What Is Due Diligence? (With Objectives And Examples)

By Indeed Editorial Team

Published 5 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Due diligence is a vital process that is undertaken before a potential deal or during legal proceedings. Knowing how to undertake it can assist you in safeguarding your own or your employer's interests. Its study typically includes a thorough examination of a company's or individual's economic, legal, fiscal and financial status. In this article, we discuss what this is, its objectives, along with its different types and provide some examples of its use in different scenarios.

What is due diligence?

It is a process of reviewing and assessing all the available information relevant to a potential merger and acquisition (M&A) deal, investment opportunity, or legal proceeding before execution. It is a verification process that helps you investigate and audit the information. This may typically help authenticate its accuracy and confirm the details of the matter under consideration. Following proper protocols allows you to gain a better understanding of the operational, financial and legal affairs of the business and ensures it is in order.

Due diligence is possible to be undertaken from the buyer's and the seller's side with an intent to establish the accuracy of the information and appraise the value of the transaction. Depending on the scope of business or size of the transaction, it can be an exhaustive investigation of matters, facts, or a simple self-evaluation.

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The objectives:

The purpose of it is to provide you with a comprehensive, all-encompassing assessment when deciding upon or entering a contract. This has the following objectives:

  • identifying potential risks and prospects

  • bridging the functional gaps in a transaction

  • assisting proper disclosure and accuracy of facts

  • improving the bargaining position of the individual in a potential deal

  • ensuring compliance to the statutory and regulatory status and pre-determined requisites

Related: What Does An Investment Banker Do? (Skills And Careers)

Types:

It applies in several cases across an array of professional fields and occupations. Below are some of the most common and customary types that are similar to associated tasks that a business entity or an individual can undertake:

Financial

Financial due diligence involves investigating and auditing the financial records of the parties involved in a transaction. It is an assessment of the financial health and condition of a business or an entity. For mergers and acquisitions, verifying the financial documents helps you certify the records in the confidential information memorandum (CIM). It enables a better understanding of the financial metrics and future projections and helps you identify the monetary risks involved.

Administrative or operational

It involves examining the business's operational or administrative processes. This helps you in assessing the condition of the assets and the facilities of the company, the administrative or operational costs you may incur, and identify any potential risks that are possible to mitigate.

Legal

This one helps individuals or entities to comply with the statutory requirements, or to be in good standing with all proponents involved in a deal. It verifies and investigates the legal aspects of any transaction and helps you identify potential legal risks or pitfalls involved. Some of the items assessed include contracts, minutes spent on board meetings, corporate documents and articles of agreement.

Environmental

This involves the assessment and managing of environmental risks and potential hazards relating to a property or a business. Proper diligence is vital before making any purchases or investments to mitigate any hidden cost, or environmental risk involved with the location along with the structure. Several governmental agencies direct individuals or entities to comply with, and adhere to this standard with the purpose of safeguarding investments against environmental accidents.

Human resource

It relates to the company's human capital and its assessment. One of the most vital assets of a business is its human resource (HR) making proper diligence of the same becomes equally important. This helps you analyse the human capital and the HR policies that are in place and provides a scope to investigate the work culture. Diligence in this area can help you identify and maximise the employees' potential and overcome any existing bottlenecks.

Banking or customer

Companies offering financial and banking services conduct diligence on borrowers, customers or entities that approach them to ensure proper screening, and identification before going ahead with the transaction which would result ultimately in on-boarding them. Organisations can undertake this even on existing clients to establish a monitoring mechanism and this helps in identifying high-risk accounts, mitigating risks, and even in avoiding potential legal actions that these institutions can potentially face because of non-compliance and involvement in illegal activities.

Strategic

Strategic diligence is a broader form of assessment where the company's micro and macro-environmental factors concerning its goals and objectives are its main focus. It encompasses determining a deal's value in terms of adequacy, attainability and effective integration. It evaluates transactions based on strategic factors, rationale and helps you identify potential convergences, or synergies from this perspective.

Intellectual property (IP)

This is typically an audit to determine the quantity and quality of intellectual property assets that a firm, business or individual owns, or licences. It helps investigate and assess an individual's or a company's non-tangible assets like patents, trademarks, copyrights, and domain names. This also helps ascertain the legal safety of those properties.

Tax

Tax diligence involves examining and ratifying the various kinds of taxes relevant to an individual or a business. It helps you assess and review tax liabilities, historical tax exposure, expected tax structure, and compliance with tax laws. It includes investigating and validation of documents like tax returns, corporate agreements, audit reports, and related financial documents.

Related: How To Become A Lawyer: A Complete Guide With FAQs

Examples:

Here are some examples of how a professional may conduct diligence in several sectors:

1. In a merger and acquisition deal

Here is an example of how forms of diligence may work during an M&A deal:

A well-known video game development studio is considering merging with a smaller developer with the aim to absorb their operations. After agreeing in principle, the development studio enters the due diligence phase and performs in-depth research on the company they are considering to acquire. During this step, the acquiring studio asks the company they wish to buy, for extensive financial information. Financial professionals at the company look over the documents and development personnel at the smaller studio request access to projects in the works.

After completing its thorough financial diligence of the smaller developer, the studio directs the developmental staff to evaluate the value of the developer's IP assets, namely their game designs and the texture models they developed. This entire process bore positive reactions from all involved. The owner of the acquiring studio was content because he had bigger plans with this merger and his objectives combined with that of the developer owing to the strategic diligence he had undertaken in the developer's company four months ago. This becomes a positive opportunity for both to expand into a larger company.

2. In real estate

Here is an example of how forms of diligence may work in a real estate transaction:

A couple seeking to buy their first home seeks a pre-qualified loan from their bank to finance the purchase. The bank runs a customer diligence process on them. After selecting the house of their choice, the buyers agree with the seller on the purchase with a condition that the property has no groundwater or soil contamination. Post analysis thorough environmental diligence**, no risks were detected and the relevant information was shared with the bank.

The bank informed that the value of the property suffices to serve as collateral for the home financing and that they require additional verification from a certified inspector who may assess the property records and look into the tax diligence checklist for the proponents involved. After completing the assessment, the loan agency concludes that the agreed-upon price is reasonable and approves the transaction.

3. In human resource

Here is an example of how diligence may work when human resources are a critical part of operations:

A manufacturing firm that builds components for lithium batteries wants to develop and manufacture entire battery systems autonomously. They are looking at merging with a mid-sized firm that is into manufacturing battery cases and would be interested in conducting strategic diligence to identify firms that align with the vision of the company, and who can enable their manufacturing objectives. They find the best fit for the company and observe that a proper diligence on the human resources of the firm is crucially fundamental, as the operations of the manufacturer are labour intensive.

To understand if the work culture can align with their objectives, the executives from the former firm conduct diligence on the HR policies in place. The results were favourable, as the policies in place were conducive to the merger. They further conduct thorough diligence on the employee demographics for a better understanding of the salaries, tenure, specific skill sets, work hours put in, the average age and the bonuses drawn. There is a thorough assessment of any pending litigations or claims regarding breach of contracts, pensions, and employee's compensation to ensure everything is in order before proceeding with the merger documentation.

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