due diligence

DEFINITION: The phrase “due diligence” refers to the moral or legal obligation to undertake a comprehensive review—usually involving extensive auditing—of the relevant financial details and other facts relevant to a proposed business purchase, sale, or other transaction.

ETYMOLOGY: The English term “due” is attested from the fourteenth century.It derives from Middle French deu, the past participle of the verb devoir (“to be obliged to”), which itself ultimately derives from Latin dēbeo, dēbēre (“to owe”).

The word “diligence” is also attested from the fourteenth century. It derives from identical forms in Middle English and Middle French, and, ultimately, from the Latin noun dīligentia; the noun, in turn, derives from the past participle dīligens, dīligentis of the verb dīligo, dīligere (“to choose,” “to prize,” “to esteem highly”).

USAGE: The phrase “due diligence,” as well as the practice it refers to, came into being thanks to the enactment of the US Securities Act of 1933, which required securities brokers to provide full disclosure (transparency) about the financial instruments they were offering.

As a result, failure to disclose material information to potential investors exposed dealers and brokers to criminal prosecution.

In response to this potential legal liability, the financial industry made due diligence a standard “best practice.” From there, the practice spread throughout the business world.

The drafters of the 1933 Securities Act acknowledged the possibility that the requirement of full disclosure might subject dealers and brokers to unjust prosecution, if they were unaware of certain material facts at the time of the sale and could not have been reasonably expected to know about.

To address this concern, the act incorporated the following legal defense: As long as dealers and brokers diligently investigate the companies whose equities they are selling and openly share the findings, they will not be held legally liable for any information that remains undisclosed.

Specialized equity research analysts, individual investors, broker-dealers, fund managers, and companies that are considering acquiring other companies all perform due diligence.

Due diligence conducted on the part of individual investors is voluntary. However, broker-dealers are legally bound to perform due diligence on securities before selling them.

Kinds of Due Diligence

Commercial due diligence: This type of due diligence involves assessing a company’s competitive position, market share, and growth potential. It usually includes such things as an evaluation of the company’s supply chains, both incoming from vendors and outgoing to customers, thorough analyses of the market and sales pipelines, and research and development activities. Finally, this form of due diligence may include a thorough examination of the company’s overall operations, covering the composition and activities of the management, human resources, and information technology teams, among other things.

Legal due diligence: The purpose of this kind of due diligence is to ensure that a company is in full compliance with all legal and regulatory requirements. This thorough examination covers various aspects of a company’s legal involvement, including ongoing or potential legal disputes, the safety of intellectual property rights, and confirmation that the company was correctly incorporated. In essence, the process ensures that all legal matters are appropriately addressed within the company.

Financial due diligence: This form of due diligence involves a comprehensive review of a company’s financial statements and records with a view to identifying any anomalies and ensuring the company’s financial integrity and stability.

Tax due diligence: This type of due diligence examines the company’s tax liabilities, potential outstanding, as well as its opportunities for minimizing its future tax obligations.

Hard versus Soft Due Diligence

Hard due diligence: The primary focus of this sort of due diligence is on analyzing the numerical data presented in financial statements, such as the balance sheet and income statement. It involves conducting fundamental analysis, including utilizing financial ratios, in order to obtain insight into a company’s present financial health and to make responsible future earnings projections. While this type of due diligence may help to identify potential issues or accounting discrepancies, it is worth noting that it is primarily driven by objective mathematical and legal considerations. That said, it is essential to be cautious of overly optimistic interpretations from enthusiastic salespeople, as they may attempt to present a positive picture of the company’s financial situation that is unwarranted on the basis of hard due diligence alone.

Soft due diligence: This form of due diligence takes a more qualitative approach. Business success is influenced by various factors that cannot be entirely quantified, including effective leadership, employee relationships, and corporate culture. For this reason, soft due diligence focuses more on human factors like the caliber of the company’s management and personnel, and the loyalty of its customer base. Unfortunately, a significant number of mergers and acquisitions—more than 70 percent—end up failing, often due to ignoring the all-important human element in the due diligence process.