Due diligence – why it matters

Why is due diligence important in business transactions?

If you’re considering going into business with a partner, or investing in a company, or possibly merging your company with another, you have almost certainly been advised to carry out due diligence. Due diligence has a specific meaning in the world of finance, but it has entered the lexicon to mean, according to the Cambridge dictionary: “action that is considered reasonable for people to…take in order to keep themselves or others and their property safe”. In other words, we might all be wise to undertake due diligence at some point in our lives. But this popular use has diluted the original meaning of the phrase, which is: “the detailed examination of a company and its financial records, done before becoming involved in a business arrangement with it”. What does due diligence entail in its financial and legal context, and why is it important if you are carrying out a business transaction?

Types of due diligence

Due diligence is a systematic process of investigation, research, and analysis conducted by individuals or organisations to assess the viability, risks, and potential benefits associated with a particular investment, business transaction, or decision. It is typically performed before entering into certain types of business deal, such as mergers and acquisitions, partnerships, or investments. It involves gathering relevant information to evaluate the target company or investment. Although due diligence is clearly defined, there are different types of due diligence, or DD as it is often called. If you are buying a company, you will perform all types. But there may be situations in which one or two types are the most important, or indeed one kind of DD may not be possible, for example with a start-up company. It would not have a tax history, for example, or a market share. We look at the four context-specific types of DD, as well as the distinction between hard and soft DD.

Commercial DD

Commercial DD looks at a company’s market share and competitive positioning, including future prospects and growth opportunities. A company considering an acquisition or merger as a means to enter a new market, either geographically or in terms of a product line or market sector, needs to undertake commercial DD. The purchaser examines the target company’s supply chain from vendors to customers, market analysis, sales pipeline, and R&D pipeline. It’s advisable to review the firm’s overall operations, including management, human resources, and IT. Commercial DD helps the purchaser determine if the merger, investment or acquisition has the potential to deliver the desired market expansion.

Legal DD

Is the company in question in compliance with all legal and regulatory requirements? Is it properly incorporated? Is there any pending litigation against it? Has it been the subject of lawsuits in the past? What about its intellectual property rights? No one wants to invest in a company about to be sued, or one whose business practices have attracted lawsuits in the past. And there is no point in merging with a company whose prize innovation is about to be copied by a competitor because someone forgot to file a patent application.

Financial DD

A company may be legally clean as a whistle and have a healthy market share, but not be profitable. Financial DD audits the financial statements to check that the company is financially sound, i.e., costs are under control, cash flow is positive, and the balance sheet doesn’t raise any alarms. Auditors will also use this process to ensure there are no irregularities, accounting standards are adhered to and records are properly maintained.

Tax DD

This may be done in conjunction with financial DD, as the two are not unrelated. But tax DD specifically looks at a company’s tax exposure and tax compliance. Does the target company owe any back taxes? Does it have a clean record of paying its tax in full and on time? Are there ways to reduce its tax burden that might make it a more attractive investment? If the merger or acquisition is cross-border, this can be a complicated process, and it may be helpful to employ tax professionals from both jurisdictions to ensure the tax liability is fully understood.

Hard vs. soft DD

Due diligence can be “hard” or “soft”. Hard DD is what most people think of as due diligence: it is the analysis of the financial statements, the use of financial ratios, and financial projections. It is also the investigation of all legal requirements to ensure the company being acquired is bona fide. Hard DD involves documents and facts. But it does not tell the whole story.

A company can look financially attractive but have a high employee turnover or low employee morale. Its customers may not be loyal and success is achieved by salespeople constantly chasing new accounts. Soft DD looks at the management approach, the quality of the managers and staff, the corporate culture, and the leadership style. Soft DD looks at the drivers of business success that are not captured by numbers alone. These are often the factors that determine whether a merger or acquisition will succeed or fail.

Why carry out due diligence?

Firstly, the Financial Intelligence Centre Act 38 of 2001 (FICA) requires “accountable institutions” to perform certain checks – due diligence – when undertaking certain business transactions. This follows on from the obligation to understand the purpose and intended nature of the business relationship. Ultimately, the purpose of FICA is to prevent fraud and financial crime. And the objective of any due diligence exercise is risk management. It ensures you do not commit an offence through ignorance. It also ensures that, if you are buying or entering into a relationship with another company, you do not unwittingly take on financial risk that could have a negative impact on your existing business. Due diligence protects you, and it makes sure you go into any business transaction fully apprised of all the facts you need in order to make good decisions.

Help with your business

SD Law can help you carry out due diligence if you are considering a partnership, merger, acquisition, or investment. We can carry out the legal due diligence for you and assist with other types of due diligence. Contact Simon on 086 099 5146 or email sdippenaar@sdlaw.co.za to arrange a preliminary discussion.

Further reading:

• Which legal structure is right for your business start-up?
• Incorporation – what are the benefits?
• Protecting intellectual property
• Drafting effective contracts

SD Law

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