Due Diligence: What is it and how to do it?

A business that seeks investments or wants to sell its activities must certainly produce a business plan. It is an introduction to the company and it is critical. But once the investor or buyer has expressed interest, a second, more serious, onerous, and time-consuming step begins: Due Diligence.

The term “due diligence” is a legal term adopted from the securities sector. It essentially means ensuring that all facts about the company are available and have been independently verified. It is, in some ways, similar to an audit. All of the firm’s documentation is gathered and evaluated, the management is interrogated, and a team of financial experts, lawyers, and accountants descends on the firm to conduct an analysis.

Step 1

A single due diligence coordinator must be appointed by the firm. This individual communicates with all outside due diligence teams. He gathers all needed materials and supervises all operations associated with the due diligence process.

The company must have ONE VOICE. When the DD teams want to interview persons related to the firm, just one person must represent the company, answer questions, provide presentations, and act as a coordinator.

Step 2

Inform your employees. Provide them with the big picture. Why is the company raising cash or selling? Who are the investors or buyers? What will the firm’s (and their personal) future look like if the investor comes in or with new management? Employees and company managers must both understand that this is a focal point for the company’s growth. They must be taught not to lie. They must be acquainted with the DD coordinator and the company’s spokesman during the DD process.

Documents

The DD is a more systematic procedure than the creation of a Business Plan. It is limited in time and must thoroughly cover the following topics: legal, financial, technical, marketing, and controls.

Legal Due Diligence

The following documents and information must be included:

1. The full name of the company;
2. Ownership of the company;
3. Documents for court registration;
4. Copies of all Board of Directors and General Assembly of Shareholders procedures;
5. Signatory rights supported by relevant rulings;
6. The firm’s charter (statute) and other incorporation documents;
7. Copies of licenses awarded to the company;
8. A legal opinion on the aforementioned licenses;
9. A list of lawsuits filed against the firm and lawsuits filed by the firm against third parties (litigation), as well as a list of disputes that are likely to reach the courts;
10. Legal opinions on the prospective outcomes of all cases and disputes, including their potential impact on the firm.

Financial Due Diligence

You will need the last three years’ income statements for the firm or its constituents if the firm is the consequence of a merger. The following statements must be included:

1. Balance Sheets;
2. Profit and Loss Statements;
3. Statements of Cash Flow;
4. Audit reports (ideally done in line with International Accounting Standards, or in accordance with FASB if the firm is intending to obtain money in the United States);
5. Cash Flow Projections and the assumptions underlying them, for example.

Technical Due Diligence

1. Manufacturing process description (hardware, software, communications, and others);
2. Necessary knowledge, technological transfer, and licensing;
3. Equipment, software, and service providers (including offers);
4. Labor (both skilled and unskilled);
5. Infrastructure (e.g., power, water, etc.);
6. Transportation and communications (for instance, satellites, lines, receivers, and transmitters);
7. Sources, pricing, and quality of raw materials;
8. Supplier and support industry relationships;
9. Import limitations or licensing (where applicable);
10. Sites and technical specifications;
11. Environmental issues and their resolution;
12. Leases and specific arrangements;
13. The incorporation of new activities into existing ones (protocols, for example).

Marketing Due Diligence

It should include the following elements:

1. A brief history of the company (to demonstrate its past success and growth);
2. Political, legal (licensing), and competitive environment considerations;
3. A future vision for the company;
4. Products and services the company offers and their applications;
5. A comparison of the firm’s products and services with those of competitors;
6. Warranty, assurances, and after-sales service;
7. Creation of new products or services;
8. A general market overview and market segmentation;
9. What consumer needs are met by the products/services you offer?
10. Which market segments do you focus on, and why?
11. What elements may influence a customer’s decision to buy (or not buy)?
12. A list of direct competitors, along with a brief description of each;
13. The competitors’ strengths and shortcomings in comparison to the firm;
14. A list of unknown information about markets, clients, and competitors;
15. What market research has been planned?
16. A sales projection broken down by product group;
17. Pricing strategy (how pricing is determined);
18. Product sales promotion (including a description of the sales force, sales-related incentives, sales targets, sales personnel training, special offers, dealerships, telemarketing, and sales support). Attach a flow chart depicting the purchasing process from the time the client is approached by the salesperson until he purchases the product;
19. Marketing and advertising campaigns (with cost estimates) – segmented by market and media;
20. Product distribution;
21. A flow chart describing order receipt, invoicing, and shipment;
22. After-sales customer care (hotline, support, maintenance, complaints, upgrades, and so on);
23. Customer loyalty (for instance, the turnover rate and how it is tracked and controlled).

Controls Due Diligence

1. Accounting systems employed;
2. Pricing methods for goods and services;
3. Payment terms, debt collection, and receivables maturation;
4. International accounting standards adoption;
5. Sales monitoring;
6. Order and shipment tracking;
7. Record keeping, filing, and archiving;
8. Accounting system for costs;
9. Budgeting, budget monitoring, and budget controls;
10. Internal auditing (frequency and processes);
11. External auditing (frequency and methodology);
12. The banks with which the firm works: history, references, and balances.

Due diligence is the key to successfully bringing on board new investors. Before closing a purchase or investment agreement, a buyer or investor can detect and assess risks, liabilities, and business problems in the target company, potentially averting losses and negative news.