09/ 06/ 2006
by Marcia Passos Duffy
The term "due diligence" is thrown around quite a bit in business circles, but what does it really mean?
Due diligence is lawyer-speak for what is, basically, a business investigation. The term can be used for a multitude of business situations, but it is most commonly used when one business is about to purchase another.
When you are about to buy another business, you don't want to leave any stone unturned, and a good due diligence does just that: It is a thorough business investigation that gives a detailed analysis and risk assessment of a commercial transaction that is about to occur. It should reveal all aspects of the business about to be purchased––the good, the bad, and, yes, even the ugly. The hope is that with all the good and bad sides revealed, the potential purchaser of a business can make an intelligent decision and minimize any post-settlement surprises and liabilities.
The due diligence process
Once a purchase price is agreed upon (based on limited information about the business) the prospective buyer will then usually include a conditional agreement with a due diligence clause with the target business, in which the buyer has a limited period to conduct due diligence.
During this time, the potential buyer requests full access to all relevant materials in the target business––all customer, vendor, financial and other information––in order to conduct a thorough investigation. To ensure that the potential buyer does not use this information to its own benefit if it decides to back out of the deal, a confidentiality agreement is usually signed to protect the target businesses' interests.
In short, the goals of due diligence are:
- To analyze the strengths and weaknesses of the target business.
- To possibly renegotiate the purchase price or cancel the agreement if the information found is not acceptable to the potential buyer.
- To ferret out any information that can be a risk or liability to the potential buyer and minimize post-settlement surprises.
What due diligence should reveal
The process of due diligence should reveal the strengths and weaknesses of not only the financials but also the desired assets of a company, which can sometimes be intangible.
To do this effectively, the potential buyer needs to be crystal clear about the goals and motives for acquiring the target company, as well as the value the buyer is attempting to create with the purchase: For example, does the buyer want the company's new market of customers? Employee talent? A new category of products? Production capacity?
For example, is there a legal risk, such as an outstanding lawsuit, that will not only jeopardize the financial stability of the company but also the loyalty of existing customers? Is the target company's market of customers being eroded by a new and stronger competitor? If the target company's talent is the asset desired, then how are employee relations? That asset will be eroded if the employees are upset and ready to walk out.
The stumbling block to a good due diligence
While, in theory, a thorough due diligence ought to reveal any of these negatives, in reality the process of due diligence rarely goes smoothly because of one major stumbling block: information. The target company is rarely eager to reveal to the world that it is up for sale and wants to keep this information confidential from its competitors, customers and employees. So getting any information from these sources can be tricky, if not impossible, depending upon what the potential buyer wants to gain from the transaction.
For example, the buyer who aims to get new market of customers with the transaction wants to make sure that the target company has a good relationship with existing customers. But, during due diligence, the target company does not want any contact with its existing customers for fear that customers might leave because of the impending sale. As another example, a potential buyer sees the employee talent as the company's main asset, but the target company is nervous about letting the potential buyer talk to key employees because it does not want to let on that it is going to be sold.
Because of the confidential nature of sales transactions, not all the information that is necessary to make a good decision can be revealed. This is why it is important to hire a lawyer and an accountant experienced in due diligence before beginning the process so the buyer receives reliable guidance. It's also critical to meet with trusted advisors––both inside and outside your company––about what has been discovered and brainstorm the different scenarios of what can go wrong if you went ahead with the deal. You should also look at what can be rectified and made right.
After due diligence
Often after due diligence, the goal is to either reaffirm the purchase price or renegotiate, depending on what was discovered.
But the ultimate goal is to make a rational decision based on the facts. While it may be hard to overcome the excitement of purchasing a business, the potential buyer must be prepared to cancel the deal if something is discovered that runs counter to why the business looked like a good deal in the first place.
The most important step to a successful due diligence––and a successful acquisition––is having a team experienced people who can give trustworthy advice and objective opinions. The ultimate decision to weight out the good, bad and ugly of a potential business transaction should not rest solely on the shoulders of a business owner; it ought to be the decision of a team of his or her trusted advisors and employees.
