Due diligence typically refers to the astute research and analysis of something being considered before making a decision. When this refers to legal, due diligence, this activity pertains to an investigation performed on a business. This is done to help an investor, for example, when they are interested in acquiring a business or adding it to their portfolio. An investor may request due diligence to see how a business impacts the environment before they purchase real estate, before investing in private equity ventures, and to review the legal history of a business.
Due diligence typically involves a buyer, attorney, accountant, and the business being investigated. After the intent-to-purchase agreement is signed, the investor may perform due diligence to learn more about the business. This happens before the purchase agreement so that no funds are exchanged yet or any finalized decision behind the purchase of the business. That is because the letter of intent is non-binding, allowing all parties to change their minds if they find unfavorable information. The due diligence process typically involves advisors to help guide the investor through the process. Typically, the investor’s lack of insight will weigh heavily on their attorney. They will need to look to their law firm to help them deal with the legal aspect to find out more information about the company’s history.
The attorney will likely review any information that may create liability for the company. This can include any liens on assets, tax documents, judgments, and other legal activities that might involve the company. For example, the latest litigation and the threat of lawsuits are issues that may make a business unsuccessful in the long run.
Due diligence is recommended to any individual before making an important real estate, business purchase, or investment. The buyer is supposed to exercise caution before entering into a contract with the other party. They should exhaust all aspects of their search to find out everything about the investment they intend to take on. This means evaluating past transactions, looking through any chains of ownership, finding out what types of funds are held in the business’s accounts, and more. This is why an accountant will also be useful during the investigation so they can double-check that the finances make sense and that it isn’t made up.
Those performing due diligence should follow these steps: The first step is to check the past annual and quarterly financial information. The gross profits and past sales should also be reviewed. Any revenue and rate of return should be noted. The accounts receivable should be checked, and also the breakdown of the business’s inventory. Additionally, the business's equipment should be reviewed. If applicable, the attorney can check any real estate owned by the company.
Although this type of audit seems tedious, it is necessary so that the investor knows exactly what they are getting into. If they aren’t aware of the business's financial state and don’t review its records, their purchase can bring monetary ruin.