What is due diligence and how important is it for investors?

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Due diligence is a thorough investigation of a target company to confirm facts and details of an investment before it is signed off on. A systematic diligence investigation includes an analysis of financial records before a business transaction or potential acquisition takes place.

Due diligence can be conducted for a variety of reasons and by many people, such as by equity research analysts, fund managers, individual investors, or during the acquisition process when one company is considering purchasing another. Due diligence can also be outsourced by investors to experts, which both streamlines the process and ensures the investigation leaves no stone unturned.

Essentially, diligence checks identify risks and help make plans to mitigate them in the future. They ensure that the target company is not withholding any information that could potentially cause an adverse impact, either financially or to the business relationship, or any signs that could indicate a missed opportunity.

The due diligence process has been prevalent for many years and has adapted over time to account for new industry trends and to ensure more responsible business conduct can take place. Originating in the United States in 1933, due diligence originally stipulated that those entering into an investment agreement were legally obliged to disclose all material information. Over time, this process has developed, and now, provided both parties entering an agreement have carried out “due diligence” on the other party, neither will face legal repercussions for any information not found during the investigation but uncovered later instead.

Is due diligence a legal requirement?

Due diligence investigations are considered responsible business conduct by any reasonable person undertaking common business practices. However, whether diligence checks are legal obligations or not depends on the type of business activity taking place. For example, whereas due diligence is optional for individual investors, for broker-dealers who are intending to sell a security it’s a legal requirement.

If you’re unsure whether or not due diligence is a legal requirement for your business activity, then you should consider seeking legal advice from a due diligence consulting company or a legal team.

What information should due diligence investigate?

The precisions of the due diligence process depend on the type of activity taking place. Ultimately, a diligence report will be appropriate for the size of the proposed acquisition, meaning that the larger the acquisition, the more meticulous the due diligence should be. However, most due diligence investigations will look for the same information which will include analysing the same certain documents and financial statements. Here is our diligence checklist of what an investors advisor would recommend examining during a due diligence investigation:

  • Assess whether the target company’s business plan and predicted financial performance is reliable or unreliable,
  • Check that the target company’s assets and liabilities are what would be deemed typical,
  • Confirm the main revenue drivers of the target company,
  • Consider any opportunities for improvement once an acquisition has taken place,
  • Verify that any appropriate warranties are included in both the sale and the purchase agreement.

If any unexpected information is discovered during the diligence process, then re-negotiations of the purchase price may be considered to account for this.

How important is due diligence for investors and startup companies?

There are many reasons why exercising due diligence is important for both investors and startup companies.

For startup companies:

It’s ideal to work with an investor who ensures that due diligence is carried out on a business before investing. Since a worrying 50% of Venture Capitalists (VCs) looking to make an investment will not conduct due diligence on their target company before making a decision, this means that a relationship with an investor who does, shows that they are knowledgeable in the field and fastidious in their decision-making (via Harvard Business School).

Taking the time to really assess the startup business shows that the investor is careful and will know the startup on a more profound level than an investor who doesn’t perform their due diligence. This demonstrates commendable qualities that a startup should ideally look for in their investor.

For investors:

Looking to perform due diligence on the target company of an investment opportunity, this means that they will therefore have a better, and hopefully complete, understanding of the company they are investing into. If this is a business activity wherein due diligence is carried out by both parties on the other, then due diligence will help the business relationship get off on the right foot and ensure no unfortunate surprises are revealed once a financial transaction or contractual obligation has been confirmed.

As discussed, diligence practices carried out before a transaction or legal agreement help mitigate potential risk and will develop a risk profile for the target company. This helps the party executing the diligence activities to fully understand the financial risks they are undertaking and help create a thorough risk management plan for the future. Despite this, however, 78% of VCs do not take into consideration the financial risk they are undertaking (via Harvard Business School). Whilst intuition and experience are key attributes for VCs, a lack of preparation and utilisation of accurate metrics and data could ultimately spell disaster for their financial future.

Need some help with due diligence?

If you don’t want this to be your future, make sure you take the time to conduct proper due diligence. Investors looking for more information on conducting proper due diligence can apply for their FREE copy of our investor guide to early stage due diligence here: https://bit.ly/39CTg5z

Alternatively, investors can outsource their due diligence to our expert team. We assist investors to perform data-driven due diligence on the companies in their investment portfolio. Using our very own innovative risk model and psychology assessments, we go beyond the traditional due diligence process. Our team of experienced consultants will thoroughly assess the target company’s business and financial models, valuations, and pitch decks, to help predict the scalability and financial forecast of your investment. This process will highlight any red flags and potential pitfalls, as well as bringing to attention any overlooked opportunities.

Don’t miss out on this critical data. Replace risk with reliability today.

Summary

Due diligence is an investigation process carried out by those entering into a financial agreement with another party. A diligence check should investigate many aspects of the target company, including their current and future performance, in order to develop a risk profile before an acquisition has taken place. Assessing and mitigating risk means that diligence measures also help secure a more prosperous future for both parties involved. For sensible investors looking to evaluate the risk of an investment, working with experts such as our team at 7startup can help you invest with confidence.

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