Due Diligence

What is Due Diligence?

Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all facts, financial informationThree Financial StatementsThe three financial statements are the income statement, the balance sheet, and the statement of cash flows. These three core statements are intricately linked to each other and this guide will explain how they all fit together. By following the steps below you'll be able to connect the three statements on your own., and to verify anything else that was brought up during an M&A dealMergers Acquisitions M&A ProcessThis guide takes you through all the steps in the M&A process. Learn how mergers and acquisitions and deals are completed. In this guide, we'll outline the acquisition process from start to finish, the various types of acquirers (strategic vs. financial buys), the importance of synergies, and transaction costs or investment processEquity Research vs Investment BankingEquity research vs Investment banking. When looking at a career in the capital markets it’s important to understand if you’re a better fit for investment banking or equity research.  Both offer excellent work experience and great pay, but choosing one over the other really comes down to personality.  Due diligence is completed before a deal closes to provide the buyer with an assurance of what they’re getting.

Importance of Due Diligence

TransactionsDeals & TransactionsDue diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all facts, financial information, and to verify anything else that was brought up during an M&A deal or investment process.  Due diligence is completed before a deal closes that undergo a due diligence process offer higher chances of success. Due diligence contributes to making informed decisions by enhancing the quality of information available to decision makers.

From a buyer’s perspective

Due diligence allows the buyer to feel more comfortable that his or her expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.

From a seller’s perspective

Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reportsDue Diligence ReportExample due diligence report on M&A transactions. This DD report is for M&A due diligence provides a list of questions to be answered prior to close. A due diligence report is sent as an internal memo to members of the executive team who are evaluating the transaction and is a requirement for closing the deal. themselves prior to potential transactions.

Reasons For Due Diligence

There are several reasons why due diligence is conducted:

• To confirm and verify information that was brought up during the deal or investment process
• To identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
• To obtain information that would be useful in valuing the deal
• To make sure that the deal or investment opportunity complies with the investment or deal criteria

Costs of Due Diligence

The costs of undergoing a due diligence process depend on the scope and duration of the effort, which depends heavily on the complexity of the target company. Costs associated with due diligence are an easily justifiable expense compared to the risks associated with failing to conduct due diligence. Parties involved in the deal determine who bears the expense of due diligence. Both buyer and seller typically pay for their own team of investment bankers, accountants, attorneys, and other consulting personnel.

Due Diligence Activities in an M&A Transaction

There is an exhaustive list of possible due diligence questions to be addressed. Additional questions may be required for industry-specific M&A deals while fewer questions may be required for smaller transactions. Below are typical due diligence questions addressed in an M&A transaction:

1. Target Company Overview

Understanding why the owners of the company are selling the business –

• Why is the owner selling the company?
• Have there been efforts to sell the company before?
• What are the business plan and long-term strategic goalsCorporate StrategyCorporate Strategy focuses on how to manage resources, risk and return across a firm, as opposed to looking at competitive advantages in business strategy of the company?
• How complex is the company (in terms of products, services, subsidiaries)?
• Has the company recently acquired or merged with other companies?
• What is the geographical structure of the company?

2. Financials

Examining historical financial statements and related financial metrics, with future projections

• Are the financial statements auditedAudited Financial StatementsPublic companies are obligated by law to ensure that their financial statements are audited by a registered CPA. The purpose of the independent audit is to provide assurance that the management has presented financial statements that are free from material error.  Audited financial statements help decision makers?
• What do the financial statements imply about the financial performance and condition of the company?
• Are marginsOperating Profit MarginOperating Profit Margin is a profitability, or performance, ratio used to calculate the percentage of profit a company produces from its operations, prior to subtracting taxes and interest charges. It is calculated by dividing the operating profit by total revenue, and expressed as a percentage. for the company increasing or decreasing?
• Are future projections reasonable and believable?
• What amount of working capitalNet Working CapitalNet Working Capital (NWC) is the difference between a company's current assets (net of cash) and current liabilities (net of debt) on its balance sheet. It is a measure of a company’s liquidity and its ability to meet short-term obligations as well as fund operations of the business. The ideal position is to is required to run the company?
• What are the current capital expendituresHow to Calculate CapEx - FormulaThis guide shows how to calculate CapEx by deriving the CapEx formula from the income statement and balance sheet for use in financial modeling and analysis. To calculate capital expenditures, use depreciation on the income statement, add current period PP&E and subtract prior period PP&E. This guide has examples and and investments?
• What amount of debt is outstanding and what are its terms?
• Is there any unusual revenue recognitionRevenue Recognition PrincipleThe revenue recognition principle dictates the process and timing by which revenue is recorded and recognized as an item in the financial statements.?
• Does the company have enough financial resources to cover the cost of transaction expenses for the deal?

3. Technology/Patents

The quality of the company’s technology and intellectual property

• What patents does the company have?
• What trademarks does the company have?
• What copyrighted products and materials does the company use or own?
• How are trade secrets preserved?

4. Strategic Fit

How the company will fit into the buyer’s organization

• What synergiesTypes of SynergiesM&A synergies can occur from cost savings or revenue upside. There are various types of synergies in mergers and acquisition. This guide provides examples. A synergy is any effect that increases the value of a merged firm above the combined value of the two separate firms. Synergies may arise in M&A transactions will be obtained?
• What products or services will be provided that the buyer does not already have?
• Will there be a strategic fit?

5. Target Base

The company’s target consumer base and the sales pipeline

• Who are the company’s top customers?
• What consumer risks are apparent for the company?
• Are there warranty issues, and what is the customer backlog?

6. Management/Workforce

The company’s management, employee base, and corporate structureCorporate StructureCorporate structure refers to the organization of different departments or business units within a company. Depending on a company’s goals and the industry which it operates in, corporate structure can differ significantly between companies. Each of the departments usually performs a specialized function

• What is the current compensationCompensationDue diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all facts, financial information, and to verify anything else that was brought up during an M&A deal or investment process.  Due diligence is completed before a deal closes structure for officers, directors, and employees?
• What are the current employee benefits?
• What are the management incentives or bonuses?
• What are the policies and employee manuals?
• Detailed background on the company’s CEOCEOA CEO, short for Chief Executive Officer, is the highest-ranking individual in a company or organization. The CEO is responsible for the overall success of an organization and for making top-level managerial decisions. Read a job description and CFOWhat Does a CFO DoWhat does a CFO do - the job of the CFO is to optimize a company's financial performance, including: reporting, liquidity, and return on investment. Within a company, these responsibilities fall into departments typically known as the controller's group, treasury, and financial planning and analysis (FP&A)

7. Legal Issues

Pending, threatened, or settled litigation

• What is the nature of any pending or threatened litigation?
• What claims, if any, are there against the company?
• Settled litigations and the terms of settlements
• Are there any governmental proceedings against the company?

8. Information Technology

Capacity, systems in place, outsourcing agreements, and recovery plan of company’s IT

• What softwareFinancial Modeling SoftwareFinancial modeling software is likely to be more incorporated in financial modeling, but will not replace Excel when it comes to bespoke analysis packages are being used by the company?
• What are the annual IT maintenance costs?
• What is the capacity of the usage level of existing systems?
• Is there a disaster recovery plan in place?

9. Corporate Matters

Review of organizational documents and corporate records

• Charter documents of the company
• Who are the current officers and directors?
• Who are the security holders (holders of optionsStock OptionA stock option is a contract between two parties which gives the buyer the right to buy or sell underlying stocks at a predetermined price and within a specified time period. A seller of the stock option is called an option writer, preferred stocksCost of Preferred StockThe cost of preferred stock to a company is effectively the price it pays in return for the income it gets from issuing and selling the stock. Download the free calculator template to determine the cost of preferred stock based on the company's preferred dividend payment, share price, warrantsStock WarrantsStock warrants are options issued by a company that trade on an exchange and give investors the right (but not obligation) to buy the company’s stock at a specific price within a stipulated period. When an investor exercises a warrant, they purchase the stock, and these proceeds are a source of capital for the company.) of the company?
• Are there subsidiaries of the company?
• Current stockholdersStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, we get Stockholders Equity = Assets – Liabilities and voting agreements
• Are securities properly issued and in compliance with applicable laws?
• Are there any recapitalizationRecapitalizationRecapitalization is a type of a corporate restructuring that aims to change a company’s capital structure. Usually, companies perform recapitalization to make the capital structure more stable by exchanging one type of financing for another. One example is when a company issues debt to buy back equity shares. or restructuring documents?

10. Environmental Issues

Environmental issues that the company faces and how it may affect the company

• Are there hazardous substances/materials used in the company’s operations?
• Does the company have environmental permits?
• Are there any environmental claims or investigations related to the company?
• Are there contractual obligations relating to environmental issues?

11. Production Capabilities

Review of the company’s production-related matters

• Who are the company’s most significant subcontractors?
• Who are the company’s largest suppliersBargaining Power of SuppliersThe Bargaining Power of Suppliers, one of the forces in Porter’s Five Forces Industry Analysis Framework, is the mirror image of the bargaining power of buyers and refers to the pressure suppliers can put on companies by raising their prices, lowering their quality, or reducing the availability of their products?
• What is the monthly manufacturing yield?
• What materials are used in the production process?
• Are there agreements or arrangements related to testing of company products?

12. Marketing Strategies

Understanding the company’s marketing strategies and arrangements

• Are there any franchise agreements?
• What are the current marketing strategies in place?
• Sales representative, distributor, and agency agreements?

Why Due Diligence Matters

Due diligence helps investors and companies understand the nature of a deal, the risks involved, and whether the deal fits with their portfolio. Essentially, undergoing due diligence is like doing “homework” on a potential deal and is essential to informed investment decisions.

Other Resources

We hope that reading CFI’s guide to due diligence has been helpful to you. To continue learning more and advancing your financial education, see the following free resources from CFI:

• M&A Considerations and ImplicationsM&A Considerations and ImplicationsWhen conducting M&A a company must acknowledge & review all factors and complexities that go into mergers and acquisitions. This guide outlines important
• Forensic Audit GuideForensic Audit GuideA Forensic Audit is a detailed audit of a company's records to be used in a court of law in a legal proceeding. Accountants, lawyers, and finance professionals are all involved. In such an audit, they will be looking for corruption, conflicts of interest, bribery, extortion, asset misappropriation, financial fraud
• Merger Consequences AnalysisMerger Consequences AnalysisMerger consequences analysis assesses the financial impact a merger or acquisition may have on a company. These must be carefully considered before
• Financial Modeling and Valuation Analyst GuideFMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy.