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What is Due Diligence? Definition and Significance

3 min read

Aug 11, 2023 11:50:00 AM

In a business world where information is the currency, due diligence is an essential examination that safeguards against significant risks. Originally emerged in the context of securities trading, it has evolved into an essential component of corporate acquisitions, initial public offerings, and compliance for anti-money laundering. Automated solutions can significantly simplify recurring Due Diligence Assessments.

Definition: What is Due Diligence?

The term Due Diligence originates from U.S. capital market law and translates to “with due care Initially”, It revolved around liability regulations for individuals involved in securities trading. Later, Due Diligence underwent an expansion of meaning, particularly focusing on objects of purchase. This primarily applied to companies that were up for sale. In the context of a company acquisition, the buyer’s side requires a plethora of information to evaluate the company. The buyer needs to be aware of the company’s financial, legal, tax, and economic conditions to be able to make an offer.

In practice, experts from the buying company conduct a Due Diligence examination. External consultants are often involved in the examination. Information about the company being sold must be thoroughly researched and analyzed. Various sources are used for this purpose. During the valuation, opportunities and risks are weighed and balanced.

Over time, Due Diligence has expanded into other areas. It is conducted both before a company’s initial public offering and during the divestiture of company divisions, such as the IT sector. Additionally, there is another crucial context related to the financial sector. Banks perform Due Diligence examinations on new and existing customers as a preventive measure against money laundering.

What is the goal of the Due Diligence examination?

Through a Due Diligence examination, a potential buyer or acquirer seeks to safeguard themselves effectively against relevant risks. Before a company acquisition, the aim is to ensure that the assumptions and premises underlying the purchase offer are accurate. In the context of Due Diligence before an initial public offering, the goal is to ensure that the information in the securities prospectus is complete, to prevent any harm to investors.

In the realm of money laundering and economic crime prevention, sanctions screening plays a crucial role. This examination, among other things, aims to uncover the sanction’s status of new or existing customers. Sanctions lists are public directories that include individuals, organizations, or assets subject to legal or economic restrictions.

These examinations involve thorough background research. All relevant facts are scrutinized to minimize the risks of a business relationship. While Due Diligence in the context of a company purchase describes a one-time procedure, Due Diligence in the customer domain is a recurring process. Both new and existing customers are involved. They must undergo regular assessments as part of the general duty of care. This is the only way to largely eliminate the suspicion of money laundering.

Key Focus Areas of Due Diligence Examinations

Depending on the type of company, Due Diligence examinations have different focal points. The following four examinations are relevant in all corporate acquisitions:

Commercial Due Diligence (Market Analysis, Business Model Analysis): This examination involves conducting a market and competitive analysis. It also assesses the sustainability of the business model and whether the value chain complies with compliance regulations.

Financial Due Diligence (Company’s Financial Situation): A central examination where the company’s financial situation is thoroughly scrutinized. In addition to equity and debt, liquidity, cash flow, income, and assets are examined in Financial Due Diligence. Furthermore, forecasts are prepared for each of these aspects.

Legal Due Diligence (Legal Situations): This examination reviews all legal risks. Questions about lease and rental relationships are examined, as well as the assessment of copyright and labor law situations within the company. Above all, it is checked whether current legal disputes are pending that could diminish the company’s value or jeopardize its continuity.

Tax Due Diligence (Tax Situation): Here as well, it is checked whether legal disputes (with tax courts) are pending. The focus of the examinations is on all tax-relevant aspects affecting the company. The risk analysis covers not only questions of group taxation, but also the crucial tax-related influencing factors of the company up for purchase.

Furthermore, additional areas of the company can be subjected to Due Diligence examination. For example, operations, IT, environmental quality, asset quality, insurance-related situations, emergency plans, and much more.

Automating Recurring Due Diligence Examinations

In the context of the risk of unethical business practices (money laundering etc.), integrity Due Diligence is particularly relevant. This procedure, also referred to as Customer or Client Due Diligence, primarily involves collecting data about the company. The goal is to uncover and minimize illegal activities, ranging from money laundering to terrorist financing…

Since each examination represents only a snapshot, the process must be initiated anew on a regular basis. This poses significant challenges for companies as the process ties up personnel resources. Often, data is still collected manually – a highly time-consuming endeavor. Pythagoras Solutions offers tool-based solutions to fundamentally simplify and expedite recurring Due Diligence examinations. For example, Partner Screening continuously monitors business relationships for risks.