“Diligence is the mother of good fortune.”
-Miguel de Cervantes Saavedra
In July 2016, the Australian Securities and Investments Commission (ASIC) stated that it’s review of 12 initial public offerings (10 of which were small and mid-sized companies), found incredibly poor due diligence processes. These companies often seem to lack documentation to back up the claims they make in their prospectus. This is a very worrying sign for investors and tells us of the immediate need to promote better due diligence practices.
With the surge in an ever growing landscape of corporate litigation, shareholder activism and a number of disclosure obligations, smaller and mid-sized companies are now seeking the smartest route forward in their growth strategies. In such situations, companies cannot afford to make a mistake in acquisitions and assume unanticipated liabilities. At the same time, companies do not want to overburden the targeted acquisitions with diligence requests that might disrupt the deal. Hence, to succeed amidst these competitive conditions a professional process of critical analysis is vital for positive acquisitions or partnerships. It prepares buyers as well as investment partners and lenders with a clear understanding of the story. This needs to be executed by a due diligence process that is planned and implemented in a systematic manner so that there is no space for an unnecessary intrusion.
The notion of due diligence is often misconstrued to apply solely to mega-deals between large companies. Small and mid-sized companies generally have less sophisticated financial reporting, which could be a prerequisite when a company is trying to secure sources of funding for a transaction. Clearly, due diligence is a necessity in all matters.
In order to clarify the aforementioned misconception, it is important to define the term. Due diligence is a program of critical analysis that organizations undertake prior to making business decisions in areas, such as corporate mergers and acquisitions, or major product purchases and sales. This process analyzes an organization's previous financial performance records and other necessary reports that help provide business owners and managers with authentic background information on the planned business deal. This, in turn, helps them make cognizant decisions on whether they must carry on.
Types of Due Diligence
Commencing the process of due diligence appropriately is of paramount importance. Appointing skilled members to the team is, hence, critical to ensure the information gathered is understood and evaluated precisely. The identification of these team members takes time and money. Buyers must keep an open mind in order to not misjudge the risks and liabilities involved in the transaction.
After the due diligence investigation has been completed, there are two important steps that must be followed. The first is to create a detailed written report of the investigation conducted. The results obtained must be analyzed thoroughly. This will be important for both parties to develop a plan incorporating the information into the transaction agreement. The second step is as important as the first one but is often disregarded. This step deals with analyzing the information and determining any impacts on the proposed transaction. One must be cautious while dealing with such circumstances. For these purposes, an action plan must be developed to manage the information disclosed. If any buyer determines that information disclosed by the seller is not substantial, he may be precluded from a subsequent claim for recovery based on those liabilities.
There are two main due diligence processes that need to be considered by organizations: post-closing transactional due diligence and ongoing enterprise due diligence. An organization’s post-closing transactional due diligence is designed to check whether key assumptions used to rationalize the transaction are being comprehended. If they are not, the management can be informed and steps for redemption can be taken as soon as possible. It also makes sure that the target company is being integrated into the organization competently.
Several factors lead to discontent in an acquisition and one of the major factors is the lack of due diligence. In recent years the importance of ongoing due diligence has escalated to a new level by new legislations such as the Sarbanes-Oxley Act of 2002. Ongoing enterprise due diligence is mainly focused on to meet the needs of an organization. It must be viewed as a dynamic process that changes depending on the circumstance of the organization. An organization’s ongoing enterprise due diligence must be structured in such a way that it ensures the organization avoids redundant losses and expenses. The organization’s governing body, including the board of directors, trustees or governors must be able to exhibit that it is involved in effective oversight and that job-and-bonus- threatening hostile events are actively being avoided. Ongoing monitoring of the organization's operations and plans is very important while dealing with customers and suppliers.
Importance of Due Diligence
This process is crucial to the ongoing success of an organization. This also makes sure activities within the organization are all in compliance with the corresponding law. The due diligence team should keep in mind that apart from taking necessary steps in helping the organization, it must also take steps to keep up with the current trends in new legislation and take proactive action to work on recommendations.
Hence, organizations that are planning an acquisition or merger should plan to assign sufficient time and resources to discover potential problems with the seller. A failure in reviewing the documents carefully might result in a clash of agreements between the buyers and the sellers. Further, if any action of fraud is discovered after the sale is completed the buyer might be prohibited from bringing an action to court.
If a serious problem has arisen in an organization, the senior officials are usually the ones who suffer the repercussions. Due-diligence, however, could have furrowed out the problem and the individuals involved could have been terminated. For many senior officials meeting the financial goals is the most important test. It could be very exasperating to motivate the junior workers to achieve high performance and yet suffer due to unexpected liabilities that could have been avoided by due diligence.
Even after the due diligence processes have been conducted, in order to make sure that none of the provided financial information changes negatively and affects the ongoing relationships of a transaction, Investors, and business partners have to initiate constant monitoring to ensure everything is functioning in order.
Monitoring is also a useful way for investors and business partners to stay conversant of the current status of litigation or negative events established during the course of initial due diligence processes. If an organization is found to be involved in litigation matters, investors and business partners should consider monitoring these issues until they are resolved. This monitoring can be useful in determining any financial responsibility ordered to be paid by the organization. This is also a method to determine whether the decision-makers of an organization remain the same as when post-transactional enterprise due diligence process was being conducted.
In conclusion, in the midst of the current economic crisis, increasing regulatory and media scrutiny, post-closing transactional and operative ongoing due diligence processes remain as valuable tools to ensure that business transactions, relationships, or investments are not jeopardized. These are not only in the best interest of the organizations as a whole but, also in the rational self-interest of senior management. Both these processes require effort and operational discipline to plan and implement. Monitoring these processes also provides an insight and indications of the current standing of a potential business partner. This up-to-date insight attained through monitoring provides the investors and business partners with the knowledge they need to make decisions that will help in the growth of the business and minimize the potential risks.