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What Is Due Diligence
Due diligence is a term used in business, law, and other disciplines to refer to an audit or review of facts.
In other words, to perform due diligence, you are performing an investigation to find factual information on a particular matter.
For example, when a company is looking to acquire another company, prior to the purchase, the acquiring company will perform a due diligence on the target company to ensure that they have all the proper facts to make a sound business decision.
In financial due diligence, the financial records and statements of a person or company will be reviewed to understand, validate, or confirm a financial position.
Origin of Term Due Diligence
The term “due diligence” started being used more commonly in the United States following the adoption of the Securities Act of 1933.
In this act, the securities law required that securities dealers and brokers provide their investors full disclosure of material and information on a company so they can make informed investment decisions.
However, to protect the dealers and brokers from not having “all” the information on a stock or company, the law required that brokers exercise “due diligence” when looking up information on a particular stock to pass on to investors.
To the extent the broker performed his or her due diligence, the law would not hold the broker accountable for an investor not having been given all the material information on a stock.
Purpose of Due Diligence
The main purpose of due diligence is to examine financial records, find factual information about a company, an investment, or other, and consult documents to confirm certain facts.
In business, due diligence is done for different reasons:
- By an acquiring company purchasing a target company
- By a company when looking to penetrate a new market
- By a company looking to evaluate competitors in its industry
- By a company to conduct a background check on individuals when hiring
- By an investor before investing in an instrument or a business venture
There are many more reasons why it may be important to perform due diligence before making a decision in business, the above list is just to give you some examples.
Types of Due Diligence
There are different types of due diligence that could be done depending on your objective and the context in which the due diligence is done.
Here are some common types of due diligence:
- Financial due diligence
- Legal due diligence
- Human resource due diligence
- Operational due diligence
- Environmental due diligence
- Strategic fit due diligence
- Asset due diligence
- Administrative due diligence
- Tax due diligence
- Intellectual property due diligence
For instance, in mergers and acquisitions, you’ll perform due diligence on the target company’s financial statements and financial records to validate their financial position.
An investor looking to invest in a startup will do due diligence to ensure that the startup founders have the skills necessary to succeed, there is a sound business plan, and they are targeting a viable market.
A bank will do due diligence to ensure that a borrower has the financial capacity and creditworthiness to borrow funds.
As you can see, foundationally, due diligence is done by a company or person to assess risk and exposure.
Due Diligence Examples
To better understand what due diligence means, let’s look at some examples of when it is useful.
You will very often hear about conducting “due diligence” in the context of mergers and acquisitions, different types of investments such as stocks, startups, real estate, legal matters, and more.
For instance, if an investor is looking to purchase a real estate property generating rental revenue and costing $2,000,000 he or she may want to perform due diligence to ensure that the property complies with zoning laws, consult the property leases, review the building expenses, ensure that all permits are issued, ensure that the seller is authorized to sell the property, the title is clear, and so on.
During this due diligence process, if the investigation reveals that in general the information shared by the seller is consistent with the information found during due diligence, then the transaction will move forward.
However, if the due diligence reveals material information the seller had not shared or had concealed, then the buyer may call the deal off, renegotiate the terms, or continue with the transaction.
What Is Due Diligence FAQs
Let’s look at common questions asked relating to what is the meaning of due diligence.
What does due diligence mean
To put it very simply, due diligence refers to the process of investigating a particular subject in order to ultimately make a decision.
In essence, when you have to make a decision requiring you to assess the pros and cons of the decision, the potential risk and return, you’ll want to perform due diligence.
You can use the words audit, investigation, review, or assessment synonymously with the term due diligence.
What is reasonable diligence definition
Reasonable diligence refers to the process of reasonably investigating a particular matter before making a decision.
For example, an investor looking to purchase equity securities can choose to do no investigation at all and invest in a stock, perform reasonable diligence, or do a full due diligence.
Reasonable diligence is to try to investigate material information relating to a transaction without having to go through everything.
What is the definition of due diligence
In the dictionary, due diligence is defined as follows:
Research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities)
This definition applies to business due diligence.
You also have legal due diligence that is defined as follows:
The care that a reasonable person exercises to avoid harm to other persons or their property
In essence, the definition of due diligence in the English language is when a person exercises prudence and diligence before undertaking a project, making a decision, or engaging in a certain activity.
It’s important to point out that some may say “do diligence” but it should be rather “due diligence”.
What is due diligence in business
Due diligence in business generally refers to the practice of making decisions based on a careful assessment of the risks and rewards associated with a particular business decision or transaction.
For example, a company may perform due diligence to ensure that the purchase of new equipment, property, or asset will add value to the organization and not expose it to any unwanted risk.
When hiring a new employee, organizations will do their due diligence to ensure that the employee has the proper skills to do the job and has a clean background.
What is financial due diligence
Financial due diligence is the process of looking at and analyzing a company’s financial statements, accounts, financial records, and financial position.
Typically, banks will perform a financial due diligence on companies before extending a corporate line of credit, loan, or any other type of business financing.
Financial due diligence is aimed at reviewing revenues, profits, sales, expenses, bank accounts, cash inflows and cash outflows, financial statements, and other financial transactions or records.
What is due diligence in law
In law, due diligence is legally defined as:
Care or attention to a matter that is sufficient to avoid liability, though not necessarily exhaustive
There are also certain situations where the law compels certain people or companies to perform due diligence.
Particularly, under the Securities Act of 1933, securities dealers and stockbrokers are legally required to provide the information they have found on a stock before recommending it to investors.
In other words, securities dealers must perform their due diligence on a stock before selling the shares to the market.
This legal obligation imposed on stockbrokers and dealers ensures that investors are better protected when making investment decisions and run a lower risk of losing their money as many did during the stock market crash of 1929.
What is a due diligence report
A due diligence report is a document that explains the type of due diligence performed, the nature of the investigation done, and outlines the particular findings in light of the scope and purpose of the due diligence.
For example, if a company is performing due diligence to purchase another company, the due diligence report will provide the details of the investigation performed on the target company and the findings that can materially impact the acquiring company’s decision.
What is due diligence process
The due diligence process refers to the actual investigation or audit process.
You can consider the due diligence process to be a fact-finding exercise where the party doing the due diligence is looking to obtain factual records and information to validate different points and eventually make a decision.
The process is typically kick-started by defining the scope of the due diligence, putting together an appropriate due diligence checklist, gathering the required information and documents, reviewing the information, and reaching conclusions.
What is M&A due diligence
In M&A, or mergers and acquisitions, due diligence is a crucial part of a successful transaction.
In the mergers and acquisitions space, there are lots of activities where companies merge with one another, split off, spin-off, divest, buy and sell assets, buy and sell shares, and do all kinds of things.
When companies intend to acquire another, merge with another, or perform a particular transaction with another, they’ll engage in a due diligence process.
For multinationals, the due diligence can take months, if not years, to complete depending on the complexity of the transaction and the needs of the parties.
What are due diligence documents
Due diligence documents generally refer to the documents that are requested in the context of a particular transaction.
When the bank is doing a due diligence to give you a loan or line of credit, the due diligence documents tend to be bank account statements, credit reports, invoices, receipts, balance sheets, income statements, cash flow statements, investments, and related documents.
What is contingent due diligence
Contingent due diligence refers to a situation where a buyer is interested in signing a contract, a person making an investment decision, a bank making a loan, or any other business decision where the final details of the transaction will be contingent on the facts discovered during the due diligence process.
For example, an acquiring company may express its intention to purchase the target company for $10,000,000 where this purchase price is contingent on a full due diligence.
If the acquiring company is satisfied with the due diligence, then the deal can move forward.
However, if the acquiring company is not satisfied with the due diligence, then it can withdraw from the deal.
What is DD in stocks
Due diligence in stocks, or DD in stocks for short, is the process a person or investor will go through to find public information on company stock in order to determine whether or not this stock should be purchased.
Value investors tend to perform a lot of due diligence on a stock before purchasing it as their objective is to ensure that the stock is priced below what the company is truly worth.
As a result, they will gather a lot of information on the company in an attempt to accurately evaluate the price of the stock so they can determine if there’s an investment opportunity there or not.
It’s important to note that dealers and stockbrokers are legally required to perform due diligence on a stock before recommending it to investors.
What is due diligence in real estate
Due diligence in real estate refers to the process of investigating the physical and financial condition of a real estate property before making a purchase.
You can perform real estate due diligence no matter the type of property you are looking to buy such as a single-family home, multi-family property, office building, industrial property, or manufacturing plant.
When a real estate property generates revenues like rental revenues, you will also want to investigate the sources of revenues, the leases, payment records, and so on, to validate the property cash flows.
What is a due diligence checklist
A due diligence checklist is a list of different elements to review or investigate in a given context.
For example, if a company is looking to acquire another company, mergers and acquisition lawyers will typically provide you with an M&A due diligence checklist covering all the different aspects they’ll want to cover during the due diligence process.
The due diligence checklist will generally be organized in different categories, such as:
- Financial records
- Intellectual property
- Corporate matters
- Company ownership
- Human resources
- Business markets
- Processes and policies
- Litigation and legal exposure
This list is just to give you an example of points that may get covered in a due diligence checklist.
You can have very targeted checklists where your focus is on a few points or you can have a very broad due diligence checklist where you are looking to know everything you possibly can about a company.
What does DD stand for in stocks
In stocks, DD stands for due diligence.
In essence, DD or due diligence is the process of investigating the potential of a stock or equity investment.
The objective is to ensure that you have all the information on the stock in question to be able to make a purchase decision and at the right price.
What Is Due Diligence Takeaways
So there you have it folks!
What is a due diligence in simple terms?
In essence, due diligence is the process of collecting, analyzing, and reviewing records, information, and documents on a particular matter such as an investment or a purchase.
The main objective of due diligence is to find and obtain relevant and material information so you can make an informed business decision.
Now that you know what is due diligence, what it means in different types of scenarios, and what are the different reasons why due diligence is performed, good luck with your investigation!
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