Business, Legal & Accounting Glossary
Due diligence is the research usually before a purchase to ensure that the assets are as expected and properly valued. The process of investigation, performed by investors, into the details of a potential investment, such as an examination of operations and management and the verification of material facts.
Due diligence is the effort a party makes to avoid harm to another party. Quite often a party in a contract may be obligated to provide due diligence.
An example of a “due diligence report” is a Phase I Environmental Site Assessment (ESA), which is performed to determine potential environmental conditions that may cause harm to the surrounding environment.
Due diligence is a formal investigation into any proposed investment. That investment can be a security, private equity capitalization, acquisition, merger, or any other contract. The term “due diligence” finds its roots in Section 11 of the U.S. Securities Act of 1933.
Although the Act does not mention “due diligence,” it stipulates that as long as an investment professional carried out and communicated the findings of due diligence on the securities they sold to private investors, the investment professionals could not be held liable for investor losses. Today due diligence is carried out by investors to find out whether the proposed investment is all that it claims to be. Due diligence into an investment may include enquiries into its real stock worth, management team, financial history, financial health, outstanding litigation, short-term and long-term processes, physical assets, strategic partnerships, credit status, revenue growth, valuation, and dozens of other legal and financial barometers. Due diligence usually falls to the investor or buyer, but sellers also do due diligence on buyers. For example, a seller may want to find out whether the buyer has the financial backing necessary to complete the transaction. Due diligence seeks to ensure that all parties have a comprehensive understanding of the quality of the investment.
In finance, for example, the term can refer to the activities of pension or investment fund managers in keeping track of the operations, solvency, and trustworthiness of the managers of a corporation in which their fund is invested, or those of the managers of an acquiring corporation toward a target corporation.
A “due diligence report” is often prepared to discover all risks and implications regarding a decision to be made. Information may be gathered by the due diligence team either by external analysis and research as is typical during due diligence for venture capital funding or information may be formally laid out using a secure data room used in due diligence for mergers and acquisitions.
In a real estate transaction, due diligence consists of the activities that follow execution of a sales contract and prior to close. The buyer is permitted to inspect the property to detect any items that might affect its value. His representatives inspect the title records to see that there are no encumberances.
When a business is acquired, the buyer sends his accountants to look over the books, and people usually visit all of the locations being purchased. They look to see that the properties exist, are properly equipped, and adequately maintained. They inspect the inventory of raw materials and products to see that they are present in the quantities specified and worthy of the value assigned. They look into real estate titles, intellectual property, etc, etc. Much of the detail depends on the nature of the business and the assets being transferred.
In a loan, due diligence involves verifying the information provided by the borrower on the loan application as well as appraisal of the property to be mortgaged, and certifications that it meets code requirements and is suitable for residential occupancy.
As CEO of the vast company, I told my executives about the importance of due diligence when pitching our ideals to new investors.
In doing his due diligence Donald decided not to invest in a new business because he found out the CEO had been at the helm of two other companies that went bankrupt.
When the company filed for Chapter 11 bankruptcy, it was discovered that it’s team of auditors did not exercise due diligence in their evaluation of it’s financial stability.
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Due Diligence is any investigation by one party of another party. When used in a fundraising context, it usually refers to the investigation conducted by a prospective investor into the background of a company, its management team, and the statements and assumptions contained in its business plan. It is usually intensive, time-consuming, and thorough. It is not unusual for the investigation to take weeks or months to complete.
Due diligence customarily includes background checks on the management team, independent verifications of statements made in the business plan, and studies of the company’s product and market. It includes extensive questioning of management and other company personnel. Most venture capitalists will talk with company suppliers, customers, competitors, and others who know the company and its industry.
Entrepreneurs should conduct due diligence too. They should investigate their industry and their partners thoroughly to gauge their company’s prospects and the depth of experience and commitment of each of its principals. Business plans should not be completed without giving careful attention to the assumptions and “facts” that support the company’s profits and cash flow projections.
Just as important, entrepreneurs should conduct due diligence investigations about the company’s potential investors. Selecting the right investor for a company can mean the difference between success and failure. A disreputable or reluctant investor can slow and even prevent company success. Conversely, an honorable investor can help management by giving it the benefit of his experience with growing companies and his contacts with financial institutions. This can be as valuable as cash.
One way to learn about a particular investor is to ask bankers, lawyers, and accountants about his reputation. If a publicly held venture capital fund is considering investing, a good deal of information about it can be obtained from the Securities and Exchange Commission. If it is privately held, management can usually obtain a copy of the offering circular it used to raise funds by simply asking the investor for one. The National Venture Capital Association, National Association of Small Business Investment Corporations (NASBIC), The Corporate Finance Sourcebook and Pratt’s Guide to Venture Capital Sources by Stanley Pratt can also provide valuable information about the size of a fund and the types of investments it makes.
Once it has begun investigating a company, most venture firms will give an entrepreneur a list of the companies in which it has invested. These companies can provide valuable insights into the operations of the fund and its desirability as a business partner. Appropriate questions to ask the founders of these companies are:
Was the firm easy or difficult to work with?
Was it prompt in making investment decisions?
What type of participation in management did it require?
Are its officers honest and candid?
Were they reasonable in their negotiations?
Have they provided services promised to the company?
Have they helped or hindered company success?
Are they responsive to company needs?
How has the firm reacted to company problems?
Is it flexible?
Has the firm participated in later rounds of financing?
Did it help identify further investors?
Did its performance live up to its promises?
The more specific the questions are, the more valuable will be the information obtained. Questions to and about the venture capital firm are appropriate and demonstrate management’s concern for the future. Questions about how long it will take the investor to make a decision and whether it has the funds and freedom to make an investment are particularly appropriate.
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This glossary post was last updated: 11th August, 2022 | 0 Views.