Protecting Your Investment: The Importance of Due Diligence When Buying a Company

Whether you’re buying a business or selling one, there’s one vital step that can make or break the deal: due diligence. It may seem like a time-consuming process that takes a lot of effort, but it should never be overlooked. Just like you should never purchase a home without having an inspection, you should never purchase a business without performing due diligence. Once a business evaluation is performed, it is the best way to decide if a business is worth the price.

What is due diligence in M&A?

Due diligence involves conducting a thorough investigation and analysis of a target company before finalizing the purchase. The process is about gathering all the relevant information about a company to evaluate its financial health, operational efficiency, legal compliance, and overall viability. Due diligence includes reviewing financial statements, contracts, customer relationships, intellectual property, regulatory compliance, and any potential risks or liabilities. 

Three types of due diligence are typically performed before a potential buyer purchases a business.

What are the 3 types of due diligence?

There are several types of due diligence, but they usually fall into three categories: financial, legal and commercial.

Financial due diligence is an assessment of a company’s financial health and involves the examination of the firm’s historical and current financial performance. This is done by reviewing financial statements, assets, debts, cash flow and projections to determine whether they are accurate. The goal is to gain a better understanding of the company’s core performance metrics and determine forecasts while also considering potential risks. 

Legal due diligence investigates potential liabilities of the target company that could impact a successful transaction. It examines all contracts, partnership agreements, licensing agreements, guarantees, and loan and bank financing agreements.

Commercial due diligence is also referred to as market due diligence. This exercise analyzes the market size, market share, customer base, competitors and potential future returns. Commercial due diligence assesses whether the deal is financially viable and if the purchaser is likely to realize value from it.

Why perform due diligence?

There are three good reasons to perform due diligence. The first and perhaps most important is to mitigate risk when buying a business is to mitigate risk. Acquiring a company is a significant investment of both time and money and without proper due diligence, you're essentially flying blind. By thoroughly assessing the target company's assets, liabilities, and potential risks, you can make more informed decisions and minimize the likelihood of unpleasant surprises down the road.

Due diligence will reveal unexpected surprises, such as undisclosed debts, pending lawsuits, or regulatory violations. These can significantly impact the company's value or future. Once this knowledge is uncovered, a buyer can choose to renegotiate the terms of the deal, walk away from the opportunity, or execute strategies to lower these risks after the purchase. 

While the first reason usually focuses on risks and liabilities, the second reason to perform due diligence is to expose a company’s strengths, competitive advantages, and potential for growth. This can include proprietary technology, important customer relationships, untapped markets, or synergies with your existing business. These insights can maximize the value of the company and uncover hidden opportunities. 

The final reason for performing due diligence is to build trust and credibility with stakeholders. These can include investors, lenders, partners, and employees. By demonstrating that you've conducted a thorough and transparent assessment of the target company, you show that you are making a well-informed decision based on objective analysis rather than speculation or intuition. This instills confidence and can be particularly important when you’re looking for financing or approval from regulatory authorities.

Who performs due diligence?

Due diligence is usually performed by the purchaser, but a business owner selling a business should do their own internal due diligence well before listing their business. This way, they will be prepared for the questions and can fix issues before the purchaser’s due diligence. A team of experts is usually required, including lawyers, accountants and other professionals. If you have engaged a business broker to help with either the selling or purchasing, they will have a network in place with access to all the professionals you need to perform a thorough due diligence exercise.