Better Safe Than Sorry: A Quick Guide to Due Diligence

By Maria Jones | Partnership Manager @ investors angel  Crowdfund Beat Guest Editor,

Better Safe Than Sorry: A Quick Guide to Due Diligence

“Carefully and diligently conduct your Due Diligence”, “Do not spare any expense when conducting Due Diligence” – these phrases are said by practically any guide for investors, concentrated on equity crowdfunding. However, not all of these guides and resources go into depth on what exactly due-diligence presents in and of itself. This process has been in business practice for quite awhile now, as such they did not see much sense in telling everyone about something that is so well-known. However with the emergence of crowdfunding (and especially the equity-model), the investment industry is becoming flooded with new, up-and-coming entrepeneurs and investors for whom this “theory lesson” will be useful. As such this article is for them – a lesson Due Diligence.

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Functional Presentation

Due Diligence is a complex review of an investment object defined by a set of procedures, aimed at defending the investor from all manners of risks. In other words, DueD is a procedure aimed at generating an analysis of a companies functional state. The goal of this procedure is as stated above – to prevent or reduce to a minimum many investment risks, such as acquiring overpriced shares, being a victim of investor fraud, in turn having your reputation and finances damaged, as well as other risks not mentioned.

To reach this goal there are different tasks which need to be completed – these tasks depend on what the economic relationship the person ordering due-diligence is planning to commit to with the target of the Due Diligence. Here are just several of the tasks needed to complete during the proccess:

 

  • сonfirmation, that the business truly exists;

 

  • identifying potential business defects which can “kill” the deal;

 

  • gathering and analysing information which can help with establishing the companies assets and overall cost.

 

The importance of Due Diligence is difficult to argue against. However, this process is especially important in the sphere of equity crowdfunding. In this form of financing the investor not only injects a company with large sums of money, risking potentially losing them, but also connects himself long-term to a Startup. He works alongside it, pushing it forward on the market and in his business-sphere (if we are talking about a lead investor).

 

Who Conducts Due Diligence

The procedure is started off as an initiative by an interested party, usually an individual businessman/investor or an organization. This party is usually looking to involve itself with the target of the Due Diligence, but is looking for confirmation to assist it’s financial decision (whether that be a negotiated investment or a simple purchase of stock).

The interested investor can certainly carry out the procedure himself, there is nothing truly stopping him. However it is necessary to understand, that for a truly well-done and thorough Due Diligence, you will have to gather and analyze a large and diverse set of information – not only financial and legal, but also more industry-specific data. It is self-evident that a single person is unlikely to be a specialist in all areas – this workload really is more suited for a team. Precisely because of that, it has become commonplace to hire third-party experts and consultants to conduct thorough Due Diligence.

There is a certain ‘baseline’ of consultants that should be involved in the procedure. They are, as prior mentioned, financial/accounting experts and a legal advisor. However, the team is not complete with just this staff. Depending on the industry and the specifics of the business, the initiator may need a very diverse set of consultants – from engineering, to information technologies, manufacturing, and etc..

No matter how many experts are involved in the Due Diligence, they should all fit two basic criteria. First, they should obviously be qualified and competent. In that sense, the person should indeed be an ‘expert’ and capable of analyzing and gathering the information necessary. Second, the individual must be an independent specialist. The procedure has to be as neutral and bias-free as possible, as such the expert has to be free of any ulterior motives.

Due Diligence In-Depth

It’s hard to give a concrete answer for how long Due Diligence will last. It heavily depends on what the goal of the initiator is, as well as what tasks are set for the experts. Precisely because of this flexibility, it is very difficult to ascertain the length of the procedure – it can be done within a month, or it can take upwards of a year.

What information is necessary for the specialists for their analysis? There are many potential sources. First, there are different types of documents which can assist them. Protocols, Financial and Techncial paper-trails, Patents, etc. These all serve as potential information sources for analyzing the business as a whole.

Second, there is information which is tied to the company management. Under this category fall data regarding the owners of the company, key employees and their competency, as well as any potential legal issues key personal may have.

Finally, there is information from external resources – studies or investigations of their products/services offered by the company, data regarding capital, and market reactions. Due Diligence is often such a complex and multifaceted undertaking, that even information from unofficial sources is taken into account.

Speaking of the structure of Due Diligence, the procedure can be broken up into 3 main stages. There isn’t any precise sequence – as a rule, for the process to be optimized and the time-efficiency, the stages are conducted parallel to each other.

The first stage, is a general gauging of the venture. This gauging is necessary to truly grasp the real, true value of the venture as a whole. The experts involved during this stage, define the concrete valuation of the company on the market, and compare it to analagous businesses. This valuation depends on what interests the Due Diligence initiator has in regards to the venture – for example, purchasing it to integrate with an existing business, or to simply invest in it’s current course of action. At the end of this stage, the initiator has an exact valuation of the business.

The second stage involves audtiors. Their task is to check the financial records and overall financial status of the company. The audit includes such points as: analyis of the main revenue streams, capital investments, credit agreements, and etc. The final facet of this stage is identifying any potential tax risks or deductions, as well as quantification of potential tax obligations of the company.

The execution of the third stage depends entirely on the company’s lawyers. They take charge of the juridical and legal aspects of the company, namely:

  • inspection of the constitutional documents of the company and their current legal status;
  • analysis of the legality of the company’s activities, i.e. the existence of the necessary licenses, certificates and permits;
  • analysis of the internal labor relations;
  • research of the corporate governance documents, principle POAs and decisions of managing departments.

As soon as these three stages are over, the client receives the finalized independent complex account, which give them the ability to make the necessary conclusions and make the final decision regarding the potential investment object.

Investor, Be Aware

In the previous section we mentioned just a small fraction of all the potential checks, analysis, and expertises conducted during the process of Due Diligence – these are in a sense what we would call the bare minimum. It is very easy to become lost in this labyrinth of percentages, numbers, and other such information. As such we feel it is prudent to discuss which of them, you should truly pay attention to.

Key Financial information for an investor should constitute data involving the current and expected revenue, the size of it’s market, as well as potential growth factors and expanded market positions. Aside from that, it is important to pay attention to the outstanding credit and debt which the business has, just as you would to signed agreements with clients and partners.

From the legal standpoint, it is important to understand the mechanism of the company, the structure of it’s team, and the level of their competency. It is likewise important to take into account the size of it’s staff and their cost to the business, the requirements for staff employment, and all legal obligations and lawsuits of the company (if there are any).

It is critically important that the Due Diligence procedure identifies all the hidden and unresolved issues that the business has, and doesn’t leave any ‘gaps’ in it’s search, nor any half-done investigations. All of these can manifest themself as an unforseen risk for the investor. To avoid such a catastrophic turn of events it is necessary to make sure that the procedure is done correctly. No document should be left unpondered, no data left unpursued, nothing should stray from the reality of what the target business truly is. Only then, can you truly make your investment, risk-free.

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