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Due diligence

Due diligence

Due diligence is the process by which a prospective investor drills down into the details of a business to form an opinion on its true state and on the viability of completing a proposed investment. The amount of time devoted to due diligence is usually proportionate to the scale of the investment and consequent financial risk. Around two thirds of proposed deals fail to complete because of issues uncovered during due diligence. Of those that complete, around two thirds that are mergers and acquisitions fail to create shareholder value for the acquirer and around half of the investments made by business angels result in a total loss. Due diligence is business critical for i) prospective investors, ii) companies being merged or acquired and iii) entrepreneurs seeking equity investment.

There are four aspects to due diligence. These are:

  • Commercial
  • Financial
  • Legal
  • Personal

Many entrepreneurs are unprepared for due diligence, especially first timers. Due diligence can feel like an over intrusive investigatory process, but the high risk nature of venture capital investment necessitates it need be. The better prepared the entrepreneur is for due diligence, the smoother the process will be. Similarly, early disclosure of potential issues will always be received better than late disclosure. And remember, it is only after the conclusion of due diligence that an investor will finally decide whether to invest or not.

The typical business angel will invest 25-30 hours in due diligence and there are usually three rounds:

  • Preliminary
  • Questionnaire
  • Deep dive

The preliminary round is where the prospective investor asks a series of business critical make or break questions. These preliminary questions typically cover:

  • Details of the business’s capital structure including the amount funded by the founders including their friends and family
  • Justification of the business valuation
  • How the funds being raised will be used
  • Robustness of sales contracts
  • Ownership of intellectual property
  • Route to market to scale the business
  • Responsiveness of the entrepreneur and management team to answer questions

Pass the preliminary ‘getting to know you’ test and a detailed questionnaire will follow. The detailed questionnaire typically covers the following areas:

  • Company and its structure
  • Management team
  • Sites, facilities and assets
  • Key products and services
  • Technologies and intellectual property
  • Customers
  • Competitors
  • Suppliers
  • Joint ventures, acquisitions, partnerships and alliances
  • Regulations affecting the business (current, impending and potential)
  • Litigation
  • Liability and insurance
  • Related party transactions
  • Any other material information
  • Supporting documentation

The supporting documentation usually includes:

  • Memorandum and Articles of Association
  • Certificate of Incorporation
  • Full business plan including financial forecasts for the next three years
  • Existing shareholder or other similar agreements
  • Statutory accounts for last 5 years for the company
  • Management accounts
  • Significant customer contracts
  • Details of any significant employee benefit packages and share options
  • Board minutes
  • Companies House filing history for the last 5 years including copies of all shareholder resolutions and annual returns
  • Details of charges on company assets
  • Details of bank accounts, facilities and loans
  • Outstanding liabilities for VAT, PAYE and corporation tax
  • Interests that the company holds in any other entity
  • Employment agreements or handbook excluding personal data that is subject to the Data Protection Act

The questionnaire will also require a declaration that the information provided is i) accurate and ii) that there are no known significant adverse factors that a potential investor or investors should be made aware of.

Assuming a satisfactory and timely response to the detailed questionnaire, the investor will then deep dive into the remaining deal specific issues that need investigating in order to provide the reassurance that the potential upside from completing the investment offsets the financial risk.

During due diligence, prospective investors are fundamentally seeking facts to verify that the business and business opportunity is as it has been portrayed and crucially, to identify issues previously not considered, which if unresolved, could turn into deal breakers.

And never forget, due diligence is not just an investigation into the viability of a business, but also an assessment of the credibility of the management team and its ability to deliver the business plan and thus the success or otherwise of the investment. About one in three prospective deals survive due diligence.

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