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The due diligence process can be frustrating and lead to reams of paperwork and extra costs if not done properly. However, with the steps we cover in this article, your process should go more smoothly.
Table of Contents
Introduction: What is Due Diligence Reporting?
Due diligence is an investigation, verification or audit of a potential investment (such as a stock) or deal.
It is done to confirm all relevant details and facts, as well as anything brought up before the completion of an investment process or merger and acquisition (M&A) deal. Such details can include items such as:
Past company performance
Anything else considered important
The due diligence process is finished before a deal closes so that the buyer can be provided an assurance of what they will be receiving. For individuals, financial due diligence is not necessary, but it is recommended.
Due diligence is performed by the following:
Companies considering acquiring other companies
Equity research analysts
Examples of various kinds of due diligence would include:
A company conducting an exhaustive examination of a different organization to determine whether it is a worthy investment prior to a merger.
An individual inspecting a property before buying it.
An underwriter auditing a business before selling it.
Why is Due Diligence Important?
For the Buyer
The due diligence process reassures the buyer of their expectations regarding transactions. Particularly in M&A, buying a business without due diligence could pose a substantial risk.
For the Seller
The process of a rigorous financial examination might reveal that the fair market value is more than originally thought. Hence, it is fairly common for sellers to conduct due diligence before transactions.
Types of Due Diligence
Not every due diligence is financial (though that is what we are focusing on). To get a comprehensive understanding of due diligence, however, it is important to know the various types.
Note that different types of due diligence may be carried out by different kinds of organizations or companies.
For example, legal due diligence would be carried out by a law firm that may also have special expertise in conducting such an exercise, whereas financial due diligence would usually be conducted by an accounting and audit firm.
Companies investigate financial records’ accuracy in the Confidentiality Information Memorandum (CIM). The aim is to gain an understanding of financial stability and performance and finding any potential issues.
Items audited might include inventory schedules, financial statements, and company projections and forecasts.
Human Resources (HR)
HR due diligence focuses on a company’s employees. It is meant to understand:
Compensation & benefits
Harassment accusations or controversial terminations
Union contracts, if any
This involves an examination of an organization’s operations to evaluate assets, facilities, the condition of the tech, and potential liabilities or risks.
In the strategic fit due diligence process, there is an assessment of whether a target company will be suitable regarding their objectives and goals. The buyer assesses:
How well the two entities might merge together
Advantages of the transaction
This identifies both the company’s customers and its industry. It helps to predict the risks and impact the transaction may pose to the purchaser’s current customers.
Legal due diligence assesses corporate document, compliance doctrines, board minutes of meetings, and contracts. It has the aim of determining whether a target company is knee-deep in issues or legally subservient.
This verifies whether a company’s equipment, facilities and processes comply with environmental regulations. Environmental due diligence helps to negate or reduce the risk of penalties, which can range from small fines to plant closures.
Self-assessment due diligence is often overlooked by companies, but it is highly important. It should be conducted even at the onset of considering an integration or investment.
Here, companies ask themselves what they need or want from a transaction.
This concludes the main types of due diligence. Note that in M&A, you may also have the following types:
6 Key Steps for a Seamless Due Diligence Process
While the full scale of due diligence preparation would lead to an article several pages long, there are some key steps that you should always include.
Bear in mind that exhaustiveness and thoroughness should always be at the forefront of your mind when conducting due diligence, no matter the step. Furthermore, investors should err on the side of caution and imagine the worst-case scenarios’ potential effects on the stock.
1. Company Capitalization
The first step is to form a comprehensive diagram or picture of the organization you are researching. Hence, you will want to examine the organization’s market capitalization, which will show how large the organization is. This is done by calculating the total market value of its outstanding shares.
Market capitalization will help to predict the volatility of the stock, the potential size of the end markets, and the broadness of the ownership. As an example, large-cap organizations are likely to have less volatility and more stable revenue streams than small-cap and mid-cap organizations.
Note that at this stage of the due diligence process you generally do not make judgements about the stock, but focus on obtaining information for later stages.
Another vital thing to do is check the stock exchange that the shares trade on. Are they based in the country? Are they American Depository Receipts (ADRs) that have another listing on a foreign exchange? (If this is the case, they will usually have “ADR” written in the title of the share listing.)
All this information will help you determine some basic facts, such as whether or not you can own shares in your current investment accounts.
2. Analyze Business Financials
This step involves an exhaustive audit of all financial records to make sure that documents in the Confidentiality Information Memorandum (CIM) are correct. It also helps to determine the company’s financial performance and stability, assess asset health, and pinpoint red flags.
The financial checklist for due diligence includes inspecting the following:
Tax forms & documents
Future projections & forecasts
Stock history & options
Long & short-term debts
Trends in profit, growth and revenue
Valuation ratios & multiples compared to industry benchmarks & competitors
3. Management & Ownership
You will want to answer some critical questions about the company’s ownership and management. For example, is it still run by its founders, or have many new faces been shuffled by the board and management?
Consider the age of the company – founding members often stick around in younger companies.
See what kind of broad experiences the top managers have via their consolidated bios. You should be able to locate this information on the company website or in its Securities & Exchange Commissions (SEC) filings.
Find out whether the managers and founders hold a high proportion of shares.
Check the amount of float held by institutions.
Percentages of institutional ownership can indicate the amount of analyst coverage of the company, as well as factors affecting trade volumes.
Generally, consider low personal ownership by top managers a possible red flag and high ownership a plus. Shareholders are usually best served when management has a stake in the stock performance.
4. Examination of Balance Sheet
A cursory examination of your company’s consolidated balance sheet will suffice at this stage.
The aim is to review the levels of assets and liabilities (pay attention to cash levels) and the amount of long-term debt. Remember that a lot of debt is not invariably a bad thing, and depends on the business model of the company.
It is vital to understand both company-specific and industry-wide risks. Ask yourself the following questions:
Is management making decisions that are leading to revenue increase?
Is the company environmentally-friendly? What long-term risks could result from it taking or not taking eco-friendly initiatives?
Are there any outstanding regulatory or legal matters?
5. Centralize the Information
Your due diligence reporting will go more smoothly if you have all your information and documentation in a central repository.
You can upload electronic files and scans into a secure drive, or create physical copies and files.
How Long is the Due Diligence Period?
There is no one answer to this. However, due diligence preparation should last only between 30 and 60 days, as you want to close the deal as soon as possible. Having said that, thoroughness will still be required, and it is best if you delegate the work to an efficient and dynamic team.
Bear in mind that some issues might still only be uncovered after integration – one cannot identify every issue and potential complication during due diligence.
If you are still in doubt, you might want to hire financial consulting services, which can answer many of your questions.
The above is in no way a comprehensive list, but it will help you immensely in conducting your due diligence. Remember that there will be specifics that you will want to investigate further.
Forewarned is forearmed, so make sure you are not leaving yourself vulnerable to renegotiations and endless paperwork.
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