What is Due Diligence?

Due diligence is the research conducted prior to engaging in an acquisition transaction. Working through a due diligence checklist allows someone to have a full knowledge of the risks associated with a transaction. With this knowledge, one can structure the transaction to minimize risks. In many cases, the outcome of a due diligence investigation will result in the decision to pull out of a contemplated transaction entirely, usually because the representations of the seller turn out to be overstated or incorrect.

Due diligence is a major part of acquisition transactions. For example, an acquirer could review the following areas as part of its due diligence investigation of an acquiree:

The ownership of all outstanding shares
Whether there are any stock options or warrants outstanding
The terms of all outstanding debt
The status of all accounts payable
Whether all taxes due have been paid
The status of all accounts receivable
Whether any receivables have been pledged
The sources of all revenues
Whether all expenses have been disclosed
The types of employee compensation being paid
Whether the auditors have found any recurring control problems
Whether the firm has experienced fraud in the past
Whether the firm has any transactions with related parties
The status of the firm’s intellectual property

Related AccountingTools Courses

Business Combinations and Consolidations

CPA Firm Mergers and Acquisitions

Divestitures and Spin-Offs

Mergers and Acquisitions

What is Soft Due Diligence?

Soft due diligence is targeted at reviewing the human elements of an acquisition, such as the culture of a target company. The intent of this analysis is to determine how well the target business will integrate into the acquiring entity’s culture. If there is no intent to merge operations, then soft due diligence is less of a consideration.

Advantages of Due Diligence

Due diligence is an essential part of the process of acquiring a business, for the following reasons:

Problem discovery. Due diligence provides you with a detailed view of any issues that an acquiree may have, some of which might be grounds for terminating the acquisition. In particular, it may spot issues of such high potential risk (such as environmental liabilities) that they could put the financial viability of the acquirer at risk.
Asset discovery. Due diligence might reveal items of great value (such as a key patent), which might entice you to increase your offer price in case the acquiree’s owners seem less interested in the deal.
Reputation protection. Due diligence allows you to spot issues, such as regulatory violations or ethical issues, that might damage your reputation if you were to proceed with an acquisition. In effect, it allows you to avoid reputational damage.
Integration problems. Due diligence helps the acquisition team identify issues to address later, as part of the integration process. These issues may involve enhanced pay packages for key personnel, the need to streamline processes, or the merger of certain functions with those of the acquirer.
Price adjustments. Due diligence is useful for giving the parties time to review their positions and negotiate further, which may alter the final price at which the deal is completed.