Company due diligence
What is due diligence, who carries it out and why do companies undertake it?
Due diligence is a service whereby advisory firms, and sometimes accounting and law firms, carry out a review of the business and financial situation of another company for a client and report their findings to the client.
When do companies undertake due diligence?
Companies usually decide to carry out due diligence before carrying out a significant transaction with another company. This may be a merger or acquisition of another company, in which case the client is usually a potential buyer of the company, or a sale of the company, in which case the seller itself is sometimes asked to carry out due diligence. The review enables the client to assess the business, financial, tax, legal and operational risks associated with the target company’s business to date. Any company planning to buy another company, sell a business or merge can use due diligence to make a lower risk decision, supported by the findings and conclusions.
Due diligence typically consists of five categories:
- Business / operating due diligence
- Financial due diligence
- Tax due diligenve
- Legal due diligence
- Technical due diligence
The due diligence provider may perform only some of these items for the client, but most often companies opt for a full due diligence of the company before the transaction.
Business / operating due diligence
Business due diligence focuses on the risks associated with the target’s existing business model, as well as risks relating to corporate governance, the adequacy of management and key personnel, operational risks and the impact of the business environment on the business. It is often at this point that assumptions about the expected future performance of the business are critically analysed and the ability to realise them is assessed. Business due diligence typically involves a number of different stakeholders: from financial advisors who use the results to determine the impact on the value of the business, to HR advisors who assess the management, employees and values of the business, to business consultants who analyse the business environment and the rationality of existing strategies, to of course the acquirer itself, who assesses whether the target is appropriately organised and where or how it should adapt its business in the future.
Financial due diligence
Financial due diligence shows the strengths and weaknesses of financial performance to date and, more importantly, the potential financial liabilities in the future. The latter can be seen from the historical financial statements (balance sheet, profit and loss account, cash flow statement, etc.) and other off-balance sheet items, as well as ancillary analyses of the company’s financial position and their expectations for the future. A thorough cost analysis of the major operating items is often also necessary. The acquirer needs to identify the potential financial synergies of the transaction. At the same time, all material potential liabilities must be evaluated before the acquisition of the business and taken into account in determining the purchase price of the business.
Tax due diligence
Tax due diligence mainly clarifies tax-related facts. Here, the review will focus on whether all previous tax liabilities have been paid and whether the company is operating in compliance with tax legislation. On the other hand, he/she is also interested in what the expected tax liability is, if there are any deviations or opportunities to optimise the tax performance.
Legal due diligence
Legal due diligence looks at the overall legal situation of an entity, such as whether it is operating in compliance with the rules, what contracts it has with other stakeholders and what contracts it has with its employees. It identifies potential liabilities from lawsuits, potential lawsuits and other disputes. Whether key risk factors are insured or whether key competitive advantages are also legally regulated (e.g. patents, trademarks) or whether sales or assets are free of encumbrances. Typically, legal due diligence is carried out by legal advisors, law firms and the acquirer itself with its own legal and compliance experts.
Technical due diligence
Technical due diligence depends on the company’s industry. It can be very specific and is usually carried out for the client by experts in that industry. Technical due diligence covers a wide range of areas, for example: software code reviews, land or real estate quality reviews, technical correctness reviews of production machinery, vessels or plant, identification of a company’s investment needs, reviews of compliance of production processes with industry standards, as well as reviews of the quality of raw materials and supplies, inventory reviews or reviews of a range of other relevant areas.
Technical due diligence could also include various environmental due diligence checks, which verify that all ecologically and health-related factors are in order, such as emission levels, hazardous waste management, contamination of natural resources, etc.
Benefits of a due diligence
Due diligence is practically essential in all major transactions. Not only does it add value by allowing verification of business facts beyond publicly available data, but it also provides the acquiring company with information on the necessary next steps for integration after the acquisition itself. If the client is the owner, due diligence gives it an important insight into the background of the management and the orderliness of the company before the actual sale process starts. Finally, due diligence is also useful for the company itself, as it gives management an insight into details that they may not deal with on a day-to-day basis.
Based on: LEP, T. (2020). The Value of Advisors to Business Owners in the Process of Selling an Equity Stake. Ljubljana: University of Ljubljana, Faculty of Economics.
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