Due diligence is a procedure where an investor considering making an investment is provided with an opportunity to examine the asset concerned in some detail prior to providing funds in exchange for shares. Investors need to be provided with a level of comfort that material information accurately reflects the assets and liabilities of the target as well as the company’s future prospects. Because a wide range of risks exist, due diligence for many investors is all about risk management.
Some investors don’t perform due diligence until they are already sold on the company. They want to verify what you said in your business plan is the truth. They might be looking for undisclosed litigation, that taxes have been paid, that any major contracts or other agreements are as represented, and, since most investments are based on the credibility of management, that management is who they say they are. (On one deal I worked on in the last two years, a founder was revealed to have lied about attending the elite university he claimed on his resume. In another deal, a founder was dropped due to prior censure by the SEC which he had not revealed.)
There is not one way to perform due diligence, and the process may vary depending on the product and people involved. Some investors will look at the product or service first. If it is attractive, they will then proceed to inquire further. Others will look at issues such as valuation first, and if satisfied, will proceed. For example, if the company indicates it will sell 1% of its stock for $1 million, the investor may believe it is overvalued and there is no point in pursuing due diligence any further.
Due diligence is all about verifying the accuracy of representations made. If management claims to own certain intellectual property, investors can search patent and trademark records to see if that’s true. If the unique features of a company are the product of certain creative talent, investors can verify that they are under contract and the company is protected by restrictive covenants. If the financial model claims that the target market has 10,000 companies, investors can review the documents supporting this claim. If there are financial representations being made, investors can investigate and analyze the accuracy of them. Even if the entity has audited financial statements, there are a great many schemes which somebody shopping a company can do which might not be caught by auditors. Using data management software, investors can analyze trends in transactions and highlight inconsistencies. While no investigation is guaranteed to catch all schemes, one thing is certain. If the acquisition target refuses to permit an independent investigation, or attempts to restrict the scope of an investigation, it’s an automatic red flag that this is an ill-advised deal.
Closing deals means submitting to due diligence. We have been there and can help you pull together the information needed to speed up this essential part of the process. And if you’re on the buy side, we have extensive checklists on areas to consider.
If you like this information, you’ll really like “Top 10 Mistakes That Cause Investors to Shoot Down Deals”.
About the author: David Brode is the Principal of the Brode Group. An economist by training, Brode has over two decades of experience helping ventures develop and communicate business strategies through financial models so they can launch, grow, and sell businesses. Brode’s financial forecasting models have been through due diligence dozens of times and have been successful in securing over $11 billion in financing for projects worldwide. Brode has a B.A. degree in Economics from the University of Michigan.
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