Due Diligence

Introduction

Evolution in the business world is more challenging and exciting than ever before. It can be understood by looking into businesses' origin, growth, and development since goods and services were traded in early civilization until now. After the growth of the railroads followed by the industrial revolution, people paid great attention to business and raising their funds. At the political level, country leaders' decisions have changed from focusing on the political system and power to economic interest, removing barriers, and free trade.

Business evolution acted as a catalyst for investors to grow beyond their immediate surroundings or their home countries. Some of them look to reduce logistics and labor costs while others look forward to investing in attractive locations on the sea, near ports, canals, sea straits, or logistics parks away from passage restrictions.?

Investment abroad has mainly two benefits: first, high demand in new markets and second, new experience with local demand patterns and other features from the companies it has acquired.?

However, investors may be deceived and fall prey to investment fraud. Fraudsters may hit their targets by giving misleading information in agreement with the seller or their representatives. There are many ways to mislead facts, known as window dressing, withheld data, or concealing historical information that may affect the buyer's decision.

In the modern age, many business concepts, tools, and arts have developed along with business management trends. New techniques have emerged as a rule base for local and international investment and even have become a legal requirement in many countries. One of these techniques is the effective due diligence process that extends to operational areas of the business and is adopted by business owners as an integral continuing corporate approach.?

Due diligence is only one part of any business deal. It comes after identifying the target investment and the preliminary agreement between the buyer and seller on broad deal items. Each business deal has its own financial, administrative, and legal issues. It also may vary significantly in complexity and risks.

The origin of term “Due Diligence” stems back to the US Securities Act of 1933. The act was designed and passed into law against dealers accused of misrepresentation and practicing fraudulent activities. In US law the process of an investigation is referred to as a ‘reasonable investigation’ and the goal is to ensure transparency and to provide investors with the right information so that they can make informed investment decisions.

People interested in Due Diligence

• Entrepreneurs or investors contemplating buying a business or becoming a member of a partnership.
• Business owners interested in practicing due diligence as a complementary verification approach to verify the top and bottom-line potential improvements and operational health of their companies.?
• Attorneys involved in business deals negotiations.?
• Researchers involved in case studies or business projects.
• Professional advisors involved in due diligence investigation projects.?
• Students in business.
• Lenders providing loans

Why it matters

Due diligence is a necessary part of any business transaction, especially in a merger, acquisition, investment in a company, or when entering into a partnership deal. It also can be described as tedious and time-consuming. It is a distinguished tool from any other verification tools by the quality and diligence required to verify the facts behind the transaction to ensure its fair value. It sounds complicated, alluding to sophisticated processes of analysis and investigation. But in reality, it is simply the process of doing your homework before you make any commitment in your life, whether on a business or personal level.?

In our daily life, everyone practices personal due diligence. We usually do this exercise to prevent fraud and make trust possible. People investigate to learn more about products, prices, models, and alternatives before making a purchase decision. ?Different types of due diligence can be made on routine issues, or even before starting a romantic relationship.?

The level of due diligence should be proportionate to the level of the status. To elaborate, money, time, and effort drained on your part to buy a house should never be as for buying a watch or simple items. Of course, due diligence on day-to-day and routine issues is less systematic and imprecise that an investor should do before entering into a business deal.

Information Overload

The deal team that drives the due diligence process may be exposed to an awful lot of information that barely represents a fraction of the buyer's concerns. The team must take this into account when gathering information not to create an information overload. This issue may lead to a reduction in decision quality and may also scatter the buyer's thoughts.?

Therefore, while collecting information, the team should focus on the deal hypothesis, weigh information and think objectively.?

When there is doubt about clarity or obfuscation on vague matters, intelligent access to sources of information is required. All these are basic pillars to ensure adequate investigation before reaching the go/no-go decision.

Executive Memo

The outcome of the executive memo is an assessment of current business value, financial impacts, and risk levels. While the two key business questions that must be answered at the end of the due diligence process are:

1. Should the buyer accept the deal, at this price, with these terms?
2. Was the information handled wisely to achieve the desired business results in a reasonable time?

Of course, answering these types of questions requires a strategic thinking approach that extends far beyond simple checklists and an average team.

Definition

Due diligence is defined as the necessary care exercised by a reasonable person to avoid causing harm to other persons or their properties.?

In business, due diligence is a thorough investigation undertaken by a potential buyer and involved parties on material facts of a contract, legal, and financial records of a company in question to confirm the accuracy of the information, and to uncover discrepancies and risks before the deal is closed.

Objectives

The objective of due diligence is to uncover red flags, risks, and critical issues. Unpreferable outcomes of the investigation may change the final elements of the deal and usually lead to:

1. Renegotiate the deal price or impose new terms and guarantees on the seller, or
2. Agree to move forward with the deal only if the risks and issues can be addressed before closing or through post-closing by a written signed warranty by the seller, or?
3. Require more investigation, or?
4. Walk away from the deal.

Challenges?

Nothing in life comes easy. Everything worthwhile comes with sacrifice and hard work. This is the logic behind the success of large ventures.?

There tend to be countless challenges while doing an in-depth due diligence process. While the existence of an experienced deal team to tackle these challenges is crucial. For example, high-risk customers and suspicious transactions pose a significant risk to financial statements and may lead to legal consequences. This issue may not be detected by a simple superficial verification process. In this case or similar, the deal team must have experience in KYC (know your customer) due diligence that provides further risk investigation about the company’s clients and their business activities. Therefore, due diligence is a highly specialized process far beyond people with average or without experience in the field.

Below are the most common challenges that have been witnessed by experts who have worked on business management projects for many years.

1. Need to know the right questions to ask: A question is an instrument for collecting data and revealing critical issues. It is also considered one of the biggest challenges in the due diligence process. Sometimes, at the beginning of any project, the team feels that the project areas are open up and they don't know which way to go. However, having straightforward well-defined questions may guide the investigation team. It produces accurate responses that help investigators in collecting actionable quantitative and qualitative data. Provided that questions are clear and focused to present their argument. Users may pick and choose questions that are relevant to the case and avoid general ones.

Different types of questions can be used to serve the investigator's purpose. Below are some widely used formats of questions in a due diligence process:

• Open-ended questions, allow the investigator to learn more about the respondent's perspective using their own words. For example, respondents can give their answers in a comment box.?
• Closed-ended questions have predetermined answers as Yes/No, or True/False.
• Multiple choice allows the respondent to choose one or more answers.
• A Likert scale question is a great tool used by market investigators to assess audience opinions and attitudes.
• A semantic differential scale asks respondents to rate any "entity" within the frames of a multipoint rating option.

The user may choose one or more formats depending on the information required, the industry, the time needed to answer, and the cost constraints. Answers could be delivered online, in interviews, or by email. Email allows respondents to take their time to complete the questions without haste. When data is collected, the team can compare and contrast events to get full insight into certain issues as well as reveal manipulation and vague feedback.? ?

2. Ensure reliable data: Let’s adopt this rule: (Reliable data will always remain true. In contrast, unreliable data may not be valid all the time).?

Due Diligence relies completely on accurate and complete data as the fuel that provides trusted assessment and insight about the business. Any inconsistency may threaten the buyer's ability to make an informed decision about a deal. Therefore, data reliability must be considered before taking action or performing an analysis based on it. In some cases, the work team may doubt the quality of data or may not discover its validity at the first glance. This may lead to serious consequences of misleading outcomes, demoralizes the team, and slows down the investigation process.

To ensure data reliability for better evaluation, here are some practices for users to follow:?

• Establish data quality standards to enhance data reliability.
• Verify the data source.
• Combine data from all the company's departments and areas and verify data consistency.
• Create a specialized database of focused information.
• Keep a record of updates on the database.?
• Create a record of correction for errors or doubtful data.

3. Knowing how to think strategically: The ideal way that ensures a successful due diligence process is strategic thinking, where work and thinking are combined. It adopts a rational thought related specifically to the buyer's objectives and motives, despite the fact that most investors are not good strategists. Strategic thinking focuses on the analysis of major factors and critical variables that may affect the long-term success of a business. It helps business people to think strategically to grow their profits, create competitive advantage, and set strategic direction for their work and life.?