What is Due Diligence?

Due Diligence

Due diligence refers to investigating and verifying information about a company or investment opportunity.

In venture capital (VC), due diligence refers to the thorough evaluation process investors use to assess potential investment opportunities. Since investing in early-stage companies is inherently risky, it is crucial to identify potential winners, assess key risks, and develop a risk mitigation strategy with company management as part of the investment decision.

The process is comprehensive and determines whether or not a venture capital fund or other investor will proceed with the investment. It involves asking and answering detailed questions to assess the business and legal aspects of the opportunity. Once completed, the findings are used to finalize the internal approval process and, if applicable, share with other investors in a syndicate when the VC is the lead investor.

Three Stages of Due Diligence

Screening Due Diligence
Business Due Diligence
Legal Due Diligence

Stage 1: Screening

Venture funds review hundreds of potential investments and apply predetermined criteria to narrow down the opportunities that align with their mandate. This initial screening helps them quickly identify promising deals worth deeper evaluation. Out of 100 reviewed opportunities, only ten may move to the next stages, and the fund might invest in just one.

Most opportunities do not pass the screening phase for two reasons:

They do not meet the fund’s criteria (e.g., stage of the business, region, deal size, industry).
Some funds only consider opportunities referred by trusted sources.

Stage 2: Business Due Diligence

Once an opportunity passes the initial screening, it is assigned to a team for more in-depth investigation. This stage involves a comprehensive analysis of the management team, market potential, the product or service’s value proposition, and the business model. The goal is to determine if the opportunity is viable and aligned with the fund’s objectives.

Stage 3: Legal Due Diligence

This involves a thorough legal review, often conducted by external counsel, to ensure the deal is sound from a legal perspective. It is essential to select reputable legal advisors with experience in this field, as their insights can be favorable to the deal. In some cases, especially with experienced VCs, the firm may handle part of the legal review internally to reduce costs.

Due Diligence from Different Perspectives

Buyer’s Perspective: It helps buyers verify that their assumptions about the transaction are accurate. In mergers and acquisitions (M&A), skipping due diligence significantly increases the buyer’s risk.
Seller’s Perspective: While due diligence is meant to build trust with the buyer, it can also benefit the seller by revealing that the company’s fair market value is higher than initially expected. Sellers may even conduct this in advance to prepare for potential transactions.

Why Due Diligence Matters

Due diligence is critical for investors and companies because it allows them to fully understand the deal, assess associated risks, and determine if it fits their portfolio. It is essentially the “homework” done to ensure informed, strategic investment decisions. For example, Daimler-Benz overestimated Chrysler’s value, which led to the merger’s failure. Similarly, HP’s acquisition of Autonomy for $10.2 billion was uneventful, but HP management didn’t understand the consequences of poor due diligence until a few months later.

How Consulting Firms Help Corporations and VCs in Due Diligence

Consulting firms are critical in assisting corporations and venture capital (VC) firms during the due diligence.

Financial Due Diligence

Consulting firms assist in financial due diligence by providing an objective view of a target company’s financial health by closely examining its financial statements, revenue models, and cash flow projections. This helps corporations and VCs assess the company’s ability to sustain growth or reveal hidden liabilities.

Competitive Landscape

Firms also provide valuable insights into the market and competitive landscape. They analyze the industry in which the target operates, its market position, and the competitive threats it might face. This allows corporations and VCs to understand the investment’s long-term viability, identifying growth opportunities or potential challenges.

Operational Due Diligence

Another key area is operational due diligence, where consulting firms dive into the operational aspects of the business, evaluating everything from supply chain efficiency to product development. This ensures that the company’s internal processes are sound and scalable, which is especially important when the acquiring firm needs to integrate the target company’s operations smoothly. In mergers or acquisitions, seamless integration is often the difference between success and failure, making operational assessments a priority.

Legal & Compliance

Legal and compliance due diligence is another critical component where consulting firms review legal obligations, intellectual property, and regulatory compliance. This legal review can uncover any pending lawsuits, regulatory breaches, or issues with intellectual property rights that could become costly problems down the line.

Consulting firms also evaluate the robustness of a target company’s technology infrastructure, data security protocols, and software assets with IT due diligence.

ESG Assessment

Additionally, with increasing focus on sustainability, Environmental, Social, and Governance (ESG) assessments are often included in the due diligence process. Consulting firms analyze a company’s environmental impact, social responsibility policies, and governance practices to ensure compliance with global sustainability standards.

Lastly, consulting firms help mitigate risks by providing a comprehensive risk assessment that spans financial, operational, legal, and reputational domains. Identifying potential red flags before a transaction is finalized ensures that corporations and VCs make well-informed decisions.