Why effective due diligence is essential during business transactions

By Anita Jaynes on 19 July, 2022

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Due diligence is an investigation or series of reasonable steps that a business must undertake in order to assess risk prior to entering into an agreement or contract with another business or individual. In this article, we’ll explain why effective due diligence is essential for successful business transactions and the many benefits of prioritising due diligence.

What is due diligence and why is it important?

When selling – or accepting an offer – to acquire a business, assets or investments, the seller should allow the buyer access to carry out due diligence investigations on the company. This process will assess financial, legal, and operational matters and verify the details set out in the deal.

Due diligence is important because it allows you as a buyer to identify any potential risks involved in acquiring the business and enables you to accurately determine assets and liabilities prior to finalising the acquisition.

Financial due diligence

Financial due diligence reviews the past financial performance of the target business along with the future financial forecast to assess whether they provide a true reflection of the target business and whether the recommended price is justified.

Ideally, financial due diligence should commence as soon as possible in the negotiation process. As the buyer incurs costs to undertake due diligence, during the process, the target business will be taken off the market and the two companies enter into what’s known as a period of exclusivity, meaning that a deal has been agreed in principle.

The financial due diligence review will assess whether the information provided by the seller is reliable, whether the historic and current earnings are sustainable and what the realistic potential future earnings are. It should also cover tax consequences and associated costs of the acquisition, whether the purchase price is reasonable and if any legal warranties or guarantees are required.

All of this can help you to negotiate a better deal where appropriate. You should work alongside experienced professionals to help you identify the possible risks and opportunities from a transaction and confirm whether you are making the right decision from a financial standpoint.

Many high-profile cases, such as the infamous AOL-Time Warner merger, and more recently the proposed acquisition of Twitter by Elon Musk, have demonstrated that the long-term costs of a bad acquisition far outweigh the initial costs of a thorough financial due diligence process.

Legal due diligence

Legal due diligence will give you an overview of the legal implications of the transaction. This will provide you with information about commercial contracts and whether they can be transferred to a new company, along with information about intellectual property and real estate, employment policies, health and safety records, environmental policies, compliance requirements and any previous or outstanding litigation issues.

Knowing all this will not only help you to decide whether the suggested price is fair but will also help protect your business’ reputation from a bad deal and ensure you know in advance about any potential risks.

Technological due diligence

Analysing the target company’s IT assets (or lack thereof) allows you to accurately assess the scalability and sustainability of the business before purchase. You can also ascertain if the IT infrastructure is vulnerable to cybercrime and factor in any potential risks or financial costs associated with this.

Improved business relationships

The due diligence process can help to provide transparency for both parties during the deal and improve business relationships. This is beneficial as the current competitive marketplace means third-party relations and robust networks are more important than ever to business success. Alongside the technological, legal, and financial aspects of due diligence, it’s also important to consider the cultural fit of the two companies and whether the acquisition makes sense in terms of the buyer’s wider portfolio and long-term strategy and goals.