Defining Due Diligence

Feb 18, 2010 - by Aaron Booth

In the business world, Due Diligence refers to the act of investigating information related to people and businesses. This can be on a voluntary basis as in conducting a background check on a future employee, or it can be a legal requirement as in investigating the legal issues around a corporate takeover bid.  However, the most common type of Due Diligence performed in business typically relates to that which is performed in relation to a merger or acquisition (M&A).

The M&A process involves buyers and sellers of businesses connecting with other buyers and sellers to complete transactions that result in one business acquiring another or two business combining into one. For example, in a typical sell-side M&A deal, a seller put together a confidential information memorandum (CIM) and distributes that document to potential buyers.   When serious buyers are identified, letters of intent are signed and the seller shares additional information with the buyers.

This is the preliminary Due Diligence, and the point at which interested buyers investigate more detailed information to determine if they will submit a letter of intent to enter into a purchase and sale agreement and close the transaction. Once a final buyer has been identified, the real Due Diligence begins. It is at this point that the potential buy and seller have agreed to share all information related to the business so that the buyer can investigate the financial statements, tax returns, inventory, fixed assets etc. in an effort to verify their understanding of the state of the business and to finalize a purchase price. In some instances, Due Diligence has been described as a process in which buyers look for reasons to reduce their risk and lower the purchase price prior to the close of a transaction.