“Think due diligence guarantees a risk-free deal? Or that it is simply about crunching numbers? Think again – there is much more at stake.”
Due diligence reduces risks by providing insights but does not guarantee a risk-free deal. It goes beyond numbers by analyzing trends, assessing the sustainability of revenue, understanding working capital needs and uncovering hidden liabilities or risks.
Many myths highlight why due diligence is critical and misunderstood. Let’s explore the origin and deeper aspects of due diligence and its role in successful transactions.
Many of you have heard the phrase “do your due diligence”, but what is that and why should it be done?
Strangely enough, the term “due diligence” originated on the stock exchange and described an obligation of the sellers, whereas nowadays it is used primarily in the context of private transactions and refers to the investors’, i.e. buyers’, best practice.
The concept of due diligence came on the scene in the 1930’s referring to broker-dealers’ duty of care toward investors in terms of reasonable investigation on the securities they were selling. The term quickly transferred over to describe the investigation process itself and was adopted beyond its original province of public offerings to private M&A and other types of investment transactions. You can encounter the term “due diligence” to signify investigations performed in a wide variety of business situations and at different stages of the investment process. However, here we are focusing on the most common use of the term in the financial world: the detailed investigation a potential investor carries out on a target business after successfully completing preliminary negotiations with the business’s owner.
The above definition excludes preliminary investigations conducted, using publicly available information, to identify and screen investment opportunities. It also excludes very specialized types of investigation, such as those that aim to check compliance with specific rules and requirements. Instead, the function of investor due diligence is to confirm the initial understanding of the investment opportunity that forms the basis for the terms agreed with the business’s owner in the preliminary negotiations. Hence, the particular scope of a due diligence and the procedures performed as part of it must be selected so as to substantiate, or challenge, the key assumptions made by the investor in valuing the opportunity and identify risks and uncertainties not captured in the initial assessment.
As a result of the due diligence, the investor may come to a different or more nuanced understanding of the opportunity and seek to renegotiate the initially agreed terms or even decide to decline the investment. For the same reason, investment due diligence commonly results in the investor negotiating additional, more detailed terms and conditions in its final agreement with the business’s owner.
A typical due diligence will include financial, tax and legal due diligence.
- Financial due diligence has a wider perspective because it seeks to both:
- Validate the investor’s valuation assumptions by looking at historical performance, if available, and concluding on whether it is consistent with projections and
- Identify financial uncertainties and exposures which could disrupt the business, or result in additional costs to the investor.
- Tax due diligence could be viewed as an extension of the financial due diligence, where the focus is on identifying potential additional tax liabilities arising from non-compliance or errors.
- Legal due diligence covers a wide scope of legal matters, including proper incorporation and ownership, contractual obligations, ownership of assets, compliance, and litigation. It seeks to confirm the validity of the rights being acquired by the investor and the absence of legal risks which could undermine the value of the investment.
Further types of investment due diligence are technical, environmental and regulatory, performed when the impact of these areas on the business is significant. Depending on the situation, the due diligence may need to address very specific and narrowly defined topics, as long as they are factors for the valuation and assessment of the risks of the investment opportunity.
Challenges of performing effective due diligence in small and entrepreneurial businesses
An investor’s information requirements in order to assess an opportunity may be more sophisticated and/or more detailed compared to the information the investee has available. This is commonly the case where a larger, more developed business invests in a smaller business, or where an institutional investor funds an entrepreneur. The business owner is focused on developing and running the business rather than on reporting and is not prepared for the investor’s scrutiny.
Here are some examples of how such challenges arise during investment due diligence. Fortunately, these scenarios can be resolved by engaging the right financial adviser, who can bridge the gap between an investor’s expectations and the investee’s available information.

As illustrated by the examples, a proper due diligence process will not only analyze the available information, but it will also assist with procuring the right information if the investee’s ability is limited. In certain situations, this may be critical for the success of the transaction.
How to due diligence?
A meaningful due diligence which actually helps mitigate the investment risk usually meets the following conditions:
- Both sides plan for investment due diligence early on, conduct preparation and allow sufficient time for it to take place at an appropriate point of the transaction process.
- A mechanism is put in place to modify the transaction terms as a result of the due diligence findings, as opposed to committing to a decision beforehand and not expecting to have to change it as a result of the due diligence.
- The scope of the due diligence corresponds to the matters of importance to the investment decision, i.e. it properly reflects the valuation drivers and the transaction structure.
Finally, but not last in importance, employing the right experts to perform investment due diligence is also a factor for getting the right outputs. In addition to specialization in regulatory, accounting, tax and technical matters, the due diligence team needs to be advised by transaction experts. To ensure that there is proper perspective to the investigation and that it serves its purpose to support the investor’s decision.
The process not only uncovers potential red flags and hidden risks but also provides a clearer picture of any challenges that may lie ahead. Ultimately, the exercise helps investors to make well-informed decisions based on reliable, thorough analysis, safeguarding their investments and enabling their ability to navigate uncertainties.