Understanding Due Diligence for Business
In Business there are terms everybody like to throw around as if they understand its meaning. Due diligence is one of those terms that you may understand on the surface but don’t know how to put it into practice. Let’s learn about due diligence and how to use it in a real-world setting. Due diligence is the process of analysis of a business prior to signing a contract or a deal before legal contract, which may be researching and verifying the accuracy or an act with a certain standard, it is simply doing your homework. It is an investigation or audit of a potential investment to confirm all facts, such as reviewing all financial records, plus anything else deemed material.
Due diligence refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. While this may not be a topic that sets the heart racing, being able to understand and evaluate a prospective acquisition, buyer or partner is essential to any growing company in today’s challenging business environment. Before putting your business funds to work on anything, you should make yourself an expert.
In simple, due diligence means verifying the accuracy of financial statements or reports.
The main motto of the process is to assure that all the stakeholders associated with a financial endeavor have the information they need to assess risk precisely. The scope of due diligence usually depends on the nature of transaction or the deal to be embark on. Due diligence is not only limited to buyers, but even sellers can perform a due diligence on the buyer. It includes of background, legal, accounting, factual checks, verifications and validation. The basic purpose for doing such an implementation is to make sure that there are no disclosures after the agreement is signed. Many Companies performs due diligence when they add new vendor, purchase commercial property or hire a new employee.
Various information’s are collected after the process and then reviewed to make a final decision. Both parties perform due diligence after both the seller and the buyer have agreed in principle to agreement, but this is done before they have signed a binding contract. It aids in understanding the seller’s reasons for selling their service or the business, it paves a way to know the depth and details. The information that we collect in the process is highly delicate, sensitive and confidential.
What to consider?
As the part of the due diligence process, the involving party who is investing the money have to also review the business’s fixed and intangible assets. An individual investor performs due diligence by studying annual reports, Securities and Exchange Commission (SEC) filings and other relevant information about a business and its securities. An investor verifies the material facts related to purchasing the investment and determines whether it fits his return requirements, risk tolerance, income needs and asset allocation goals.
For example, an investor may read the company’s last two annual reports, several recent 10-Qs, and any independent research available. He can then develop a sense of where the business is heading, what market factors may affect the stock’s price and how volatile the stock is. The investor then has guidance on whether the investment is right for him, and how much and when to purchase it. The depth and details will always help the buyer in valuing the business accurately.
Types of Due Diligence
- Loans and debts
- Property and assets
- Employment and contracts
- Pending litigation (the process of taking legal action)
Legal due diligence attempt to find the legal basis of a transaction, for example: ensuring a target business clutches or can work out with the intellectual property rights that are crucial to the future success of the company. Other areas that is most probable to discover includes: A Legal structure
- Cash flow
Financial due diligence emphases on verifying the financial figures provided and to assess the underlying performance of the business. The financial records and statement are the most important and plays vital role in due diligence process. Income statements, balance sheet, accumulated financial statements, insurance, tax fillings and various uses and sources of funds are the records to review during the process. This is done in case of business whereas it differs if due diligence is done for different sector for example; hiring an employee. We can expect to consider following areas.
Commercial due diligence reflects the market in which a business exits. For example involving exchanges with customers, an assessment of players and a fuller investigation of the assumptions that exit behind the business plan. The commercial due diligence intends to determine whether the business plan stands up to the realities and genuineness as per the market.
It covers other area such as audit at the time of merger, tax filing, IT systems and intellectual property etc.
What does the due diligence process involve?
The procedure involves both the principal (purchaser or investor) and an accountant and attorney. In business purchase, it is usually conducted after intent to purchase documents have been signed but before formal purchase contract. During due diligence, while purchasing the business one should: Need to examine all records, statements and documents, as labelled below
- Suppose you are buying a business then you must spend time at the business location, talking to managers, executives, employees and know more in details.
- Need to have information about the accurate customers
- You must know about the conditions of facilities and assets, future scope and plans, possible drawbacks overtime and poutine of business
- Examination of all the legal documents and contracts with suppliers, contractors and clients.
- Does the business have healthy cash flow?
- By looking at the books, can you tell where the revenue stream is coming from?
- If the company has physical assets, is their value correct anf fair?
- Is any liability hidden?
- How reliable are its financial projections and what multiple is it placing on those earnings?
- Are the company documents complete? (Articles of incorporation, board meeting minutes, tax registration, etc.)
- Is the business up to date on its taxes?
- Does it lease property? If so, when does the lease end?
- What insurance information to provide and what to cover?
- Are there complete employee files including salary and benefits?
Of course, this is a very short list of the due diligence that would take place before purchasing another business. But maybe you are not in the market to purchase a business. Maybe you’re planning to purchase a new building, add a new vendor or product line.
There are plenty of decisions you are likely to make where proper due diligence is key. Important aspect in due diligence is taking a note on differences between what is stated & what is actually happening on. It requires a lot of questioners, why, how, when exactly & sometimes necessary to prove the negatives & positives. The hard truth is that the due diligence is time consuming, inconvenient, tedious, and sometimes expensive. It goes beyond the basic checks you would normally make and it’s safe to say that if you didn’t find it to be about as fun as going to the dentist, you probably didn’t do it right. You should know just as much about the business or person as you do about your own business.