Due Diligence

Due diligence is a program of critical analysis that companies undertake prior to making business decisions in such areas as corporate mergers/acquisitions or major product purchases/sales. The due diligence process, whether outsourced or executed in-house, is in essence an attempt to provide business owners and managers with reliable and complete background information on proposed business deals so that they can make informed decisions about whether to go forward with the business action. "The [due diligence] process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers, and key developers," wrote Lee Copeland in Computerworld. The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business action under consideration.

Many companies undertake the due diligence process with insufficient vigor. In some cases, the prevailing culture views it as a perfunctory exercise to be checked off quickly. In other instances, the outcome of the due diligence process may be tainted (either consciously or unconsciously) by owners, managers, and researchers who stand to benefit personally or professionally from the proposed activity. Businesses should be vigilant against letting such casual or flawed attitudes impact their own processes: an efficient due diligence process can save companies from making costly mistakes that may have profound consequences for the firm's other operational areas and/or its corporate reputation.

AREAS OF DUE DILIGENCE

The due diligence process is applied in two basic business situations: 1) transactions involving sale and purchase of products or services, and 2) transactions involving mergers, acquisitions, and partnerships of corporate entities. In the former instance, purchase and sales agreements include a series of exhibits that, taken in their entirety, form due diligence of the purchase. These include actual sales contracts, rental contracts, employment contracts, inventory lists, customer lists, and equipment lists. These various "representations" and "warranties" are presented to back up the financial claims of both the buyer and seller. The importance of this kind of due diligence has been heightened in recent years with the emergence of the Internet and other transforming technologies. Indeed, due diligence is a vital tool when a company is confronted with major purchasing decisions in the realm of information technology. "A due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a high-end system," said Copeland.

In cases of potential mergers and acquisitions, due diligence is a more comprehensive undertaking. "The track record of past operations and the future prospects of the company are needed to know where the company has been and where its potential may carry it," explained William Leonard in Ohio CPA Journal. In addition, observers note that the dramatic increase in information technology (IT) in recent years has complicated the task of due diligence for many companies, especially those engaged in negotiations to buy or merge with another company. After all, system incompatibilities can require huge amounts of time, money, and personnel resources to integrate.

Leonard notes that traditional due diligence practices in acquisition/merger scenarios called for detailed examination of financial statements, accounts receivable, inventories, workers compensation, employment practices and employee benefits, pending and potential litigation, tax situation, and intellectual property prior to signing on the dotted line. But in this dynamic business era, other areas should be looked at as well, including (if applicable): intellectual property rights, new products in the production pipeline, status of self-funded insurance programs, compliance with pertinent ordinances and regulations, competition, environmental practices, and background of key executives/personnel.

Many business experts also caution that the due diligence process is incomplete if it does not incorporate an element of objective self-analysis. "Self-analysis is the fundamental first step to realistically determine whether the post-acquisition 'whole' will be greater than the sum of its part," wrote Aaron Lebedow in Journal of Business Strategy. A detailed assessment of the market that is the target of the proposed acquisition should also be undertaken prior to closing a deal. Both of these requirements can be completed in a reasonable period of time, even in today's fast-changing business environment, by companies that either 1) outsource the due diligence task to a reputable research firm or 2) build an efficient in-house program within their legal, marketing, or corporate security sectors. "Unquestionably, opportunities for growth through acquisition exist," stated Lebedow. "Exploiting these opportunities has risks, but to those companies that acquire only after a comprehensive and systemic assessment of the marketplace and competition, the rewards justify the risks. Limiting due diligence to financial and managerial review is rarely enough. Successful acquisition strategy depends on the structure and depth of the due diligence process."

SUPPLEMENTING DUE DILIGENCE

Growing numbers of business enterprises are pursuing additional legal protection for themselves so as to shield themselves from harm if their due diligence efforts fail to uncover a serious problem with a merger or purchase transaction. One means of mitigating the risks associated with such major business transactions that has become increasingly popular in recent years is to secure a form of insurance coverage known as "representations and warranties liability insurance." A growing number of insurance underwriters are providing these policies, which call for them to pay insured parties for losses resulting from various "wrongful acts." This umbrella term generally covers errors, misstatements, misleading information, etc., but underwriters do include exclusions, some of which should be noted by potential buyers. These include acts of "fraud" (if adjudicated in the courts), pollution (which is typically covered under separate policies), or situations in which a party has received benefits—financial or otherwise—to which it is not entitled. One significant benefit of "representations and warranties liability" policies, however, is that the coverage can be used in place of reserves, escrow, or indemnity provisions that are included in purchase agreements.

Premiums for such policies can be expensive, especially for small and mid-sized firms with limited financial resources. Moreover, securing such insurance is a time-consuming and painstaking process, for underwriters are putting themselves at considerable financial risk. "Premiums will be determined based on the risk and the comfort level of the underwriter," summarized Leonard. ""It is most important that the process start early and not be left to a time when someone gets a 'feeling' things may not be entirely up to snuff. Although this type of coverage can be purchased after the closing, understandably the most beneficial time to place the coverage is during the due diligence phase preceding the closing."

BIBLIOGRAPHY

Bernstein, Leopold A., and John J. Wild. Analysis of Financial Statements. McGraw-Hill, 2000.

Copeland, Lee. "Due Diligence." Computerworld. 6 March 2000.

Joukhadar, Kristina. "Faster Due Dilligence." InformationWeek. 22 January 2001.

Kroll, Luisa. "Gotcha: Pushing the Limits of Due Diligence." Forbes. 30 October 2000.

Lebedow, Aaron L. "Due Diligence: More than a Financial Exercise." Journal of Business Strategy. January 1999.

Leonard, William J. "Representation and Warranties—When Due Diligence Fails." Ohio CPA Journal. January 2000.

Torrey, Rebecca and Larry Scherzer. "Doing Due Diligence to Uncover 'Bad Apple' Applicants." Los Angeles Business Journal. 21 October 2000.

                                  Hillstrom, Northern Lights

                                    updated by Magee, ECDI

Due Diligence

Due diligence is a legal term that describes the level of care or judgment that a reasonable person would be expected to exercise in a given situation. The term, synonymous with “background check,” finds application in a wide range of business settings, including mergers and acquisitions, occupational health and safety, environmental impact assessments, supplier and vendor relationships, asset purchase decisions, and employee hiring or promotion practices. Performing a due diligence analysis in such situations helps managers make informed decisions and reduce the risks incurred by the business. “Real due

diligence analyzes and validates all the financial, commercial, operational, and strategic assumptions underpinning the decision,” an analyst for Price Waterhouse Coopers told Mondaq Business Briefing. “Due diligence is a strategy to reduce the risk of failure, as well as the embarrassment of discovering what underlies spectacular success,” Herrington J. Bryce added in Nonprofit Times.

In the area of workplace safety, employers have a responsibility to exercise due diligence in eliminating hazards and creating a work environment that minimizes the risk of accidents or injuries. In fact, due diligence is the legal standard used to determine whether employers can be held liable under occupational health and safety laws. Employers are generally not held liable for accidents if they can prove that they took reasonable precautions to protect workers from injury. Companies can establish due diligence by putting workplace safety policies and procedures in writing, providing appropriate training to employees, and holding managers accountable for following safety guidelines.

Due diligence also applies to the process of making investments, whether personal investments in shares of stock, corporate investments in technology, or the purchase of one company by another. In the area of mergers and acquisitions, a due diligence analysis is an important part of the process of evaluating potential investments and confirming basic information before entering into a transaction. “Quite often, a proposed merger or acquisition gets canned or valued down following conflicts over intellectual property rights, personnel, accounting discrepancies, or incompatibilities in integrating operating systems,” wrote Lee Copeland in Computer World. “The process of researching, understanding and, in some cases, avoiding these risks is known as due diligence.”

When a business makes a purchase offer of any kind, it is often a matter of policy to make the offer contingent on the results of a due diligence analysis. This analysis might include reviewing financial records, hiring experts to examine the assets in question, and taking other reasonable steps to make sure that all questions are answered and expectations met. Experts suggest that sellers also perform due diligence analysis prior to entering into a transaction. Going through this process helps sellers be prepared for any questions that might arise out of the buyer's due diligence analysis, and also gives sellers a basis on which to evaluate the merits of potential purchase offers.

Changing accounting rules are prompting companies to consider tweaking the structure and timing of due diligence when entering into a corporate merger. The rules, two released by the Financial Accounting Standards Board and two companion mandates issued by the International Accounting Standards Board, affect companies both in the United States and abroad. The most sweeping changes happen in America; for example, buyers must value the amount paid for a target company on the day the transaction closes, rather than the day of the deal announcement, as the earlier rules stipulated. The rule is effective for all acquisitions that close in fiscal years that start after December 15, 2008, and includes recording the value of stock the buyer may use to pay for all or part of an acquisition.

Although the legal concept of due diligence endured for half a century, it came under siege in the early 2000s following a spate of accounting scandals and revelations of deceit and ethical lapses by senior executives at major corporations. “The issue of due diligence arises whenever a financial transaction generates questions, such as: How could this have happened? How could this have gone undetected for so long?” Bryce noted in Nonprofit Times. Rather than dismissing due diligence as an outdated concept, however, some analysts argued that such incidents underlined the importance of due diligence as a way for managers to be informed about and exercise judgment over all transactions that affect the welfare of the business.

In a critique of traditional due diligence practices for Mondaq Business Briefing, Charles F. Bacon warned that traditional due diligence tends to be reactive. For example, senior management might order a due diligence analysis after making the decision to purchase a competitor. “In effect, they bought the car and now that the tires are getting kicked, they don't want to hear about the bad transmission or leaky gaskets because that would tarnish the fun of deal-making,” Bacon explained. Instead, he recommended that businesses take a systemic approach to due diligence starting at the top and incorporating due diligence into all organizational decision-making. The ultimate goal is to create a culture of due diligence in which all employees are encouraged to question and explore the implications of financial and strategic decisions.

SEE ALSO Entrepreneurship; Licensing and Licensing Agreements

BIBLIOGRAPHY

Bacon, Charles F. “Next Generation Due Diligence.” Mondaq Business Briefing 1 October 2004.

Bryce, Herrington J. “Due Diligence: Evaluation of Financial Matters.” Nonprofit Times 15 October 2002.

Cecil, Mark. “Financial Services Players Rework Due Diligence.” Mergers and Acquisitions Report 4 February 2002.

Cipra, Richard R. “There Is No Substitute for Due Diligence.” Los Angeles Business Journal 8 November 2004.

Copeland, Lee. “Due Diligence.” Computer World 6 March 2000. Available from: http://www.computerworld.com/news/2000/story/0,11280,42836,00.html.

Hallinan, Eric. “Due Diligence.” Reeves Journal 3 June 2004.

Leone, Marie. “New Merger Rules May Spark Cash Deals.”

CFO.com 4 January 2008. Available from: http://www.cfo.com/article.cfm/10522704?f=search.

Kroll, Luisa. “Gotcha: Pushing the Limits of Due Diligence.” Forbes 30 October 2000.

Nadler, Paul. “In Due Diligence, Numbers Are Just the Beginning.” American Banker 23 June 2004.

“What Does ‘Due Diligence’ Mean When Buying a Business?” 20 October 2004. Available from: http://www.allbusiness.com/buying-exiting-businesses/purchasing-a-business/360-1.html.

DUE DILIGENCE

In general business terms, due diligence refers to the scrutiny used by an individual or a group of individuals considering making a purchase of some sort. Those conducting due diligence do so to determine the degree of risk associated with a particular course of action, such as funding an initial public offering (IPO) or an investment. In the case of an acquisition or merger, the attorneys or accountants working for the purchasing party conduct due diligence when they examine the financial status, competitive position, and management practices of the business under consideration, as well as the legality of the deal. When upstarts and established companies seek funding, one of the main reasons they complete detailed business plans is to assist lenders in conducting due diligence. It is the responsibility of the lenders, however, to verify the data contained in such a document.

In the late 1990s, the dot.com bubble, which continued to grow as highly publicized predictions of astronomical growth in e-commerce began to saturate mainstream media outlets, prompted many venture capitalists considering an investment in a young Internet upstart to relax due diligence standards. The highly successful IPOs of firms like Netscape Communications Corp., Amazon.com, and eBay.com, fueled the investment community's desire to move dot.com upstarts towards IPOs as quickly as possible, despite the fact that obtaining profitability would, in all likelihood, take many years. Venture capitalists tended to overlook the fact that most of these new businesses were based on unproven business models. The examination of things such as the likelihood of long-term success, the experience of executives, and the integrity of financial forecasts became increasingly relaxed. According to an April 2001 issue of Oregon Business, "Many investors, fearful of missing out, seemed to skip the traditional drawn-out due diligence and hardly paused before infusing startups with capital to get a piece of the dot.com action. The message was clear: strike now or taste dust." Formal business plans for dot.com, if they were submitted at all, tended to be much shorter and less detailed than their traditional counterparts. In fact, a March 2000 study of 300 e-commerce businesses in California revealed that most launched operations with no business plan in place.

This lack of planning eventually caught up with many of the fledgling firms when shareholders began pressuring on some of them to achieve profitability. When dot.com stocks began tumbling in 2000, funding sources evaporated in a hurry. Many upstarts, which had relyied on the availability of additional capital for expansion, had no choice but to close their doors, a phenomenon which drove the stock prices of the remaining Internet players down even further. Recessionary economic conditions compounded the problem, and dot.com investors sustained major losses. As a result, venture capital funding by the middle of 2001 was less than half of what it had been during the first half of 2000. In the third quarter of 2001, only 540 companies had raised $6.7 billion in venture capital funds, compared to the 1,634 companies that raised $23.9 billion during the third quarter of 2000. Although investors willing to pour capital into Internet related ventures still exist, the level of scrutiny to which they subject their applicants has substantially increased. As stated by an October 2001 article in Puget Sound Business Journal, "The venture community is witnessing a return to stricter investment criteria, more thorough due diligence and tighter term sheets…venture capital funds can no longer rely upon abundant capital, frothy IPO markets, and a carnivorous mergers and acquisitions market to mitigate lax investment practices."

FURTHER READING:

"Back to Basics." Oregon Business, April 2001.

Blakey, Elizabeth. "Tech VC: Looking Back While Looking Ahead." E-Commerce Times, May 31, 2001. Available from www.ecommercetimes.com.

Simpson, Tom. "Investing Today Versus During the Dot-Com Boom." Puget Sound Business Journal, October 5, 2001.

Walsh, Mark. "Wary Angel Investors Answer Fewer Prayers; Due Diligence Replaces 'Just Do It'; Entrepreneurs Scramble for Funds." Crain's New York Business, June 18, 2001.

SEE ALSO: Initial Public Offering (IPO); New Economy; Shake-Out, Dot-com