The Ultimate Guide to Due Diligence

due-diligence-guide
Your due diligence efforts are key to making a smart investment. The goal of this guide is to ensure that your process is as efficient and thorough as possible.

Whether you are a seasoned VC firm considering your hundredth deal, an M&A fund looking to acquire a company, or a real estate investor looking to buy your first commercial real estate property—the due diligence process is key to making a smart investment decision.

This high-level guide will explore the nuances of due diligence as it applies to various sectors, compare internal vs. external analysis, and outline a broad checklist covering key areas to address.

Depending on what type of investment is on the table, the due diligence process may involve different considerations and steps. The goal of this guide is to ensure that your process is as efficient as possible, with deeper dives per industry slated for future posts – stay tuned.

The Meaning of Due Diligence

The term due diligence refers to the process of evaluating and investigating a potential investment. Be it a venture deal, real estate property, or business acquisition—due diligence is key to helping potential buyers gather the necessary information to effectively evaluate an investment. The main goals of due diligence are to substantiate the information provided by the seller, analyze the external environment and market relevant to the prospective investment, and to accurately appraise the investment to reach a fair valuation and purchase agreement.

How Important is Due Diligence?

In the angel investment sector, related studies pinpoint a correlation between time spent on due diligence and return on investment. Data shows that angel investors spending fewer than 20 hours on due diligence activities per deal saw an overall return multiple of 1.1x IRR in 3.4 years, while those that dedicated north of 20 hours had a return multiple of 5.9x in 4.1 years. And when angel investors dedicated more than 40 hours, that return jumps to 7.1x.

Put simply, the insights you collect from your diligence efforts are a critical component on the path towards making a smart investment. Not only does it allow you to identify potential in a prospective investment, but the process provides you with the information critical to the valuation and negotiation process. Through thorough due diligence, you may also identify areas of potential concern that prepare you for obstacles you may face down the road as an investor.

The Due Diligence Process

The areas of focus involved vary depending on the type of investment being considered. However, broadly speaking, every attempt at due diligence should involve both an external and internal analysis, ideally summarized in a detailed due diligence report. Before diving into the industry-specific intricacies, let’s discuss the foundational concepts important to the general diligence process.

External Analysis

Begin by evaluating the relevant environmental issues of the investment. This should include an evaluation of the market in which the investment operates in. For example, in venture capital and private equity, an external analysis should include an evaluation of the startup’s competitive landscape. When analyzing the competitive landscape, take note of key competitors: both current and potential. Do current market players pose a threat to the venture’s ability to obtain market share? Are there prominent players in a related market that could pivot to become future competitors? In real estate investing, a market analysis entails affirming market assumptions through evaluating local market factors such as vacancy rates, leasing costs, and rental prices. Such factors will enable you to gauge the health of the relevant real estate market.

An external analysis should also take into account important market trends, including consumer behavior, demand and supply shifts, and projected aggregate revenue growth. These trends will give you insight into the market’s potential condition five or ten years down the road. Also, take note of any macro factors that have the potential to affect the market, and in turn influence the trajectory of the investment. This could include relevant legal and regulatory considerations, industry standards, and economic or political factors.

The goal of such a thorough external analysis is to identify potential threats and opportunities in the market that could either positively or negatively affect the success of the investment. It’s also important to compare your external analysis with the seller’s expectations and assumptions. If your findings indicate that the seller has over-ambitious expectations, then you may be able to use this information to negotiate more favorable deal terms. Keep in mind that the external aspect of diligence should be forward-thinking. Not only should you consider an investment’s current external environment, but also consider how those external elements will likely change and evolve in the long term. An investment is a long-term commitment, therefore you should approach due diligence with a forward-thinking mindset.

Internal Analysis

Despite the importance of a comprehensive external analysis, it’s often more important to conduct a thorough internal analysis that dives into the bones of the investment. From intellectual property and legal concerns to financial records and cash flow to quality of earnings and business plans—you should carefully analyze each aspect that makes up the investment. You should also consider ownership status when considering the investment context of the deal. Are there current stockholders or equity holders that influence your stake of ownership in the investment?

Any internal analysis should reveal any “red flags” about the structure and character of the investment. It should highlight areas of concern that should be addressed be prior to closing a deal, and/or point out potential issues that may present you, the investor, with obstacles down the road.

While the principles of an external audit easily apply to various investment sectors, variables to be considered in an internal analysis will vary greatly depending on the type of investment under consideration.

To help you hone your due diligence activities accordingly, let’s break down the unique internal aspects of due diligence as it applies to various sectors.

M&A Due Diligence

Mergers and acquisitions typically involve a hefty due diligence process. Among the many factors to consider when evaluating a potential merger or acquisition, synergy potential, financials, organizational structure and workforce, production capabilities and suppliers, and legal issues are some of the most important.

M&A transactions can involve different types of buyers, including private equity firms and larger corporations. Depending on the type of M&A deal at hand, due diligence may focus in on specific factors listed above. For example, in larger corporate M&A, evaluating synergy potential is a driving force behind due diligence. In context of M&A, synergy refers to the increased financial benefits achieved when combining companies—be it through cost savings or revenue enhancement. Synergies you should look for when evaluating an M&A deal include supply chain efficiency, complementary products or customers, research and development capabilities, and intellectual property.

Financials are an obvious yet vital part of the M&A process, as they provide the acquirer insight into the target company’s balance sheet, financial performance, and profit potential. An in-depth review of the company’s financial statements should be conducted, with extra attention towards specifics such as working capital, cash flow, and development spending, assets and liabilities, and audit reports—these factors will help you gauge the financial health of the company under consideration.

It’s also important to evaluate the various aspects of the organizational structure and characteristics relevant to the company’s workforce. How is the company structured and operated? How do management, board members, and employees play into said structure? How will this structure affect a smooth merger or acquisition? What is the background of C-level leadership?

The company’s current legal situation should also be evaluated. Are there any threatened, pending, or settled litigation against the company that could affect the impacts of a merger or acquisition? What type of intellectual property does the company currently own? Finally, it is also important to note the company’s production capabilities and relationships. This includes evaluating its supply chain to identify suppliers or subcontractors. What activities integral to the company’s supply chain or value chain are outsourced? In addition to giving you a better understanding of the company’s production process, evaluating factors related to the company’s production abilities and supply chain will help you gauge how much of the company’s value chain is contained within the organization. In other words, how large of a role to outside parties play in enabling the company to provide value to the market?

Hiring M&A experts, like investment banks or consultants, can streamline the research and evaluation process. An investment bank can provide strategic guidance and resources to advise buyers throughout the M&A process. In addition to supporting due diligence, an investment bank will also support the buyer in crafting a bidding strategy and negotiate a final deal.

Related: Form a Deal Team

Angel Investing, Venture Capital, & Private Equity Due Diligence

When it comes to evaluating potential investments in the broad private equity sector, many factors used in evaluating M&A transactions still apply. Factors related to a startups’ legal, financial, organizational, and production-related circumstances still apply. However, because startup companies are inherently more flexible and ‘unproven’ than larger organizations, they are harder to evaluate. When it comes to startups, there’s often less financial history available and—depending on what stage of funding the startup is seeking—business models and products are often underdeveloped and evolving. In other words, because startups are constantly pivoting and changing, there are a lot of unknowns in private equity due diligence.

Because there may be less concrete information available to evaluate a startup, it’s important to consider a startup’s potential when conducting due diligence:

  • Does the startup have the foundation to grow into a successful company? For example, does it have a user acquisition strategy that is adaptable and able to pivot if needed?
  • Is adaptability built into the company’s structure, enabling the team to deal with change and pressure well?
  • The founding team is also a key factor in determining a startup’s success potential. Does the founding team have a diverse and well-rounded skillset? Do they have relevant industry experience and professional network? Do you think the team “has what it takes” to execute the various aspects of its business plan?
  • Note the product development progress – does the company have a working MVP that has been validated by consumer testing? Or are they still in the research and development phase? How close is the company to bringing its product to market and generating revenue?

These various factors will help you to determine if the startup under consideration has success potential and, in turn, would be a potentially good deal. In the startup world, success potential translates into exit potential. Whether it be an acquisition or going public, does the startup have the potential to reach a profitable exit? As an investor, this is key to seeing a high return. Ultimately, that’s what private equity due diligence should revolve around: identifying factors that indicate exit potential.

Commercial Real Estate Due Diligence

Although there are parallels between evaluating a company and a real estate property, commercial real estate due diligence involves a unique set of factors. The factors explored below can also be applied to other types of real estate transactions, whether you are investing in residential real estate or are playing the role of a broker helping to facilitate deals.

Although financials still come into play, the financial information for commercial real estate is specific. First, carefully evaluate the durability and performance of the property’s rent roll, which is the foundation for your investment’s return. This provides a snapshot of the various sources of rental income of the property. Not only will diving into the various leases enable you to verify contract compliance and uncover operational errors, but it allows you to gauge the property’s value by providing you an estimation of future cash flow potential. It is also important to conduct a historical financial analysis of the property, as evaluating historical financial performance will help you predict the property’s future profit potential.

It’s also important for your due diligence to cover a physical inspection of the property, as it will reveal any structural or aesthetic issues that require additional resources and investment to address. Depending on the severity of these issues, you may change your investment decision or be able to negotiate a better deal. This inspection should ideally involve third party inspectors to survey the physical condition of the property and provide estimates for future expenditures. Also, have your property surveyed to determine the property lines. This will reaffirm the terms of the deal and reveal if there is land available for expansion. A thorough property inspection is a necessity when considering any type of real estate investment, be it commercial or residential.

The Due Diligence Checklist

It may be time-consuming, but putting in the effort to conduct proper due diligence before making an investment will benefit you greatly in the long run. When considering your next investment, use this comprehensive checklist to guide your due diligence activities, step-by-step.

  • External analysis: evaluate the competitive landscape, market trends, and external macro factors that may influence the success of the investment in the future
  • Investment context and equity distribution: evaluate the investment context and distribution of equity to other investors, employees, and/or stockholders
  • Financial Due Diligence: evaluate financial statements to gauge financial performance and future cash flow potential
  • Organizational structure & management team: if applicable, evaluate the organizational and management structure of leadership and founders
  • Legal: evaluate legal condition, including ongoing litigations, intellectual property, and leases and contracts
  • Business model and product: evaluate the current business model and product/ product development progress of the company or rental property
  • Production capabilities and supply chain: if applicable, evaluate the supply chain and production capabilities of the company
  • Physical: if applicable, conduct a physical assessment of the property or any physical assets included in the investment deal
  • Note future obstacles and expenses: note weaknesses and threats that may present obstacles in the future, as well as areas requiring future expenditure

Additional Considerations

Create a Virtual Data Room

A Virtual Data Room (or Virtual Deal Room) is an online database where companies can store and share confidential data, typically organized by checklist area (see above). VDR’s provide a place for deals to be conducted and negotiated, for deal teams to collaborate, and act as a unified silo for all relevant information about the deal. Stand-alone virtual deal room products are available for purchase, while others opt for file collaboration services like Dropbox and Google Docs.

An example of a Virtual Data Room from SecureDocs

Form a Deal Team

Every deal is different, so building a team of experts covering a variety of focuses is a catalyst to an enhanced and timely deal examination. Each specialist in an M&A deal team, for example, provides an area of expertise that is vital to the process while also providing a direct contact for any requests made for information, files, or any other pertinent matter to the deal. Deal teams should consist of more than just subject matter experts – they should also be collaborative and flexible. If not, requests for information and additional details can create time-sucking delays in responses, which can delay the timeline for completion.

“We leave no stone unturned. When we get into areas where it might be more difficult for us to learn about something on our own, we certainly use outside resources in the diligence process to help us do that.”

David Mann – Dundee Venture Capital

Use a CRM

Many of the activities outlined in this guide rely on efficient communication, networking, and organization. Custom CRM’s that are built for deal flow management can help your team track and collaborate on all of the various moving pieces in your diligence process.

Related: Deal Flow Management Software by 4Degrees

Durations Will Vary

The time requirements of due diligence vary based on a number of factors, including deal size & complexity, the type of deal, and available resources on both sides of the table. Common issues that slow the process down include miscommunications regarding timing, missing or inaccurate documents, confidentiality issues regarding information, and inexperience of those involved. Both sides should agree on a timeline in order to establish a mutual motivation towards a timely delivery of requested documents and information. It is also important to note that time spent on due diligence varies widely across sectors; the due diligence requirement for pre-seed angel deals differ greatly from multi-billion dollar M&A transactions.

Using the Due Diligence Process to Make Smart Investment Decisions

As discussed above, the purpose of conducting due diligence is to help you make an informed and profitable investment decision. All of the considerations involved aim to solve one key question: does this investment have high-growth and high-return potential? When considering each factor discussed in this guide, ask yourself: how does this factor play into the investment’s return potential? At the end of the day, due diligence is all about helping you to discover and/or affirm if the deal at stake has the foundation and qualities needed to produce a solid return on your investment.

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