Purpose of Due Diligence
The term due diligence entered common usage 4 years after the stock market crash of 1929 to induce transparency in financial markets. Initially, the phrase referred to a legal standard of care or obligation, implying that securities brokers and dealers must fully disclose information about instruments they are selling. Since that time, the phrase has grown to encompass a more general sense of prudent, well-informed action in business and investment transactions.
Due Diligence is an extensive review of a company’s records, assets, liabilities, and practices before a sale takes place. It is often a lengthy process and involves going over every piece of documentation, verifying information, double-checking all details, and looking for red flags. Performing this investigation before placing a business on the market allows the seller to work out any potential problems in advance and prevents buyers from walking away after an initial offer if they discover unforeseen issues during their own due diligence.
Performing due diligence before putting a business on the market also reduces the time and costs of preparing for a sale. It helps the owner work out a few kinks and streamlines the process by making the documents easier to read and understand. Having a well-organized and complete set of financial records can also speed up the due diligence process, which may lead to a quicker closing and higher sales price.
What Is the Purpose of Due Diligence?
A comprehensive due diligence process can last anywhere from 30-60 days. It varies depending on the type of business and how detailed the buyer wants to be in their evaluation. For example, a private equity or strategic buyer will likely do more in-depth due diligence than an individual purchaser looking to acquire a MidStreet-size ($1M-$25M in revenue) business with the help of an SBA 7(A) loan.
Explaining the concept of Due Diligence
As part of the due diligence process, the buyer will review the company’s tax records and the company’s structure. This includes a thorough examination of income and non-income tax areas, such as sales and use, payroll, property, and transfer taxes. This is an important element because the acquiring firm could be held responsible for unreported tax liabilities and exposures resulting from a merger or acquisition.
Inquiring about the nature of Due Diligence
Another area that is examined during due diligence is the company’s environmental compliance. This is to ensure that the company is not in violation of any environmental regulations that would result in fines or even plant closures should they be acquired. Finally, operational due diligence examines the company’s operations and facilities to make sure that they are functioning properly. This is to ensure that the company will continue to function well under new ownership and to minimize the risk of disruption in service to customers. All of this can add up to a significant amount of money in upfront expenses, but avoiding costly mistakes down the road can greatly offset the costs of due diligence.