Due Diligence Process Step-by-Step: How to Get it Right (+ Checklist)

Due diligence is a process that underlines all good decision making, whether that be in M&A, acquiring real estate, or even just buying a car. In this article, we look at the due diligence process from a general perspective, understand its importance, and talk about how it functions.

What is The Due Diligence Process?

The due diligence process is undertaken to make more informed decision making.

By collecting, analyzing, and interpreting information, the due diligence process underpins informed decision making. This enables the individual or company driving the due diligence process to avoid being held legally liable, or to make better acquisitions, whether that be another company or a personal asset such as a car or house.

Due Diligence is about unpacking the company, understanding what's inside before closing the deal to avoid surprises and liabilities.
_{Amr Abdelaziz, Global M&A & Strategy Finance Director}

The meaning of a due diligence process is sometimes lost because of its the amount of information collected - participants may believe it’s a document-gathering exercise.

Documents are only gathered in the due diligence process for the team leading due diligence to gain information.

The information drives informed decision making, and informed decision making leads to better outcomes than uninformed decision making.

The Importance of Due Diligence

As the paragraphs above alluded to, due diligence can generate value from the smallest transactions - personal purchases - to billion-dollar investments.

As an example of the former, research conducted by Google shows that over half of all customers conduct research before making purchases.

Similar data provided by Statista shows that 70 percent of online shoppers read between one and six customer reviews before making a purchasing decision.

These statistics show the importance of due diligence to relatively insignificant personal purchases.

At the transactions become larger, the importance of due diligence tends to grow. A distributor looking to source goods in a foreign country will usually travel to a few suppliers, test the products, look at the operations, and seek out other distributors that have bought from them.

This is a form of due diligence (although it isn’t always referred to as such).

Moving further up the scale of transaction size

Real estate transactions are generally only made after extensive due diligence.

And again, the larger the due diligence, the larger the scale of the transaction. Buyers usually hire architects and engineers to conduct analysis of the property or properties before signing off.

In certain circumstances, the buyer may also want to conduct an appraisal and a title search for the property.

But perhaps due diligence is more important in acquiring companies than anywhere else. At the lower end of the spectrum, there is a temptation with small business owners to believe that by looking through a few documents (mainly the financial statements), they can make an informed judgement on a business.

They rarely can and we can reasonably expect that more deals are jeopardized at the lower end of the transaction scale owing to this mentality.

Finally, there is due diligence from the middle market and upward. Enough academic material has been published on its importance to fill the Library of Congress.

It is also critical that the due diligence process here should also be conducted in the right way (although it could be said to different degrees for all of the categories above).

FirmRoom’s due diligence data room has been designed specifically to address this requirement.

Reasons for Conducting Due Diligence

If ‘informed decision making’ is a general way of talking about the reason for conducting due diligence, there are a range of more specific reasons for doing so. These include, but are not limited to:

Financial

The overriding motive for most due diligence is financial - ensuring value generating purchases, by being more informed. In the case of an asset or group of assets, like a portfolio, the buyer would also check historical financial performance.

Valuation

Whatever the transaction, valuation will be important. Nobody likes to overpay, whether that be for an online transaction or a billion-dollar company. Due diligence reduces the likelihood of this occurring.

Legal

A company is a nexus of contracts, which means that acquiring one can be like stepping close to legal landmines. A proper legal due diligence process reduces the buyer’s liability on closing the transaction.

Confirming Hypotheses

Every buyer, whatever the transaction, approaches the seller with some hypothesis about what they might be acquiring. A good confirmatory due diligence process aims to confirm this hypothesis or otherwise.

The buyer’s perspective

From the buyer’s perspective, the due diligence process should be viewed as a way of de-risking a transaction and extracting as much value as possible. Whatever information needs to be obtained to reach this state should be requested during due diligence process.

In this way, the process ultimately assesses how attractive an opportunity the potential acquisition is.

The seller’s perspective

From the seller’s perspective, the due diligence process can be seen as a way to cooperate with a buyer who wishes to buy an asset they’re interested in selling.

Whether the asset is a tract of land, a property portfolio, a piece of machinery, or a company, the aim should be to keep the buyer informed, outlining everything about that asset, good and bad.

Areas of Due Diligence

Our reputation as one of the world’s leading due diligence platform means that FirmRoom has worked with all manner of due diligence processes.

None is too obtuse for our platform to deal with. This is underlined by the extensive range of due diligence checklists that users can avail of.

Typical areas of due diligence include:

1. Financial due diligence

Depending on the acquisition, this could include anything from the cost of purchase loans to mortgage costs to a company’s previous financial results.

2. Legal due diligence

Considers the legal aspects of an acquisition - who really owns the property? Are there legal cases pending against the company?

3. Operational due diligence

An analysis of how the asset generates its income and how secure that process looks when considering the future.

4. Commercial due diligence

An analysis of the company’s commercial context, its competitors, and the dynamics of its market(s).

5. Human resources due diligence

If the acquisition involves taking on people, it makes sense to know what kind of people you’re taking on. Enter HR due diligence.

6. Technological due diligence

These days, most acquisitions involve some form of technology (even buildings have IoT) requiring some level of technology due diligence.

7. IP due diligence

Some companies, particularly those in technology and the life sciences, derive significant value from their IP, creating a necessity for IP due diligence.

8. Tax due diligence

An analysis of the tax assets and liabilities of the company, and how they will impact on the buyer’s own tax assets and liabilities.

9. Regulatory due diligence

An assessment of how the company is impacted by regulation, how it complies with them, and how regulations are likely to evolve.

10. Environmental due diligence

An increasingly important component of due diligence, where buyers assess the environmental impact of a target company.

These are just the headline categories of due diligence.

But everything relevant to a transaction can have a form of due diligence attached to it. For example, before sports teams shell out millions of dollars to acquire players, they are known to ask about the company the players keep, their character, their diet, and so on.

This is yet another form of due diligence.

Preparing for Due Diligence

Due diligence cannot be an ad hoc process. The expression, ‘prepare to fail, fail to prepare’ is highly applicable here.

A due diligence process, will include at least some of the following steps (whose order will largely be the same, independent of the due diligence type):

Assign a due diligence team

Designate and assign a team of capable individuals with experience in each of the fields which will require investigation and analysis. Legal due diligence requires attorneys, financial due diligence accounts, and so on.

Establish objectives and scope

Talk through the process with each of the due diligence team about the objectives and scope of their work. This phase may involve returning to stage 1 to hire more specialists.

Set up Virtual Data Room (VDR)

Good information gathering requires strong documentation, organization, and communication. For this, you’ll need a due diligence VDR. There is a reason why all investment banks use these. Follow this practice.

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Set milestones

Setting milestones as part of the due diligence process is vital. A quality virtual data room like FirmRoom enables users to set milestones and connect them to tasks. This in turn enables everybody to see what’s done and what remains to be done at any point in time.

The Due Diligence Process

The due diligence process itself can be divided into various phases (coinciding with the milestones mentioned in the last section). Again, the list below is general, but will be relevant to a greater or lesser degree for whatever kind of due diligence is being conducted:

Phase I - Non-confidential information exchange

This is where the target shares relevant but non-confidential information about the business. This is typically the information available from public sources combined with some extra non-privileged information (e.g., hiring plans, market analysis, etc.).

Phase II - Confidentiality/Non-Disclosure Agreement

At this point, both sides have admitted that a transaction could be mutually beneficial and the target begins sharing confidential information (after the NDA has been signed).

This should not be conducted without a virtual data room for the following reasons:

• Safety: VDRs are designed to share information securely, unlike most e-mail platforms.
• Organization: Forwarding documents to several teams, who then exchange those documents between them is a clunky process which can only lead to failure. A VDR like FirmRoom enables seamless communication and everybody working from the same documents.
• Communication: By ensuring that everybody is communicating in the same channels, communication remains efficient, streamlined, and on-message.

Phase III - In-depth analysis and validation

The information gathering aspect of due diligence inevitably leads to gigabytes of relevant data shared across different files and mediums (Excel, Email, Word, PDF, etc.).

This requires an in-depth analysis and validation that FirmRoom is adept in helping to manage and chart progress of the progress that is required in the due diligence process.

Phase IV - Final negotiations and deal closure

As transactions enter the final phase, due diligence will be required to highlight important outstanding issues. This is where platforms like FirmRoom can be used to highlight and share these issues between the VDR participants, to bring the deal to its conclusion.

Timeline and Costs for the Due Diligence Process

A typical due diligence process typically takes between 4 and 20 weeks, with an imperfectly positive correlation between due diligence time and transaction size.

Milestones along the way here might look something like the following:

In terms of costs, the best way to reduce costs is to invest in a virtual data room.

Professionals’ money costs time, so by reducing their workload, you reduce the overheads.

Costs will vary but those that should be considered include:

• Virtual data room costs (usually on a per seat or per data used basis);
• Existing staff costs, including overtime
• Travel costs to target company
• External Legal/financial/HR/Technology/IP specialist costs
• Administration costs (e.g. notary costs, registration costs, etc.)

Roles and Responsibilities in Due Diligence

The roles and responsibilities in due diligence are as follows:

Advantages of using FirmRoom in Due Diligence

As a platform which has been involved in thousands of due diligence processes over the past decade, FirmRoom gives its a unique perspective on due diligence.

Highlights of the advantages that it provides any individual or company conducting due diligence include:

• Streamlined document management and organization
• Enhanced security and access controls
• Improved collaboration among internal and external teams
• Tracking activity and progress through analytics

Challenges and Risks in Due Diligence and How to Avoid Them

There are several challenges and risks inherent in due diligence.

Below we suggest some simple ways these risks can be overcome:

Inability to meet deadlines

It’s important to be flexible about deadlines. Although the due diligence process should be efficient, it cannot be rushed. If the process continues to overrun deadlines, establish why this is the case and if there are underlying reasons.

Ignoring red flags

Never ignore red flags in due diligence. That is ultimately what the process is seeking to bring to your attention, so to avoid them renders the process useless. Remain disciplined and objectively critical at all times.

Cultural differences

Cultural differences are inevitable in due diligence with so many parties being involved. Keep communication polite and remain flexible with buyer/seller demands. Be mindful of the fact that a due diligence process can be stressful for even the coolest of heads given the responsibilities involved.

Information gaps

Sometimes even due diligence cannot uncover all of the information required that the transaction requires. Establish early on which pieces of information are critical and stick to them. For example, information on IP may be critical, but resumes of non-key personnel may be far less important.

Risks for the disclosing party

• Leaks to competitors
• Loss of time and money
• Potential loss of corporate secrets
• Reduced business focus
• Diminished internal and external relationships

Risks for the receiving party

• Losing the deal
• Losing the good faith deposit (if this is requested at the outset of due diligence)
• Incomplete disclosure by the selling team
• Counter-offers being made
• Inability to properly interpret the information obtained

Due Diligence Checklist

The thoroughness of information required for conducting value-generating due diligence inevitably means that gaps can appear in a company’s process.

Having worked on thousands of deals, FirmRoom is less inclined to be victim to these gaps. Its due diligence checklists have informed many due diligence processes since being created and are available exclusively to our members here.

Takeaways

Without thorough due diligence, complex transactions are a lottery.

With due diligence, they have the potential to generate massive value.

Moving from a lottery to a massive generator of value is a choice that sensible actors should require no convincing on.