Due diligence processes and phases

The due diligence process involves verifying all available information on a person, company, or entity. 

Conducting a due diligence check is especially important if you’re considering prospective business partners or forming new commercial relationships. It’s also important if you’re looking to purchase another business or make an investment in a company. By conducting a comprehensive due diligence process, you can be more informed and confident in your dealings. Plus, a due diligence check can protect you from liabilities and regulatory non-compliance.

Due diligence is particularly important because it reveals everything you need to know about a company you’re either establishing a relationship with or investing in. The due diligence process itself involves a review or an audit of a company’s financial position, organizational structure, product lines, physical and intellectual property, and any existing business relationships and obligations it has.

Before the due diligence process begins, you should already be aware of some of the basic merits and drawbacks of the business in question. The job of due diligence is then to dig deeper into the company’s position to make sure there are no nasty surprises, such as legal issues and politically exposed persons on the board. With this in mind, let’s take a step-by-step look at what the due diligence process involves in a B2B context.

A step-by-step due diligence process to follow

The due diligence process differs on a case-by-case basis. Depending on the size of the transaction and the businesses involved in the discussions, it can take anywhere from a few days to several months.

That said, the majority of due diligence processes follow the same step-by-step structure. Here’s exactly what each stage of the process involves.

Understand the company size

The first step of the due diligence process involves developing a deeper understanding of the company you’re researching. To complete this stage of the process, you should do some base-level research that shows you how many employees the company has, the markets it operates in, and the number of stores or warehouses it has. This will reveal any information that you may need to look at more closely, such as whether there are any legal issues that may arise if your company creates a partnership with an entity that’s located in a certain foreign territory.

On top of this, if the company is public, you should also look at its market capitalization. This shows you how volatile a company’s stock is likely to be, how broad the ownership might be, and the potential size of the company’s end markets.

Generally speaking, companies with a large market capitalization will tend to have stable revenue streams and low levels of volatility. Meanwhile, companies with a lower level of market capitalization may only serve a single area of the market and will experience more fluctuations in their stock price and earnings. If you’re researching a private company, equity capital is a good indicator of its size.

Management and ownership analysis

Now that you know a little more about the company’s background and current performance levels, you need to answer some key questions regarding the company's management and ownership.

Start by looking at whether the company is still run by its founders or whether management and the board have changed in recent years. You should then look at the consolidated bios or CVs of top managers to see what kind of experience they have. You can find this information on the company’s website or in its Securities and Exchange Commission (SEC) filings. 

You should also ensure that none of the people who will be involved in the new business relationship are politically exposed persons, and that no adverse reports exist about your new potential business partners. You must also ensure you’ve obtained information to confirm the true beneficial owners. These people should then be screened so that you know the exact level of risk associated with establishing a new business relationship with these people. 

To help you with this process, you should check:

• Sanctions lists
• Politically exposed persons lists
• Watchlists
• Compliance-related lists
• Company profiles on third-party databases
• Any summaries of legal proceedings that mention the people involved
• News reports about the people or the company involved

This way, you can effectively analyze the risk of entering a relationship with this business. You can also reduce your company’s risk of missing important information, or failing to satisfy the statutory compliance requirements. This process can be completed with the help of due diligence software. 

Analyze sales and profit margins

Now you know the basic information about the company’s size, its market reach, and its operations, you need to analyze its sales and profit margins. To do this, you’ll need access to the following documents:

• Balance sheets and income statements
• Inventory schedules
• Future forecasts and projections
• Revenue, profit, and growth trends
• Stock history and options
• Short and long-term debts
• Tax forms and documents
• Valuation multiples and ratios in comparison to competitors and industry benchmarks

By carrying out this stage of the process, you can accurately gauge the company’s asset health and assess its overall financial performance and stability. It can also help you detect any potential red flags. Generally speaking, this part of the process will tell you whether the company is growing, stagnant, or shrinking. If it’s growing, it can also tell you what the growth drivers are and whether these are sustainable.

Analyze company stocks

Now, you need to learn about the company’s historic and current stock performance. You’d generally expect to see some price growth from the company’s stock over time, but it’s just as important to determine whether performance has been choppy and volatile, or smooth and steady.

Stock volatility may be a cause for concern, as this can attract short-term shareholders and may be indicative of business blunders or increased levels of risk.

Evaluate industry specific trends, markets and competitors

At this stage of the process, you know a lot about the company’s current position. However, as part of the B2B due diligence process, you must also endeavor to understand as much as possible about what the company might look like in the future.

As a result, you must analyze:

• Key drivers in the market
• How the market is likely to grow or change in the future
• Whether the industry margins are sustainable at current levels

In addition, you must also take a look at the wider competitive landscape, including:

• Who the main competitors are
• What disadvantages and advantages these competitors hold
• How the products and services offered by competitors differ
• Barriers that prevent new competitors entering the market

Evaluate company-specific threats

At this stage, you must also evaluate company-specific threats. For example:

• Are there outstanding legal or regulatory matters?
• Is management making decisions that are detrimental to the company's revenues?
• What kind of long-term risks could result from the company embracing/not embracing green initiatives?

You should keep a healthy devil's advocate mindset at all times, picturing worst-case scenarios. However, you should also consider how you could prevent any of these potential drawbacks or pitfalls if you enter a business relationship with the company, make an investment, or purchase it outright.

Future planning and expectations for the business

As part of future planning and forecasting, you must also evaluate the company’s business plan and any models they’ve produced. In doing this, you can assess whether the business plan is viable and whether that firm’s models are accurate. 

When assessing the business plan and any models, ask yourself the following questions (depending on your intentions):

• Does the document provide a clear path to income growth?
• How realistic is the document?
• Could the document be improved following an acquisition?
• How does this business plan fit with my own strategic objectives?

Valuations

Now, the due diligence process is complete. By ensuring that you’ve carried out a comprehensive range of due diligence checks and by making sure that you’re aware of all the necessary information, you can establish a more accurate valuation for the business. Crucially, because you have all the information available, you can also defend the valuation you’ve come up with and negotiate accordingly. As a result, when the due diligence process is carried out effectively, it can provide an investor with the edge over a seller during negotiations.

Processes for different scenarios

The above step-by-step due diligence process is followed in a number of instances. However, certain scenarios require slight alterations to the process and different points of emphasis. Here’s why.

For start-ups

Initial funding rounds for startups often involve angel investors, rather than venture capitalists. As angel investors invest their own money, they view risk differently to venture capitalists and usually only perform a much softer level of due diligence as a result. In doing so, they will get to know:

• The team involved
• The market size and competitors
• IP rights
• Budget and forecasts
• Initial traction
• Contracts

The type of due diligence performed when a startup founder exits the business and someone else takes control will depend on the market, the geographic location of the business, and the buyer.

For acquisitions

When one company is acquiring the other, due diligence is vital for both the buyer and the seller. Generally speaking, when it comes to acquisitions, the step-by-step process we outlined above will be followed. This happens to ensure that the transaction is priced appropriately and that issues do not arise further down the line.

In these scenarios, the due diligence process usually takes up to 60 days and NDAs are signed before the process takes place. Advisers are usually used to help keep the process smooth, unless the transaction value is small.

For investments

Due diligence is also performed between a buyer and a seller when a transaction is being made for investment purposes. In these scenarios, the buyer will complete commercial, legal, financial, and tax checks after they’ve held preliminary conversations with the asset owner.

In these circumstances, the due diligence process is vital for helping the buyer and seller agree on a price for the asset in question. This is because it allows the buyer to develop a more nuanced understanding of the initial opportunity. Due to this, a buyer will often use the results of their due diligence to renegotiate the initially agreed terms. They may also negotiate more detailed terms and conditions in its final agreement or decline the opportunity outright.

For third parties

Any person or organization that is connected to your supply chain or is executing business on your organization’s behalf such as a supplier, distributor, agent and/or partner can potentially expose you to unknown third-party risk.

If these entities exist, then third-party due diligence must also be carried out. This process involves studying the third parties involved in order to accurately identify these risks, so they can be understood and managed.

On occasion, third-party due diligence also refers to the process where parties who are independent to the transaction carry out research on behalf of the buyer and request documents from sellers. Often, companies will provide pieces of software and tools that can be used to vet individuals and companies around the world. This can part-automate the due diligence process and help identify any legal, ethical, or financial issues, or other red flags.

For selling a business

Anyone who is selling a business must be prepared for the due diligence process to take place. This means that they should endeavor to get as much paperwork and information together in advance of a sale.

As we mentioned earlier, the scope and the extent to which due diligence is carried out will largely depend on the buyer’s specific requirements and the size of the deal. But, to ensure the process goes as smoothly as possible, the seller should gather the following documents together, in case the buyer asks for them:

• Statutory records and documents
• Tax documents
• Information on the legal structure of the business
• Information regarding the shareholding position
• Documents that clearly show how staff are engaged and classified. This should include information regarding their roles and responsibilities
• Proof that your trademarks, company name, domain name, and other forms of intellectual property are properly protected
• Copies of business contracts

You should also be aware that the buyer may inquire about tax, business accounts, finance, assets and property owned, environmental information, IT systems, and proof of regulatory compliance.

For IPOs

An Initial Public Offering (IPO) represents the first time a private company makes its shares available for trade on a public stock exchange. As part of the IPO process, private companies must perform due diligence to ensure that they’ve met all the requirements for going public.

As you may expect, the due diligence process in these scenarios can be complex and wide ranging. As a result, it can be lengthy and a lot of information must be shared. This is to ensure that the company carrying out the IPO has a thorough understanding of the factors that may either positively or negatively affect their success.

Before the IPO, the business must gather information regarding their:

• Organizational data, such as their articles of incorporation and a list of shareholders and committees
• Licensing and taxation data, such as business licenses and annual tax returns
• Board and employee information, including an employee list and information about employee status, including each employee’s position and salary
• Financial information, such as a list of financial accounts and copies of financial analysis reports
• Customer/service information, such as copies of consumer complaints and copies of the company’s trading policies
• Company property, including a list of business locations, trademarks and copyrights, and approved patents and real estate agreements

Speak with the B2B due diligence experts at Veriff

By carrying out an appropriate level of due diligence, you can ensure that your company meets its regulatory obligations, prevents itself from entering a potentially risky situation, and makes sound financial choices.

If you’re interested in discovering more about conducting due diligence, then speak with the B2B due diligence experts at Veriff today. We’ve created a range of identity verification and AML and KYC compliance solutions that can help you with the due diligence process and would love to explain exactly how we can help you and your business. Get in touch for a free and personalized demo today.