Tuesday, August 08, 2006

Due diligence

From Entrepreneur magazine:

The process by which persons conduct inquiries for the purposes of timely, sufficient and accurate disclosure of all material statements/information or documents which may influence the outcome of the transaction. Due diligence is a critical component in mergers and acquisitions.
Due Diligence definition – usually associated with contracts or investments, this term , in general, means that proper efforts will be made in investigations or examinations of efforts put forth in a transaction. Good faith efforts are to be made in performing obligations.

First, the definition should mean nothing more than an investor being "diligent" when checking out the substance of the claims made by an entrepreneur with respect to the market, the product or service concept, the competition, the management team and so on. The term "due" means that it's expected and someone has to perform this task. So the concept is really all about the diligence that is due the investigation into an emerging company's plan for doing business. There are some in the financing environment who expect this to be done by the entrepreneur on behalf of the investors, and that's a completely wrong understanding. The company founder makes some form of disclosure within the business plan, but the responsibility to follow-up on and check out the statements made in that document falls squarely on the shoulders of the investor. For the scope of your financing experiences, always assume that the potential funding source is the one that will check and recheck everything presented by the entrepreneur.

The next issue to consider is how the due diligence gets accomplished. As I said before, this varies considerably from deal to deal. At the first level, a potential investor may pass the business plan along to a colleague who has specific experience in the same (or a similar) area of the new venture. Technical drawings, terminology, articles cited, machinery or processes described, pricing and shipping practices, and marketing channels are all examples of categories within the plan that need to be checked carefully by investors to see if the entrepreneur really knows what he or she is talking about. Certain industries may have very unique issues in these and other company functions. A skilled eye with experience in that same market space will be able to comment on the accuracy of the statements made. If your general contracting business idea doesn't convey a clear understanding of the specific issues related to building supplies, pricing, payment terms or financial commitments on real estate, then due diligence should readily pick up on these as red flags that bring into question the overall quality of the deal.

Due diligence can also go several steps further. Investors will often pick up the phone and contact people or companies named in your business plan. If Jill Smith is listed on your advisory board with an impressive electrical engineering background, investors will want to speak directly with her and follow-up on where she went to school, how long has she been in the industry and hear her version of what she's doing on the board. If Jones and Jones Inc. is listed in the plan as the primary supplier of parts inventory to the new venture, not only will investors want to talk with shipping and manufacturing people at Jones and Jones, but they may also want to visit the factory to meet the owners and production crew and see the operation firsthand. When an accounting practice, law firm or design company is named in the plan, a thorough due diligence speaks directly with each of these and discusses the extent of the business relationship with the entrepreneur and the new company.

This also applies to statements about patents, trademarks, exclusive contracts and deals currently in process with a large buyer. Investors would like to mitigate as many risks as possible related to the funding opportunity. Due diligence simply allows them to check and double-check the pertinent pieces of the deal before deciding whether to provide capital. So don't get upset when an exhaustive due diligence is performed on your business proposal. If everything's accurate in your presentation, then the due diligence will further validate that fact and investors will be more likely to put money into your deal.

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