What is Due Diligence?
In general usage, the term “due diligence” means “required carefulness” or “reasonable care.” The term became a specialized legal term and later a common business term due to the United States’ Securities Act of 1933, where the process is called “reasonable investigation” (section 11b3).
According to Merriam-Webster, the term due diligence has been used since at least the mid-fifteenth century and has the literal meaning, “requisite effort.” Centuries later, the phrase developed a legal meaning, namely, “the care that a reasonable person takes to avoid harm to other persons or their property.” In this sense, it’s synonymous with another legal term, ordinary care. More recently, due diligence has extended its reach into business contexts to describe the research and analysis of a company or organization done in preparation for a business transaction (such as a merger, acquisition or purchase of securities), specifically the research a company performs before engaging in a financial transaction. Due diligence in this context can also apply to individuals: people are often advised to perform their due diligence before buying a house, signing a loan, or making any important purchase.
In plain English, due diligence is simply doing your homework. For example, before buying a company you should make yourself an expert on that company and all of its operations. That means investigating every aspect of the company and asking many questions, such as:
- Does the business have healthy cash flow?
- Where does the revenue stream come from?
- If the company has physical assets, are they valued correctly and fairly?
- Does the company own all of its intellectual property? Is there any source code that is licensed to a third party that may not be legally transferable?
- Are there any hidden liabilities such as outstanding lawsuits or employee complaints?
- How reliable are the company’s financial projections, and what multiple is placed on those earnings?
- Are the company documents complete (articles of incorporation, board meeting minutes, tax registration, etc.)?
- Is the business up to date on its taxes?
- Are patents and copyrights up to date? How strong are they?
- Does the company lease property? If so, what are the terms of the lease?
- What insurance does the company hold, and what is covered?
- Are employee records, including salary, benefits and employee agreements, complete and up to date?
Due diligence can be a tedious, time-consuming, and a sometimes expensive process, but it’s an essential step in making informed business decisions. Today, it’s common to conduct due diligence by placing all of a company’s corporate information in a virtual data room so that it is organized, secure and can be reviewed by multiple parties simultaneously. A virtual data room also provides detailed analytics, allowing administrators to monitor a user’s activity in the data room on a page-to-page basis, even keeping track of how long the user spent reviewing each page of a document. This functionality can be invaluable during due diligence in assessing a potential buyer or partner’s interests and concerns, and addressing them proactively.