What is the Due Diligence Process?

What is due diligence?

In its simplest terms, due diligence is an evaluation of risk versus reward. It is most commonly used during the negotiation and discussions involved in a possible merger or acquisition (M&A), but there are many different situations when it may be helpful. For M&As, the due diligence process analyses a target business in terms of its operations, financial and tax position, its current assets and liabilities. 

• Selling or buying a business or division
• Entering into a joint venture
• Acquiring a minority or majority interest
• Forming a strategic alliance

What is the due diligence process?

The process of effective due diligence can be time-consuming and complex. It is a consideration of many detailed aspects of an organisation’s business practices, financial and legal position, and even ethics. 

A simple transaction between two parties might require only basic due diligence lasting around thirty days, however, more complex transactions can take twice that amount of time and perhaps even several months. 

While it is essential that proper time and attention are dedicated to the due diligence process, there is such a thing as ‘deal fatigue’. In fact, if discussions drag on for too long, with little progress made, it can be one of the reasons that up to 50% of deals fail leading to one or both parties to lose focus and walk away. 

Of course, it is common for deals to fail for perfectly legitimate reasons too, but it should be a considered decision based on information uncovered in the fact-finding stage of due diligence. It should never simply be because of an inefficient or ineffective due diligence process itself. 

What does a good due diligence process involve? Typically, there are six main steps.

1. Information and document gathering

• Audited financial accounts and statements, balance sheets and profit and loss
• Taxation documents and statements
• Financial projections and budgets
• Contracts relating to business partnerships
• Business, sales and marketing plans
• Litigation and disputes, past and present
• Patents or trademarks held and pending
• IT infrastructure, software and data protection policies
• Overview of business operations, products and services
• Personnel information including organisational structure, staff turnover, salaries etc

2. Set up your virtual data room 

Once the documents have been gathered and collated, they are uploaded to a virtual data room (VDR). Unlike standard cloud storage or file sharing applications, a VDR is built with the needs of high-stakes transactions such as a merger or acquisition in mind. 

Utilising technology with advanced levels of security and encryption, VDRs ensure sensitive information is safe while also making it straightforward for another party to review documents based on assigned permissions. A data room will support more efficient collaboration too, providing encrypted messaging and question and answer (Q&A) tools that are far more secure than email communication. 

In short, a VDR is an essential tool for conducting due diligence on a company. It will streamline workflows and processes, keep sensitive business information secure at all times and enable multiple parties to collaborate more effectively. 

Further reading
Tips for setting up a virtual data room 

3. Read and review

Step three of the due diligence process is where the detail of a potential deal is considered. The buyer or other third party reviews the documents within the VDR building a picture of every aspect of the target company’s position, gathering insight and factual information that will inform decision-making. 

At this stage, it is crucial that access to the documents is controlled appropriately. Permissions are normally set by the data room’s administrator enabling control over who has access to what and when. 

4. Q&A

Next, both sides of a transaction engage in a back-and-forth discussion based on the review of the documents. This Q&A stage can be one of the most time-consuming aspects of any due diligence process.

Typically, a potential buyer will pose a question within a dedicated area of the VDR and the data room administrator on the seller side will assign it to a member of their team to be answered. This might be based on the topic or the specialist knowledge required to provide the appropriate response. With so many complex business issues contained within the documents of a VDR, there can be many questions covering broad strategic issues right down to questions of very specific detail. 

The Q&A function is therefore a key component of any VDR. It streamlines this critical stage of the due diligence process by keeping all Q&As in one place and organises them according to the structure created during VDR set-up. It also helps administrators keep track of important timelines and to ensure continual progress is made. 

Reports & audit trails

Once the due diligence period comes to a close, there may be compliance and reporting requirements to meet including maintaining a thorough audit trail of paperwork and the processes associated with a transaction. 

Even if the deal is abandoned or perhaps delayed or re-negotiated, the documents stored within the VDR may be kept there securely and the data room becomes a secure storage facility, access to which can be simply and efficiently managed. In fact, many organisations maintain a data room for that very purpose and of course to be prepared for a future deal or project. Most importantly, every aspect of the due diligence process, the associated documents, the Q&A and communications are readily accessible. 

Types of due diligence

So far, we have largely looked at the general principles of due diligence and how it is used to explore a merger or acquisition opportunity. Due diligence as a wider concept has many purposes, however. For example, it is also an important part of raising investment funds for a business and in an Initial Public Offering (IPO) of shares. 

Similarly, there are many distinct types of due diligence; some may be used alone but are often most helpful when combined together. Like pieces of a jigsaw puzzle, each focuses on specific areas or themes but when combined as part of the bigger picture, they offer the most effective approach to due diligence. 

Financial due diligence

Perhaps the most familiar type of due diligence, it is a review of the financial performance, position and forecast of a business. From balance sheets to debts, tax liabilities to budgets and working capital, every aspect of a company’s financial landscape is reviewed in detail. Financial due diligence can be seen as an initial benchmark and may reveal aspects of a company’s position that create a make-or-break decision before any other areas of the business are reviewed. 

Legal due diligence

A target company’s legal position in terms of litigation proceedings, its structure, liabilities and contractual obligations all fall under legal due diligence. For some sectors, such as banking and investment, due diligence will involve reviewing policies for preventing financial crime as well as regulatory compliance. 

Intellectual property due diligence

Often part of the wider legal due diligence process, patents and copyrights, both existing, spent and pending, are an additional consideration. Understanding the intellectual property (IP) of a target company looks at what assets are licensed to the company or an individual, how they are protected, and over what period of time. Unsurprisingly, a portfolio of IP assets can add considerable value to a company’s net worth both in financial and reputational terms or, conversely, cause significant issues too.  

Commercial due diligence 

Commercial due diligence looks at the market(s) in which a business operates. Gaining an understanding of market and competitive forces as well as the profile of the customer base provides an important context to strategic and operational objectives. Are those goals feasible and realistic, what barriers are there to overcome, and how much customer goodwill is there? These are all vital questions that must be answered when conducting due diligence on a company. 

Technical due diligence

As the name suggests technical due diligence is a deep dive into the technological aspects of a company, from its software to IT systems and practices. However, this type of due diligence also looks at the products and services of a business; how they are developed and launched to the market and development roadmaps for the future. 

Cyber-security due diligence

With increasing risks associated with data protection and cyber-attacks, the detailed examination of a company’s approach to cyber-security is fundamental. In particular, this type of due diligence establishes what governance and controls are in place to monitor and protect systems and data, as well as the processes adopted should a cyber-attack occur. 

Operational due diligence

Often used in the manufacturing and industrial sector, operational due diligence examines the functional aspects of a company, from its facilities and buildings to its capabilities in creating or providing a product or service. Do the company’s facilities and structural assets match its objectives for the future? Is the capital expenditure invested appropriately and does the employee structure and skill set align with the company’s operational requirements? Operational due diligence can identify gaps between aspirations and reality; a critical consideration prior to agreeing on a deal. 

Human resources due diligence

Good due diligence involves more than just balance sheets and company assets. It’s also about people - a company’s workforce and its human resources (HR) processes and policies. Increasingly, this type of due diligence process also considers company culture, values and ethos. 

Most businesses, large or small, will have some kind of mission statement and values, but are they woven through the culture of the business in reality? How do staff feel about the culture and senior management in their workplace? Importantly, is there a good fit between HR policies and corporate culture where two separate businesses are considering a merger? It is not uncommon for a deal to be struck after protracted negotiations only for it to fail in the longer term due to poorly considered cultural similarities and differences. 

Environment, social and governance (ESG) due diligence

With the growing importance of environmental and social responsibility to investors, this type of due diligence has become more significant. Reviewing company practices and operations from green commitments through to its policies on modern slavery helps a buyer to assess the strength and potential of an investment. This applies equally in the case of a merger; where investors will expect certain ESG standards to be in place in order for it to appear an attractive proposition to both shareholders and customers alike. 

These factors are not just crucial to both buyers and sellers, but are also prompting renewed M&A activity in their own right. Consumers have become more socially and environmentally aware, choosing to spend their money on goods and services that reflect their own beliefs.
Deloitte, The growing importance of ESG in mergers and acquisitions

What happens after due diligence?

Depending on the outcome of the due diligence process and the subsequent decisions taken, there are a number of things that can happen next. 

Firstly, regardless of whether the deal went ahead or not, it’s important to keep records of the process and all of the associated documentation. This is simply known as a due diligence record. 

Although documents are held securely within a virtual data room, there should be a record that describes what information is being maintained, in what format and for how long. While legal requirements will vary by territory and should always be checked locally, there are some best practices including:

• Retaining certified copies of due diligence materials informing all parties that originals are available for review
• Verifying the results of electronic checks by keeping electronic and/or hard copies
• Maintaining auditable proof of due diligence checks, particularly to demonstrate duty of care in the prevention of money laundering

The due diligence record should be kept securely for a specific time depending on the laws of the jurisdiction where the deal was made.

Create a due diligence report

One of the most important documents produced following the due diligence process is the report that summarises findings from the individual audits. This report then serves as a basis for decision-making. 

The report should cover all of the areas reviewed during the main due diligence period and reflect the types of due diligence selected based on the transaction or deal. As a minimum, this is likely to include the target company’s financial and tax position, its operations and market analysis, its intellectual property, employee structure, budgets and so on. 

How to write a due diligence report

There are four main principles to follow when writing an informative due diligence report.  

Make it easy to gather key facts quickly

• Including an executive summary that groups together high-level takeaways
• Covering issues that might affect an acquisition’s purchase price or risks that could impact company operations in more detail
• Highlighting opportunities for leveraging competitive advantage
• Quantifying anything that could improve or impact the bottom line

Don’t lose sight of the objectives and stay on point

Before beginning due diligence, objectives for the outcome of the process should have been agreed. Whether the findings are good or bad, it is helpful to present them in how they relate to those original objectives and in as concise a manner as possible. 

Another good practice is arranging the sections of the report in line with the due diligence checklist. It helps identify issues that could be a risk, as well as important financial considerations and opportunities for the business, including:  

• Risks associated with ongoing operations
• Compliance with legal and intellectual property laws
• Suggestions on ways to retain key personnel
• Changes in operating expenses, for example, vendors' issues
• The need for capital expenditures and the potential impact on the acquisition value
• The potential for improved earnings when there is leverage

In essence, the due diligence report should cover all items relevant to the purchase or ongoing operations of the acquired company and nothing else. 

Create a report structure that can be reused

Investing time in creating a report structure that can act as a template for the future is helpful. Regardless of the outcome of a deal, there will be many times when the report may be referred to and it can act as a valuable snapshot of a company’s position at a certain point in time. 

Where a deal goes ahead, for example, when a merger has been completed, it is best practice to measure progress at key milestones, for instance after six and 12-month periods, and a logical and concise report structure will make this process much easier. 

Review and integration

Once due diligence has been completed, and where a deal has been agreed, the next step is to create a detailed integration or launch plan. For example, in the case of a merger, a detailed plan is needed to successfully knit together two separate entities. Naturally, this is not a simple process but the insight gained during the due diligence process should act as a basis for the plan’s creation.

It might seem that at this stage, the role of the due diligence team is done. However, with so many deals failing at this very point, or at least not providing the value anticipated, continuity is key. The deep knowledge gained during the due diligence process should continue to inform the way ahead and support the c-suite and leadership team as they guide the integration process. 

If the outcome of weeks or months of due diligence is that a deal cannot be struck, there is still valuable insight to be gained. If we leave aside the natural disappointment that many weeks of hard work did not result in a successful deal, we can instead focus on what was gained from the process. Indeed, not reaching a deal can be the best outcome for both parties - the stakes are high and more damage than good can result from an ill-conceived or mismatched deal. 

Of course, there’s also the opportunity to review the due diligence process itself and this should be seen as a crucial last step. Taking the time to step back from the day-to-day detail of the process that has consumed so much time and energy over previous weeks or months, often reveals many process refinements for the next time.

For more insight, and tips on making your next due diligence process as successful as possible, download our new ebook.