Due diligence in a broad sense refers to the level of judgement, care, prudence, determination, and activity that a person would reasonably be expected to do under particular circumstances. In corporate law, due diligence is the process of conducting an intensive investigation of a corporation as one of the first steps in a pending merger or acquisition. In a company acquisition, due diligence would include fully understanding all of the obligations of the company: debts, pending and potential lawsuits, leases, warranties, long-term customer agreements, employment contracts, distribution agreements, compensation arrangements, and so forth.
For example, due diligence in a property transaction may refer to an assessment made to discover and evaluate any environmental liabilities that could impact the future of the property. It may include researching real estate records to determine any liens on the property, providing an itemized list of needed repairs and deferred maintenance items, or determining compliance with local building code provisions as well as the regulations contained in the American with Disabilities Act (ADA). The nature of the tasks performed in due diligence depends on the nature of the property involved.
Due diligence is a process of acquiring objective and reliable information, generally on a person or a company, prior to a specific event or decision. It is usually a systematic research effort, which is used to gather the critical facts and descriptive information which are most relevant to the making of an informed decision on a matter of importance.
An affidavit of due diligence is made to attest to the efforts made by someone under a duty to make diligent efforts in a matter. It is most commonly filed by a person who has unsuccessfully made attempts to personally serve another with legal papers. The affidavit will set forth the attempts made to serve the person, such as times and date of attempted service, efforts to locate the person through neighbors, etc. The purpose of such an affidavit is to show the court that all legal obligations to discharge a duty have been met, and possibly may justify alternative measures, such as service by publication.
Due diligence is a program of critical analysis that companies undertake prior to making business decisions in such areas as corporate mergers/acquisitions or major product purchases/sales. The due diligence process, whether outsourced or executed in-house, is in essence an attempt to provide business owners and managers with reliable and complete background information on proposed business deals so that they can make informed decisions about whether to go forward with the business action. "The [due diligence] process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers, and key developers," wrote Lee Copeland in Computerworld. The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business action under consideration.
Many companies undertake the due diligence process with insufficient vigor. In some cases, the prevailing culture views it as a perfunctory exercise to be checked off quickly. In other instances, the outcome of the due diligence process may be tainted (either consciously or unconsciously) by owners, managers, and researchers who stand to benefit personally or professionally from the proposed activity. Businesses should be vigilant against letting such casual or flawed attitudes impact their own processes: an efficient due diligence process can save companies from making costly mistakes that may have profound consequences for the firm's other operational areas and/or its corporate reputation.
AREAS OF DUE DILIGENCE
The due diligence process is applied in two basic business situations: 1) transactions involving sale and purchase of products or services, and 2) transactions involving mergers, acquisitions, and partnerships of corporate entities. In the former instance, purchase and sales agreements include a series of exhibits that, taken in their entirety, form due diligence of the purchase. These include actual sales contracts, rental contracts, employment contracts, inventory lists, customer lists, and equipment lists. These various "representations" and "warranties" are presented to back up the financial claims of both the buyer and seller. The importance of this kind of due diligence has been heightened in recent years with the emergence of the Internet and other transforming technologies. Indeed, due diligence is a vital tool when a company is confronted with major purchasing decisions in the realm of information technology. "A due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a high-end system," said Copeland.
In cases of potential mergers and acquisitions, due diligence is a more comprehensive undertaking. "The track record of past operations and the future prospects of the company are needed to know where the company has been and where its potential may carry it," explained William Leonard in Ohio CPA Journal. In addition, observers note that the dramatic increase in information technology (IT) in recent years has complicated the task of due diligence for many companies, especially those engaged in negotiations to buy or merge with another company. After all, system incompatibilities can require huge amounts of time, money, and personnel resources to integrate.
Leonard notes that traditional due diligence practices in acquisition/merger scenarios called for detailed examination of financial statements, accounts receivable, inventories, workers compensation, employment practices and employee benefits, pending and potential litigation, tax situation, and intellectual property prior to signing on the dotted line. But in this dynamic business era, other areas should be looked at as well, including (if applicable): intellectual property rights, new products in the production pipeline, status of self-funded insurance programs, compliance with pertinent ordinances and regulations, competition, environmental practices, and background of key executives/personnel.
Many business experts also caution that the due diligence process is incomplete if it does not incorporate an element of objective self-analysis. "Self-analysis is the fundamental first step to realistically determine whether the post-acquisition 'whole' will be greater than the sum of its part," wrote Aaron Lebedow in Journal of Business Strategy. A detailed assessment of the market that is the target of the proposed acquisition should also be undertaken prior to closing a deal. Both of these requirements can be completed in a reasonable period of time, even in today's fast-changing business environment, by companies that either 1) outsource the due diligence task to a reputable research firm or 2) build an efficient in-house program within their legal, marketing, or corporate security sectors. "Unquestionably, opportunities for growth through acquisition exist," stated Lebedow. "Exploiting these opportunities has risks, but to those companies that acquire only after a comprehensive and systemic assessment of the marketplace and competition, the rewards justify the risks. Limiting due diligence to financial and managerial review is rarely enough. Successful acquisition strategy depends on the structure and depth of the due diligence process."
SUPPLEMENTING DUE DILIGENCE
Growing numbers of business enterprises are pursuing additional legal protection for themselves so as to shield themselves from harm if their due diligence efforts fail to uncover a serious problem with a merger or purchase transaction. One means of mitigating the risks associated with such major business transactions that has become increasingly popular in recent years is to secure a form of insurance coverage known as "representations and warranties liability insurance." A growing number of insurance underwriters are providing these policies, which call for them to pay insured parties for losses resulting from various "wrongful acts." This umbrella term generally covers errors, misstatements, misleading information, etc., but underwriters do include exclusions, some of which should be noted by potential buyers. These include acts of "fraud" (if adjudicated in the courts), pollution (which is typically covered under separate policies), or situations in which a party has received benefits—financial or otherwise—to which it is not entitled. One significant benefit of "representations and warranties liability" policies, however, is that the coverage can be used in place of reserves, escrow, or indemnity provisions that are included in purchase agreements.
Premiums for such policies can be expensive, especially for small and mid-sized firms with limited financial resources. Moreover, securing such insurance is a time-consuming and painstaking process, for underwriters are putting themselves at considerable financial risk. "Premiums will be determined based on the risk and the comfort level of the underwriter," summarized Leonard. ""It is most important that the process start early and not be left to a time when someone gets a 'feeling' things may not be entirely up to snuff. Although this type of coverage can be purchased after the closing, understandably the most beneficial time to place the coverage is during the due diligence phase preceding the closing."
Bernstein, Leopold A., and John J. Wild. Analysis of Financial Statements. McGraw-Hill, 2000.
Copeland, Lee. "Due Diligence." Computerworld. 6 March 2000.
Joukhadar, Kristina. "Faster Due Dilligence." InformationWeek. 22 January 2001.
Kroll, Luisa. "Gotcha: Pushing the Limits of Due Diligence." Forbes. 30 October 2000.
Lebedow, Aaron L. "Due Diligence: More than a Financial Exercise." Journal of Business Strategy. January 1999.
Leonard, William J. "Representation and Warranties—When Due Diligence Fails." Ohio CPA Journal. January 2000.
Torrey, Rebecca and Larry Scherzer. "Doing Due Diligence to Uncover 'Bad Apple' Applicants." Los Angeles Business Journal. 21 October 2000.
Hillstrom, Northern Lights
updated by Magee, ECDI