Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and 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 to provide the buyer with an assurance of what they’re getting.
Importance of Due Diligence
Transactions 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 their 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’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports 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 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.
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: