing a deal. Both of these requirements can be completed in a reasonable period of time, even in today's fast-changing business environment, by companies that either 1) outsource the due diligence task to a reputable research firm or 2) build an efficient in-house program within their legal, marketing, or corporate security sectors. "Unquestionably, opportunities for growth through acquisition exist," stated Lebedow. "Exploiting these opportunities has risks, but to those companies that acquire only after a comprehensive and systemic assessment of the marketplace and competition, the rewards justify the risks. Limiting due diligence to financial and managerial review is rarely enough. Successful acquisition strategy depends on the structure and depth of the due diligence process."
Growing numbers of business enterprises are pursuing additional legal protection for themselves so as to shield themselves from harm if their due diligence efforts fail to uncover a serious problem with a merger or purchase transaction. One means of mitigating the risks associated with such major business transactions that has become increasingly popular in recent years is to secure a form of insurance coverage known as "representations and warranties liability insurance." A growing number of insurance underwriters are providing these policies, which call for them to pay insured parties for losses resulting from various "wrongful acts." This umbrella term generally covers errors, misstatements, misleading information, etc., but underwriters do include exclusions, some of which should be noted by potential buyers. These include acts of "fraud" (if adjudicated in the courts), pollution (which is typically covered under separate policies), or situations in which a party has received benefits—financial or otherwise—to which it is not entitled. One significant benefit of "representations and warranties liability" policies, however, is that the coverage can be used in place of reserves, escrow, or indemnity provisions that are included in purchase agreements.
Premiums for such policies can be expensive, especially for small and mid-sized firms with limited financial resources. Moreover, securing such insurance is a time-consuming and painstaking process, for underwriters are putting themselves at considerable financial risk. "Premiums will be determined based on the risk and the comfort level of the underwriter," summarized Leonard. ""It is most important that the process start early and not be left to a time when someone gets a 'feeling' things may not be entirely up to snuff. Although this type of coverage can be purchased after the closing, understandably the most beneficial time to place the coverage is during the due diligence phase preceding the closing."
Bernstein, Leopold A., and John J. Wild. Analysis of Financial Statements. McGraw-Hill, 2000.
Copeland, Lee. "Due Diligence." Computerworld. March 6,2000.
Kroll, Luisa. "Gotcha: Pushing the Limits of Due Diligence." Forbes. October 30, 2000.
Lebedow, Aaron L. "Due Diligence: More than a Financial Exercise." Journal of Business Strategy. January 1999.
Leonard, William J. "Representation and Warranties—When Due Diligence Fails." Ohio CPA Journal. January 2000.
Schilit, W. Keith. The Entrepreneur's Guide to Preparing a Winning Business Plan and Raising Venture Capital. Prentice Hall, 1990.