Due Diligence: Definition and a Checklist

If you are considering acquiring a company, being acquired or about to carry out a merger & acquisition, you will soon be hearing of the due diligence, aka “due dil” or even “DD”. This process, even if not mandatory in some countries, is highly recommended for the success of the transaction.  

Let’s start with a concise definition so you understand why. Due diligence refers to all the best practices and verification operations carried out by a potential buyer or investor before a transaction, in order to get a clear idea of ​​the situation of a company. In business relationships, the due diligence process is based on the principle of “Caveat emptor” which means “let the buyer be vigilant”. 

Due diligence makes it possible to answer any questions that the buyer or potential investor may have before the purchase. It allows them to gather as much information as possible and to carry out a complete assessment of the value chain, the potential risks and the opportunities of the company concerned in order to ensure that the transaction is viable.

This is a key step in business relations, particularly during the process of buying a company, merger and acquisition, investment in the capital of a company or initial public offering (IPO). This duty of vigilance must be carried out after the letter of intent and before the effective date of acquisition.

The due diligence involves the use of external experts or consultants (accountants, financial, legal, tax or environmental experts) to assess the strengths and weaknesses of a targeted company.

The duty of vigilance brings together the legal measures that oblige credit institutions to check the identity of potential investors and the origin of their funds and sources of financing in business relationships.

The main objective of due diligence is to limit the risks of acquisitions such as an overvalued sale price; inconsistent balance sheets leading to financial losses; the existence of tax evasion; money laundering; an adjustment of social security contributions.

Therefore a full due diligence process can regroup several due diligence on different fields. Depending on the size of the deal and the budget allocated by the buyer, not all fields will be audited. Let’s focus here on the most common ones. 

Financial audit is the most spread, quite logically. This is where the potential buyer / investor and its advisors will confirm all the facts from previous discussions on the financial health of your company. The financial audit consists of the analysis of the company's accounting documents and its past, present and future financial situation. 

You can store in it:

• Accounting principals
• Income statements: product and loss (P&L), balance sheets, cash flow statements
• Sales
• Accounts Payables and Accounts Receivables
• Debt details
• Equity
• Profitable level
• Projections in the 3 coming years 

Another highly important one is legal due diligence. This is where the potential  buyer / investor and its advisors will assess the juridical risks of the deal. 

Typically, you will put:

• Customers contracts
• Partnership contracts
• Employee / Contractors contracts
• Providers contracts
• IP
• Licenses agreements
• Offices / Buildings contracts

The market or commercial audit aims at checking within the framework of strategic due diligence and focuses mainly on the development potential of the target company. They relate to:

• The positioning of the company on the market;
• Leadership skills;
• Market analysis (demands, trends);
• Competition analysis.

In addition to the financial audit and the strategic due diligence, the acquirer can call on an audit firm to carry out checks on the following areas:

Social audit

• Whether or not the cultures of the two companies are compatible;
• Shareholders' pacts;
• Buildings and land owned by the company;
• Employment contracts;
• Registered trademarks and patents;
• Operating licenses for software, designs and models.

Tax audit

The objective is to avoid tax disputes in the event of administrative controls. In addition to the tax situation of the target company, the buyer must know the extent of his obligations, i.e.:

• The tax system;
• Applicable rates.

Ultimately, due diligence allows the acquirer to ensure that the information given by the target company during negotiations is accurate. If we focus on the main advantages of this audit, here they are: 

The ability to negotiate the price

Once in possession of key information on the weaknesses and strengths of the target company, the acquirer is able to determine its real value. In case of overvaluation of the transfer price, he can negotiate a reduction and avoid an exorbitant investment.

The addition or reassessment of contractual guarantees

If the acquisition audit reveals risky assets, the buyer can request the insertion of certain clauses such as the asset guarantee which obliges the seller to compensate the buyer in the event of a reduction in assets whose cause is prior to the transfer operation.

liability guarantee. This protects the buyer against an increase in liabilities after the sale, but caused by an event prior to its signing.

Other alternatives are also possible. The buyer can for example negotiate a longer warranty or simply retract and cancel the assignment.