Due Diligence

Definition of

Due diligence is an assessment used, for example, in merger or acquisition projects to analyze a company’s financial, legal, tax, and economic circumstances. The goal is to identify potential risks that could arise in connection with a business relationship. In addition to corporate acquisitions, due diligence reviews are also used in the context of financing rounds, initial public offerings, and investments. A properly conducted due diligence provides insight into the true value or costs of an organization and ensures that there are no discrepancies between a company’s public image and its actual condition.

Purpose of Due Diligence

Due diligence reviews are typically conducted as part of transactions and are intended to protect companies from potential risks as much as possible. Due diligence reviews conducted for other reasons—such as a financing round—may focus on a different objective.

The following sub-objectives are typically pursued in transactions, but some are also relevant when conducting due diligence in other contexts:

Ensuring Financial Viability: A due diligence review allows you to assess the profitability of an investment by analyzing its opportunities and risks. This helps avoid investments that are highly likely to prove unprofitable later on and are therefore not worthwhile.

Minimizing Legal Risks: By reviewing the legal landscape, companies can ensure that they do not inadvertently become involved in legal problems through their collaboration with new business partners. It can have serious consequences for buyers if a company they acquire is linked to corruption or money laundering. If the buyer fails to exercise the necessary due diligence to verify this in advance, they may face fines or even prison sentences.

Reputation Protection: Links to non-compliant behavior—such as criminal activities, environmental violations, or poor working conditions—can not only result in legal consequences but also damage a company’s reputation. Even in the absence of any wrongdoing on the company’s part, the trust of customers and investors can be undermined if organizations collaborate with problematic business partners.

Avoiding Financial Risks: By analyzing a company’s financial situation, it is possible to identify challenges—such as hidden financial obligations—that could lead to losses. The goal is to identify all risks early on in order to reliably assess whether an investment in a company is viable in the long term.

Vendor Due Diligence vs. Buy-Side Due Diligence

In the context of transactions, due diligence is often divided into two types: vendor due diligence and buy-side due diligence. Which type is used depends on who initiates the review. In vendor due diligence, the selling party initiates the review, while in buy-side due diligence, the buying party takes the lead.

Vendor due diligence is less common, but is sometimes used when there are multiple prospective buyers. Companies seeking an exit use the results of the review to identify and address weaknesses or factors that could reduce value before the sales process begins. This can reduce the risk of unexpected problems arising during any subsequent buy-side due diligence. In addition, the results of the review provide sellers with guidance for determining the purchase price and other terms of the contract. A transparent due diligence report also strengthens the confidence of potential buyers, thereby increasing the chances of a successful closing.

Vendor due diligence also offers advantages for buyers. If they trust the objectivity of the results, they can forgo conducting their own due diligence, which speeds up the overall process and increases transaction efficiency. If they still wish to conduct their own due diligence, they can build on the information from the vendor due diligence, thereby reducing the scope of work and costs.

The overall effort involved in conducting vendor due diligence is greater than that required for buy-side due diligence, since the interests of all potential buyers must be taken into account. In addition, the seller incurs the costs of conducting the due diligence even if the sale is not successfully completed.

Buy-side due diligence is initiated by the purchasing party to independently assess the potential risks and opportunities of a transaction and to use the results as a basis for negotiations. By engaging one or more independent experts, buyers can ensure that the objectivity of the due diligence findings is guaranteed and tailor the focus of the review to their own concerns. However, this form of due diligence also has drawbacks: Depending on its scope, conducting it can require significant financial and time resources, without guaranteeing that the transaction will ultimately be successful for prospective buyers.

‍What types of due diligence are there?

‍Depending on the risks associated with a transaction, due diligence may focus on different areas. For this reason, various types of reviews are used. There may be some overlap among them, as certain risks can affect multiple areas and must therefore be addressed in different reviews.

The species include:

Commercial Due Diligence‍: Commercial due diligence involves analyzing a company’s business plan to determine the extent to which it has established a sustainable position in the market and whether there is potential for growth. Factors such as location and the competitive landscape may be considered as part of this process. A potential weakness could be declining demand in the target market.

Financial Due Diligence: ‍Thisform of due diligence focuses on analyzing a company’s financial data and projected future financial performance. Potential risks here include unreported liabilities, as they can lead to unexpected financial burdens.

HR Due Diligence: An HR due diligence process involves analyzing a company’s human resources-related factors. This process can help identify risks such as a high turnover rate or employee dissatisfaction.

‍Legal Due Diligence‍: Legal due diligence involves reviewing a company’s legal structures. The review may cover various areas of law. Among other things, it typically examines the legal structure, contracts, loans, and ownership structure.‍ One potential risk in this area may be ongoing legal disputes.

Operational Due Diligence: This analysis focuses on the efficiency of operational workflows and processes. It identifies opportunities for improvement that can increase value. For example, outdated production equipment may be the cause of slow processes. To increase efficiency, the buyer may need to make significant investments in modernization.

Tax Due Diligence: This involves analyzing a company’s tax situation and checking for irregularities. Tax provisions represent a potential risk.

Technical Due Diligence: This assessment evaluates an organization’s technological competitiveness and potential IT risks, and identifies opportunities for development. For example, security vulnerabilities caused by outdated IT infrastructure can pose a risk.

Enhanced Due Diligence in Cases of Increased Risk

Enhanced due diligence goes beyond standard due diligence and is applied when, pursuant to Section 15 of the Money Laundering Act, there is an increased risk of money laundering or terrorist financing at the target company. This is intended to reduce the risk of financial crime. In addition, companies planning an investment can use enhanced due diligence prior to acquisitions to more reliably ensure that they will not become involved in illegal activities as a result of the acquisition.

An expanded due diligence process draws on additional data sources and involves more thorough checks than a standard due diligence process. This may include, for example, a comparison with international sanctions lists.

The exact criteria that must be met for a situation to be considered a heightened risk have not been specified. However, Annex 2 of the Money Laundering Act includes a non-exhaustive list of factors that may indicate a heightened risk. These include, among other things, the target company being based in a country that lacks adequate systems for preventing, detecting, and combating money laundering and terrorist financing, or the organization’s activities being cash-intensive.

Who conducts due diligence?

Due to the complexity of the process, external consultants—such as attorneys, tax advisors, management consultants, or certified public accountants —are typically engaged to carry it out. Depending on the type of review, experts from other fields may also be engaged to address specific issues; for example, IT professionals may be brought in for a technical due diligence review.

What is the due diligence process?

The exact procedure for due diligence may vary depending on the type and purpose of the review. Generally, however, the process is based on the following steps:

Consultation with a Consultant: First , a consultant is hired to conduct the due diligence. Together with the consultant, the parties determine what type of due diligence should be conducted and what objectives the review is intended to achieve. In addition, the scope of the analysis and the timeframe for its completion are defined.

Obtaining the Documents: The next step is for the selling party to provide all necessary documents. This is usually done through a digital data room, where all documents can be collected.

Analysis: Once all documents are complete, the consultant analyzes, reviews, and evaluates them. Depending on the type of due diligence, different areas are prioritized.

Q&A Session: Following the analysis, a Q&A session may take place during which the consultant can ask the selling party any open questions or request additional information. The review is then completed.

Preparation of a Due Diligence Report: Finally, a due diligence report is prepared. This report serves as a basis for the client to make decisions regarding how to proceed with the transaction.

What is a due diligence report?

A due diligence report summarizes all the findings of a due diligence process. The specific components may vary depending on the type of due diligence and the size of the company being reviewed. In general, however, it provides an overview of an organization’s strengths and weaknesses and identifies risks that could affect a transaction. At the end of a due diligence report, a recommendation is made as to whether and under what conditions a transaction should be carried out or continued.

This summary enables buyers to assess the viability of their planned investment. It also gives them the opportunity to take steps to protect themselves against the identified risks or to use them as leverage in negotiations.

Costs of Due Diligence

The costs of conducting due diligence can vary widely and depend on several factors, including the size of the target company, the scope of the review, and the complexity of the transaction. External consultants typically charge an hourly fee. Extensive reviews not only require a significant time investment but also involve a team of several auditors. This increases the costs. While due diligence expenses for small companies are usually manageable, they can rise into the six- to seven-figure range for large companies that require highly complex reviews.

Duration of a Due Diligence Process

The duration of a due diligence process, like its cost, depends on various factors. As a general rule, the more thorough the review and the more complex the company, the more time must be allocated for due diligence. For smaller companies, a review typically takes a few weeks. For large organizations, however, it can take several months. In addition, unplanned delays may occur during the process, for example, if the required documents are not provided on time.

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