Due Diligence
The financial standing of a company is an extremely important issue not only for the shareholders themselves. It is also important for investors who are interested in acquiring shares, i.e. taking over ownership (or becoming otherwise involved in the company), but at the same time want to be sure that the operation will prove profitable. Due diligence is used to assess the condition of a company. How does it work and when is it worth commissioning it?
What is due diligence and who performs it?
Due diligence is sometimes referred to as a pre-investment audit or due diligence. It is a series of actions aimed at identifying the strengths and weaknesses of a company, as well as potential transaction risks.
In this way, the stakeholder gathers information about the financial, legal and operational situation of the company. Shareholders or management may also choose to conduct a due diligence audit in order to evaluate past operations, make possible decisions to change the direction of the company and optimise its future operations.
The pre-investment audit is carried out by qualified professionals:
- lawyers,
- accountants,
- experts,
- tax advisors,
- IT specialists.
A comprehensive approach to the subject is necessary to create a holistic picture of the company. It is generally accepted that it is the buyer’s responsibility to commission due diligence (if it precedes the sale of shares), as it is the buyer who wants to be sure of making a profitable transaction.
Types of due diligence
Due diligence is not a uniform concept and may consist of many stages, depending on the client’s needs and the company’s profile. In practice, the most common types of due diligence include
- tax
Tax due diligence includes analysis of a company’s tax structure, its liabilities to the State Treasury and potential tax arrears. It is also the stage at which decisions of tax authorities and tax books are verified (especially in the context of revenues and tax deductible costs).
The examination of tax conditions is particularly important when planning an international transaction where the analysis of several legal systems is involved.
- financial
Financial due diligence involves examining the business aspect of a company. In this case, accounting books are of key importance. Their analysis allows for assessment of possible risks and correctness of further functioning of the company.
As part of the examination, specialists assess, among other things, the scale of the company’s operations and its profitability, the structure of sales and costs, and the potential of the assets held (real estate, intellectual property rights and other assets).
- legal
Legal due diligence assesses the planned transaction from the perspective of legal aspects. It evaluates employee issues, industrial property issues, the company’s participation in lawsuits or administrative proceedings.
Thanks to the analysis of such documents as court judgments and decisions, administrative decisions, property deeds, concluded agreements that are not covered by NDA, the investor can better plan its activities. Legal due diligence very often constitutes the first stage of investigating the situation of an enterprise and allows to prepare the ground for analysis of other aspects of its functioning.
- Business
Assessing a company on a business level primarily serves to estimate its EBITDA (earnings before interest, taxes, depreciation and amortisation), more commonly referred to as operating profit. It also helps determine its debt, claims and working capital requirements.
Business due diligence assesses sales, operating costs and margins. At this stage, individual KPIs (Key Performance Indicators), i.e. financial and non-financial indicators that allow assessing the degree to which the assumed business goals are achieved, are also evaluated. Due to differences in the way individual companies operate, business due diligence will look slightly different each time.
- IT
IT due diligence is particularly important for companies that rely on ICT. It allows for checking the stability of IT architecture and the economic risks connected with it. It also serves to assess the infrastructure itself – its maintenance costs, efficiency, scalability and the existence of the so-called technological debt (i.e. lack of design for applied solutions and use of non-optimized technologies).
IT due diligence also serves to assess the implementation of processes carried out in the company in terms of their compliance with RODO and ISO standards on information security (if these have been implemented). The human factor is also important, which is why the helpdesk, technical and IT department staff are also evaluated.
- Vendor due diligence
A specific type of due diligence is vendor due diligence. Unlike other types of pre-investment audits, this one is conducted by the seller, who cares about obtaining the most favourable terms of sale and collecting arguments for the upcoming negotiations. In practice, it precedes negotiations, proper due diligence and signing of the agreement.
Vendor due diligence covers all aspects of a company’s operation (including financial, tax, legal, employee). It allows for segregation of sensitive information and minimisation of sales risk. In practice, it also saves time, as a well-planned transaction can be finalised faster.
What services will due diligence include?
What due diligence services will include depends largely on the expectations of the buyer or seller, the profile of the company and the size of the transaction itself.
Typically, desk research is interspersed with negotiations and Q&A sessions to work out the best terms of the transaction. A good due diligence should conclude with a report that identifies:
- the most important information from the perspective of the planned transaction,
- a summary of financial data (preferably in the form of KPIs so that it is easy to analyse the financial situation of the company)
- identified risks and irregularities that may affect the profitability of the transaction (resulting from existing contracts, corporate pragmatics and laws)
- valuation of the audited entity.
A competent team will not only identify possible risks, but will also help neutralise them by taking appropriate action.
Due diligence vs. financial audit
It is important to remember that due diligence (regardless of its scope) is not the same as a financial audit. The purpose of an audit is to check the truthfulness and reliability of individual items in the financial statements against accounting standards.
Of course, due diligence also includes this element of the audit, but at the same time it goes much further. In the course of due diligence, all information that may contribute to the valuation of the entity being sold is verified.
Unlike an audit, due diligence has no such defined structure or framework. The lack of regulations that would define its structure makes it possible for business advisory law firms to take far-reaching measures to help better plan a transaction.
The activities that make up due diligence can be useful at many stages in the life cycle of a business. It is usually associated with an activity that causes high business risk. Due diligence most often precedes:
- negotiations before signing a major framework agreement,
- M&A processes (mergers and acquisitions),
- sale of shares or stocks,
- entering the stock exchange,
- initiation of restructuring proceedings.
There is no statutory catalogue of situations in which due diligence is required. However, it is worth taking it into account if the company or the buyer cares about minimising the risk associated with the transaction and wants to consciously invest in development.
How long does due diligence take?
The duration of due diligence depends on:
- scope of conducted activities,
- size of operations of the assessed company.
In practice, due diligence may last from several weeks to even several months and involve specialists from many areas. Typically, the broader the scope of due diligence, the longer the entire process takes, but it is often worth the extra time so that you can benefit from reliable and valuable information at the next stage.
Staniszewski & Partners
