You may have heard the term "due diligence" while dealing with mergers and acquisitions (M&A) deals. Perhaps, you've heard the phrase in real estate, law, investments, or something similar. You may have even heard the term in an everyday situation, where someone said, "do your due diligence." No matter where you heard the term, the due diligence meaning has not changed. However, there are many types of due diligence.
To learn more about due diligence, what due diligence means, the types of due diligence, and how due diligence works, keep reading. We're going to cover all of this and more.
Below is everything we will cover. Feel free to skip ahead.
- Due diligence meaning
- What is contingent due diligence?
- What is due diligence in law?
- What is due diligence in business?
- What is due diligence in finance?
- How due diligence works
- What happens when due diligence expires?
- Areas of due diligence
- Types of due diligence
- Due diligence examples
Due diligence meaning
Due diligence refers to an investigation or an audit of a potential investment. Usually, a prospective buyer is backing this investment.
Successful due diligence involves confirming that the seller's information is correct. On top of this, the company may want to appraise the value of the investment. This can help the company understand whether or not the investment will be worth it over time.
These investments do not have to be specific to the financial industry. Companies can make investments in several different respects.
Most often, these companies are considering a merger and acquisition deal. Both the buyer and seller have to determine whether the deal is worth it and if the other company can complete it. Therefore, they undergo due diligence, whether voluntarily or by law.
Reasonable diligence meaning
Reasonable diligence refers to the fact that every situation is unique. No two situations should be identical. No two transactions should be identical.
In terms of a merger and acquisition, reasonable diligence refers to the fact that no two companies are the exact same. No two companies have the same capital, assets, liabilities, practices, or risk. As a result, the investigation for one company is not going to be the same as the investigation for another.
Due diligence meaning in English
In English, due diligence has a slightly different meaning. Individuals may use this form of due diligence in everyday situations.
Due diligence in everyday situations refers to how careful an individual is when they're in a particular situation. Usually, this individual is known for being rational. So, they're expected to give extra care in sensitive situations.
The phrase 'due diligence' dates back to the mid-1500s. The literal definition then was "requisite effort."
Since that strict definition, the meaning of due diligence has evolved to fit into the professional world. This includes business, law, financial, and other professional situations.
What is contingent due diligence?
Contingent due diligence refers to a situation in which a buyer shows interest in a seller. This is one of the protections that a buyer has when they're undertaking an investment or starting a contract.
Even if the buyer shows and confirms an interest in the seller, the final decision is contingent on what the buyer finds during their investigation. This gives the buyer the option to withdraw from the contract/agreement if they find something that turns them off from the deal.
Contingent due diligence is often found in real estate. The due diligence period represents the time during which the buyer visits the site/home and pays for property inspections. In turn, the closing price and outcome of the deal will depend on how those assessments go.
If the buyer discovers something that they do not like, they have the option to opt out of the deal.
What is due diligence in law?
Due diligence in law refers to investigations that are required by the law. This definition came about after the stock market crash of 1929. The enactment of the Securities Act of 1933 legally created lawful due diligence.
The government created this kind of due diligence to create more transparency in finance.
When this kind of due diligence came about, security brokers and dealers became liable for releasing data and information to the public. They had to be transparent about the things that they were selling to the public.
Now, security brokers and dealers have to audit their securities to assure that they are financially healthy. This helps protect the individuals that are looking to invest. It also reduces the risk that these individuals undertake.
Underwriters have to conduct the following:
- Conduct an audit of investments before the auction to ensure that they are sound
- Validate that all of the information disclosed in the documents are true
- Obtain legal assistance and opinion where applicable
- Investigate any potential problem areas
- Double-check that there are no contractual agreements that may hurt the transactions
By legally requiring these actions, these financial professionals are doing more to protect everyday citizens who may not know much about investment and similar financial topics.
What is due diligence in business?
When it comes to business, due diligence refers to the evaluation of costs and risks before completing a transaction. The business may be buying a new property, investing in new equipment, using a new process, or starting to work with another company.
Business audits help business professionals find and fix potential issues before they harm the company.
Business organizations can perform due diligence by completing tasks like the following:
- Looking into customer reviews
- Research the company's reputation
- Taking environmental impact into account
- Investing in insurances and warranties as needed or desired
- Comparing prices to competitors
By taking the time to protect themselves, these businesses can make more money while saving more money. Plus, they're going to be avoiding risks that they may not have even noticed prior to these safety measures.
What is due diligence in finance?
Due diligence in finance involves conducting a financial audit. This means that one company is taking the time to deeply evaluate another company's financial situation.
Usually, companies complete financial audits if they're considering entering into an agreement with the company that they're auditing. This agreement could be a merger, an acquisition, or a large investment.
Overall, a financial audit can help a company appraise another company's financial value. At the same time, that company can look into potential risks associated with the transaction.
When a company conducts a financial audit, they need to gather plenty of financial records and documents to analyze the company completely. These may include the following:
- Revenue trends
- Potential profit calculations
- Growth trends
- Stock history
- Options for stock
- Short-term debts of the company
- Long-term debts of the company
- Value in terms of the company's competitors
- Value in terms of the rest of the industry
- Balance sheets
- Income statements
- Cash flow statements
By gathering all of this information, institutions are more likely to make smarter financial decisions. The more information your company gathers, the better a decision it can make.
How due diligence works
The length of the process of due diligence varies depending on the situation. However, each due diligence process follows the same general format:
- Analyze what the project is meant to do
- Analyze the financial and business aspects of the project
- Look through and verify documents
- Analyze future steps and plans
- Conduct a risk analysis
- Create the final offering
- Continue monitoring the situation
If you're undergoing a legal agreement, you will find that all of this is available in your contract. This is especially true if you're undergoing a purchase agreement.
Within the contract, you'll find the following information:
- The length of the investigation
- The items that the other party is going to review
- The expiration date.
If the other party is going to conduct an audit, they are going to review financial records, assets, liabilities, operations, and more.
When it comes to due diligence for mergers and acquisitions, the process can be pretty lengthy and complex. If the investigation isn't completed correctly, the merger and acquisition are likely to fail.
This is why companies need to complete due diligence. Each party needs to understand the other side's value before they waste their resources on a deal that may fall through.
What happens when due diligence expires?
Many times, companies will create a Letter of Intent. Also known as an LOI, the Letter of Intent includes a Due Diligence Clause. This clause defines the following information:
- The parties involved
- The conduct that each party should expect during the investigation
- The rights of each party during the investigation
- What happens after commercial due diligence
The main problem that companies may come across is timing. Many companies can't complete a full investigation given the time constraint that institutions set forth in the LOI. This leaves the company without the necessary information.
If the buyer cannot complete the investigation in the amount of time on the agreement, they must decide the information they already have. Most of the time, this means that the deal falls through. Unless the buyer has accumulated most of the information, they may feel that they are rushing through a decision.
The buyer can request an extension to the commercial due diligence period if they feel that they need more time to gather and review information. However, the seller can decline. This is especially true if the seller thinks that the buyer had ample time to collect the information they needed.
If you're a buyer entering into a due diligence period, you need to make sure that you're practicing efficiency, productivity, and effectiveness. You don't want to rush, but you are on a deadline.
Areas of due diligence
Because companies use due diligence in many scenarios, there are multiple areas of due diligence to consider.
There are two main types of transactions in business:
- Purchasing or selling goods
- Merging with or acquiring another company
In both situations, the company is trying to determine whether or not the transaction is sound. This may involve examining the following:
- Customer reviews for the other company
When it comes to mergers and acquisitions, companies may undergo enhanced due diligence. This includes auditing the following items:
- Financial records
- Business plans and practices
- The customer base of the other company
- Products and services that the other company has
- Statistics for human resources
- Environmental impact of the other company
- Sustainability practices of the other company
Even with all of this investigation, businesses tend to fail in one area: self-assessment. As the title suggests, a self-assessment refers to when a company evaluates itself. Organizations look at what their needs are and what they could get from the transaction they're exploring.
If a business can assess itself correctly, this will likely lead to smarter financial and strategic decisions.
Types of due diligence
Audits should explore multiple dimensions within a company. Because these audits look at so many different areas, it can be challenging to determine where you should start.
That's why organizations have developed and defined eight different types of due diligence:
- Financial due diligence
- Legal due diligence
- Human Resources due diligence
- Operational due diligence
- Environmental due diligence
- Business due diligence
- Strategic fit due diligence
- Self-assessment due diligence
Let's look at each type of due diligence in detail.
1. Financial due diligence
Financial due diligence is one of the popular forms of due diligence. Arguably, it's one of the most critical forms as well.
In a financial audit, organizations review the accuracy of the financial records of another company. The companies will detail this financial audit in a Confidentiality Information Memorandum (CIM).
The goal is to review and understand the financial performance and stability of the other organization. As one company is conducting the financial audit, they may also find that there are other underlying issues that they need to address.
In a financial audit, a company may review the following documents:
- Financial statements of the other company
- Any forecasts or projections that the other company has put together
- Inventory schedules
By reviewing these documents, the buyer can evaluate whether or not the deal is worth it. If the other company does not seem to be financially sound, the buyer may choose to end the deal.
2. Legal due diligence
Legal due diligence involves looking at whether or not the company is following proper laws and procedures. If a buyer finds that the company they're looking to work with is wrapped up in legal trouble, the deal will likely fall through.
When conducting legal due diligence, a company may look at the following documents:
- Current contracts
- Corporate documents
- Board meeting minutes
- Compliance doctrine
If a buyer becomes involved with a seller with legal troubles, the buyer may become associated with the problem. This is why buyers conduct legal due diligence.
3. Human Resources due diligence
Human resources (HR) due diligence refers to an evaluation of the company's employees. Some organizations consider this one of the most important types of due diligence since it involves looking at the company's most important asset: people.
By undergoing HR due diligence, companies are trying to find out the following important information:
- The organizational structure of the company
- Compensation that the employees receive
- Benefits that the company gives to employees
- Any vacancies that may currently exist within the company
- Union contracts, if this is applicable to the company that you're evaluating
- Any harassment disputes ongoing or in the past
- Any wrongful terminations ongoing or in the past
By exploring this information, a company can determine whether or not the conditions within the company that they're looking to work with are good. If employees are unhappy, this could cause issues for the company buying. The buyer has to determine whether or not the purchase will be worth the potential drawbacks.
4. Operational due diligence
As the title suggests, operational due diligence refers to an evaluation of all of the company's operations. By doing this, the buyer is looking to get an inside look into the condition of the other company's technologies, facilities, and other assets.
At the same time, the evaluating company is looking for any risks or liabilities that may come with investing in this company.
5. Environmental due diligence
Environmental due diligence involves looking at a company's processes, equipment, and facilities. This kind of due diligence looks at whether or not these are in compliance with environmental regulations.
By evaluating a company's environmental condition, the buyer is protecting themselves from potential penalties in the future. Penalties for ignoring environmental regulations could range from small fines to closures.
6. Business due diligence
In business due diligence, the buying company looks at who the company's customers are. With this, they're looking at the industry that the business is a part of.
Having this information helps the buyer evaluate where the company lies within that industry. It also helps people look at the potential risks associated with gaining the company's current customers.
If a buying company doesn't know what industry they're entering into or what target audience they're going to acquire, they're going to be lost after the sale. Knowing these things ahead of time makes the transition into business activity easier after the deal potentially goes through.
7. Strategic fit due diligence
Strategic fit due diligence looks at whether or not the business acquisition strategy falls in line with your company's strategy. If not, then the sale may not be worth the hassle. There's no point in doing business with a company that isn't going to help your business in some way.
Looking at strategic fit requires the buyer to evaluate these qualities:
- Potential similar goals and objectives
- Potential like processes
- Benefits that would come with a successful transaction
- Whether or not the two companies would merge well together
The better the fit is, the better the merger would go. Strategic fit due diligence helps businesses that are making a potential purchase choose companies that are going to integrate well after the merger.
8. Self-assessment due diligence
Companies often ignore self-assessment due diligence. Businesses may think that they already understand their current condition. However, there may be issues that the business may be blind to without a self-assessment.
Whenever a business is going to start an investigation of another company, they need to conduct a self-assessment of their own business. During this self-reflective time, the business evaluates what they want/need from the transaction that they're going to make potentially.
Undergoing a self-assessment can help a business understand what its goals are in terms of a transaction. Understanding your own goals can help you enact strategic initiatives to make those goals realities.
Due diligence examples
With so many different types of due diligence, there are examples upon examples of due diligence in all industries and disciplines.
Here are some popular due diligence examples:
- A business conducts an investigation of another company to determine whether or not that other company is a sound investment
- A potential homebuyer pays for a home inspection before completing the purchase in order to make sure that the home is in good condition
- A consumer tests out a product in the store before he or she buys it
- An underwriter audits a business and its operations before he or she sells it
- An employed contacts an applicant's references before making an offer of employment
- An individual checks their bank account to ensure that there are no unusual purchases
- A consumer reads reviews online before purchasing a product or service
- A consumer compares prices between companies before making a purchase
- A business speaks with a lawyer about their professional opinion regarding a potential purchase
- An organization reviews the financial projections of a potential investment before making the purchase
Due diligence is all around us in everyday life and in the professional world. Look out for acts of due diligence in the office, with your friends, or in your own home.
The due diligence meaning is versatile. The term applies in every industry, with one of the most popular uses for mergers and acquisitions.
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