What is Due Diligence?
Due diligence is the process of digging deep into the basic and complete facts of an opportunity with the end goal of investing.
“Buyers beware” is an axiom one has to keep in mind when dealing with any kind of financial instrument. An investment opportunity might look rosy on paper, but it could be propped up by unsustainable practices, accounting tricks, or plain fraud. It is incumbent on the investor to vet and verify before making any final decision.
If investors conducted the necessary due diligence, many Ponzi schemes would not have taken place. When presented with a promise of incredible returns, some investors did not try to assess or check how the returns would be made. Due diligence requires investors — including venture capitalists — to be skeptical of every opportunity they hear and make investment decisions only after it has been completely proven to be a safe investment.
Due diligence is not just restricted to investment decisions. It can also be conducted before signing any type of contract that has to be signed between two parties. Each party can check the potential partner’s history and ability to adhere to the terms of the contract before actually engaging in the contract. Doing so helps investors avoid difficult situations that arise due to an unexpected breach of contract by the other party.
How to conduct due diligence
In a financial transaction, the seller is obligated to reveal all relevant information. The buyer should look into the history of the other party and investigate whether any facts are misrepresented or falsified in the information provided by the seller. Thorough due diligence should bring out any such malfeasance.
Here are some steps and tips to conduct due diligence:
The team that conducts due diligence must have experience in carrying out the tasks required of them. It’s helpful to have at least one professional with experience in forensic accounting on the team. Most companies try to paint a rosy picture of themselves through financial shenanigans. Lawyers or other legal experts should also be part of the team.
The size of the team also matters a lot. In general, there’s a limited timeframe to complete a due diligence investigation. Too small a team will not be able to conduct the complete investigation in the allotted time. A larger than required team will cost more and will hinder the regular operations. The team size is determined according to the size and perceived complexity of the business it’s investigating.
Due diligence often requires obtaining confidential information. If such content is made public there could be serious repercussions to the business and even the deal. Ensure all communication regarding due diligence is secure. In digital communication, security can be achieved by using encrypted communication channels.
Take cues from previous due diligence investigations and create a checklist of items to be investigated. If you’re conducting due diligence in an industry you’re not familiar with, take advice from companies or individuals who have worked in the industry.
Look deep into the information provided by the target company. The company could be hiding incomplete or fraudulent information. Ask open-ended questions to determine whether the target company is furnishing all the facts relevant to the transaction.
Shareholders, employees, management, members of the local community, customers, suppliers, and competitors are company stakeholders. Seeking information and opinion from the various stakeholders will reveal more information regarding the company as well as the industry. Suppliers and vendors can provide insight into the ecosystem in which the company operates. This information will help to determine whether the company has furnished all the facts. It will also bring up new avenues of investigation that you might not have considered.
Document every action taken and all information extracted. Create a detailed report at the end of the exercise so that the information can be revisited when required at a later time. The report should have a concise conclusion and should explain in detail how the conclusion was reached.
Due diligence is a crucial step to be conducted before any major investment decision. It will avoid falling prey to unscrupulous deals when it’s conducted meticulously.