Business Due Diligence
Chances are you've heard the term due diligence, but perhaps you don't quite understand what it refers to or how it works. We will explore in depth the various types, such as financial due diligence, vendor due diligence, third-party due diligence, and commercial due diligence, among others. You will learn what it means, how it works, the history of due diligence, and how to execute a successful due diligence process for any industry.
What is Due Diligence in Business?
According to the Merriam-Webster dictionary, the legal definition of due diligence is "the care that a reasonable person exercises to avoid harm to other persons or their property." They also provide a business definition of "research and analysis of a company or organization done in preparation for a business transaction (such as a corporate merger or purchase of securities)."
However, actual due diligence is so much more than that. It applies to a process or steps you take to ensure the legitimacy and authenticity of something or someone before trusting it. Due diligence can be an audit, review, or investigation of facts, documents, or evidence. It applies to a systematic approach to thoroughly researching a person or business before making a decision.
The History of Due Diligence
When the U.S. government enacted the Securities Act of 1933, securities dealers and brokers became responsible for disclosing material facts about the investments they were selling. They could be held criminally liable if they failed to provide clients with this information. The loophole was that a broker could not disclose facts they were unaware of. Therefore, they could not be held liable for the omission. The Act included a legal defense, as long as the brokers conducted "due diligence" in thoroughly researching the companies and investments they were selling, they could not be held legally liable for any missing information. If they took the proper steps to learn all they could, they would not be prosecuted if facts emerged during an investigation that they were not privy to. The term caught on and now applies to other types of inquiry or research across many industries.
What is the Purpose of Due Diligence
The primary purpose of due diligence is to comply with government regulations in specific industries. Companies abide by these rules using a due diligence checklist based on their policies and procedures. Their policies include detailed steps that they must follow to thoroughly vet and investigate new partners, vendors, customers, and third parties.
Assessing and mitigating risk is another substantial reason companies must perform due diligence. A business can be held liable for any wrongdoing a partner or client engages in if they don't perform proper due diligence beforehand. The goal is to be as careful as possible to avoid businesses or individuals involved in money laundering, fraud, or terrorism financing. Other purposes of conducting regular due diligence include:
Not all companies will be well-equipped to handle all aspects of conducting the investigation and may need to rely on outside experts such as accountants, lawyers, insurance professionals, technology gurus, or other specialty investigators.
The Three Principles of Due Diligence
Although a company's specific due diligence process will vary, three main principles help dictate how due diligence should be performed to collect information while also preserving human rights. The three principles of due diligence include:
- Identify and Assess: Due diligence involves collecting information and assessing risk. Companies must follow a standard procedure that does not violate human rights or other laws.
- Mitigate Through Decision: After data collection, the company must decide whether to move forward to mitigate any risk. It is also responsible for safeguarding the information gathered so as not to put the individual or business at risk.
- Ongoing Monitoring: Ongoing risk assessment and monitoring are essential to ensure the relationships remain healthy and risk-free.
Types of Due Diligence
Companies will have strict due diligence processes that differ widely from other businesses. For example, a bakery vetting a new flour supplier will conduct due diligence much differently than an investment firm taking on a new client. Some of the various types of due diligence and how they benefit from the process include:
What is Commercial Due Diligence?
Companies looking to purchase or merge with another business perform commercial due diligence to ensure the company is a good buy. Does the business model fit with the purchaser's strategic goals? The commercial due diligence framework is long and comprehensive, with the goal of assessing the company's viability and potential for continued success. Some of the key aspects of commercial due diligence include:
Real Estate Due Diligence
Before investing in real estate, which is often one of the priciest acquisitions, you must conduct due diligence to protect yourself as the buyer. The more information you gather before the sale, the better off you will be. Some of the critical details to collect include:
Use a commercial real estate due diligence checklist to standardize your process and evaluate each potential investment thoroughly.
Customer Due Diligence (CDD)
Customer due diligence refers to risk assessment and verifying a customer's identity before doing business with them. These efforts are part of the anti-money laundering (AML) and Know Your Customer (KYC) regulations that govern specific industries and aim to prevent financial crime. Certain business types must perform customer due diligence to remain compliant. There is even an enhanced customer due diligence process for high-risk customers. The factors that govern customer acquisition due diligence include:
Some government regulations require companies to perform routine customer due diligence checks before allowing them to open an account or make purchases. Some of the reasons for performing customer due diligence are:
Many banks or other financial institutions will leverage customer due diligence automation using customer due diligence solutions and software designed to make the process quicker and easier without human intervention.
Cyber Due Diligence
You may need to perform technical due diligence before doing business with a vendor, third party, or customer. This includes thoroughly assessing their security infrastructure and practices to determine their cyber defenses' strength and ensure they align with your organization's security standards. Your due diligence checklist may include tests inside and outside of your network. Your goal will be to reduce your cyber risk, make informed decisions, comply with government cybersecurity regulations, and save money by not having to mitigate a security incident. The key factors involved in cyber due diligence include:
Due Diligence in Banking
Due diligence in banking is serious business. Banking is a highly regulated industry that is subject to anti-money laundering (AML), Know Your Business (KYB), and Know Your Customer (KYC) regulations. It involves a thorough investigation and verification process to assess the risks when doing business with customers and companies. The goal of these regulations is to prevent crimes like money laundering, fraud, and terrorist financing. These safeguards maintain the stability and integrity of the banking industry. Due diligence in banking is essential for compliance, risk management, crime prevention, and integrity. The key factors affecting financial due diligence are:
Human Resources Due Diligence
Human resources due diligence usually comes into play during a merger or acquisition. It involves deeply exploring the company's human resources department, hiring and firing practices, HR policies, procedures, and potential liabilities. The goal is to enjoy a smooth transition without any employee-related risks. Some key aspects of this type of due diligence include:
Environmental Due Diligence
Companies that create consumer products must take special care and perform due diligence to ensure public safety. The process may include conducting site inspections of a building or company to assess any environmental risks, hazardous materials, or contamination. The sale or merger of companies often triggers these environmental checks. The goal is to determine potential environmental risks or liabilities associated with a particular business, review any compliance issues, and save money. The key factors include:
Environmental due diligence is governed by the Environmental Site Assessment (ESA) and Environmental, Social, and Governance (ESG) standards.
Regulatory Due Diligence
Merging with or acquiring a company can expose you to significant liability if you aren't careful. One way to mitigate risk is to conduct regulatory due diligence to review a company's compliance status. The review may extend beyond internal players to external third-party relationships like vendors, suppliers, and partners. The aspects of regulatory due diligence are:
The end result will be that you fully understand how the company complies with industry-specific regulations, which may enhance your reputation by association.
Investigative Due Diligence
Before investing in a company or purchasing a portion of the business, you must conduct due diligence to understand what you are getting into. Investigative due diligence includes a thorough evaluation of the company's investment prospects. The goal is to verify all the facts and figures and identify potential risks, liabilities, or opportunities. Investigative due diligence aims to mitigate risk, make informed decisions, protect your investment, and ensure regulatory compliance. Some of the different types include:
Private Equity Due Diligence
Private equity firms are vulnerable to risk. Therefore, anyone investing (both General Partners (GPs) and Limited Partners (LPs)) with them must perform due diligence in the form of a comprehensive analysis to assess viability, risks, and potential returns. The private equity due diligence process helps investors decide whether to proceed with a specific investment. The areas of concern with private equity include:
During the investment due diligence process, you will investigate the company's financial, legal, operational, management, IT, ESG, and HR aspects.
Operational Due Diligence (ODD)
Operational due diligence occurs before a merger or acquisition to evaluate the company's operational status and output. The process includes examining the company's internal processes, management, and overall efficiency and assessing potential risks and opportunities. ODD often uses a tailored approach to satisfy its objectives. Some key aspects of operational due diligence include:
This type of review aims to assess the company's operational efficiency, internal controls, legal compliance, supply chain resilience, and human resources practices.
Pharma Due Diligence
Big pharma has a lot of responsibility to keep the public safe while also developing new life-saving medicines. These firms often seek funding for a new research study or drug trial. Before funding, merging, or acquiring a pharmaceutical company, you must conduct due diligence that assesses the risk tolerance, financial health, and scientific validity of the investment and company. The key areas of focus during pharma due diligence include:
The goal of pharma due diligence is to reduce risk, provide proper valuation of an investment, enhance decision-making, and streamline the merger or acquisition. In addition to reviewing the company, you may also need to perform vendor due diligence and evaluate anyone else with a business relationship with the company.
M&A Due Diligence
Mergers and acquisitions make the world go round. They occur constantly, but not before an exhaustive M&A due diligence process. Since mergers and acquisitions are so common, many investors or large firms will use M&A due diligence software or an M&A due diligence consultant to assist with the process. The purpose of the M&A due diligence is to help the buyer fully understand the target company's business, confirm the information it provided, and make a solid decision about the potential viability and value of the deal. Some of the aspects include:
Performing M&A due diligence can help you negotiate the deal better, knowing all the facts. It can also give you a much better understanding of the deal's value, risks, and profit potential.
Healthcare Due Diligence
Healthcare due diligence focuses on medical facilities like hospitals, doctors' offices, healthcare clinics, and emergency facilities to ensure they are compliant, safe, financially solvent, and operationally effective. Along with the facility's viability, this type of due diligence also focuses on risk management and fraud detection, as these types of places can be vulnerable to fraud. Some of the areas of focus include:
Third-Party Due Diligence
Anyone who partners with third parties must also conduct thorough due diligence to protect themselves. Many corporate firms use third-party due diligence solutions or software to facilitate a more efficient process. The process involves checking out vendors, suppliers, and partners to evaluate the risk of engaging with them. Your third-party due diligence checklist may be very different than other types of due diligence, including various points of focus such as vetting their financial stability, ethical considerations, regulatory compliance, etc.
Third-party due diligence best practices include:
Hard vs. Soft Due Diligence
Typically, due diligence can be categorized into one of two buckets, "hard" or "soft." Hard due diligence involves collecting data and hard facts, like numbers on a financial statement or business transactions. During this phase, you may also collect contracts and licensing agreements and check for any lawsuits. These figures can be analyzed to formulate an opinion about the company and its viability. Research into the details can also reveal any red flags and indications of risk, but it fails to incorporate the softer side of business, impacting success. Soft due diligence examines the people who run the company, their goals, values, and work ethics. It also evaluates customer loyalty and the company's reputation. Both the quantitative and qualitative approaches are combined to provide the whole picture so you can make better, more well-informed decisions.
How to Conduct Due Diligence
You can conduct due diligence in two different ways: manually or using due diligence automation. Either way is fine. The steps may differ based on your situation and the industry, but the general outline of performing due diligence includes:
- Define the due diligence goals and tasks.
- Assemble a team to carry out the due diligence work. Set the roles and responsibilities of who will do what.
- Coordinate with the company and request the proper documentation or materials to be reviewed.
- Conduct the due diligence.
- Review and analyze the findings.
- Summarize the results in a final report and submit it to all parties.
- Monitor ongoing transactions and the relationship to mitigate risk.
EntityCheck Background Reports for Due Diligence
Due diligence is a crucial aspect of risk management and compliance. Before partnering with customers, vendors, suppliers, or companies, be sure to conduct the proper due diligence. The more information you have, the easier it is to make sound decisions. EntityCheck was founded to help companies perform due diligence quickly and easily by supplying them with vast amounts of business data. We collect our information from government, public, and private sources, and you can access everything you need from one easy-to-use dashboard.
The information you can find in an EntityCheck background report includes the following:
Sign up with EntityCheck business search today and enjoy unlimited searches. You'll also learn more about a company than you thought possible.