Useful and Useless Due Diligence

Having been in the venture capital and start-up business for more than 30 years I have seen my fair share of due diligence data rooms.  I may be dating myself by remembering when the data rooms were actual physical rooms full of banker boxes, not online cloud storage accounts.

Due diligence is the often-abused process describing the investigation of a company’s records for the purpose of establishing the risk surrounding a purchase or round of financing.  Most due diligence lists are compiled by the buyer’s counsel whose job is to minimize the risk to their client.  Typically lawyers and public accountants are hired to perform the diligence reviews.  I use the word abused purposely as these service providers are billing time by the hour, not by the level of risk associated with the diligence items they are reviewing.  Sellers of companies or securities rarely want to invest funds in making their companies diligence ready until the transaction is imminent.  If diligence is not properly managed the process can feel like a witch hunt and sow seeds of discontent post sale/purchase.

It is common practice for auditing firms when going over a company’s books to create review programs that first assess risk before they plan their examinations.  This is a rational way to minimize costs.  This is not the case for most due diligence programs.  Two examples:

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Example #1 A company with $11m in revenues and 50 employees was bought by a large private equity fund.  The fund’s legal and accounting due diligence teams had 16 people review the company’s records.  The diligence took four months and the 16 experts still missed $1.5m in unrecorded tax liabilities on a $26.5m purchase price.

Example #2 A company had four purchase offers within the owner’s target range of between $6m-$8m.  The owners, who had never sold a company before, balked at bringing on board help to compile the data room and ensure its completeness and accuracy.  The prospective buyers walked away and the company remains unsold.

Like auditing firms, buyers or sellers of companies should first assess areas of risk such as market, intellectual property, finance, legal, and tax before embarking on building or evaluating data rooms.  For sellers of companies, quality corporate governance is always good hygiene for running the business not just readying the company for sale or investment.

We always advise our clients who are either on the buy or sell side to stack rank the risk by area in descending order of importance.  Then invest the funds or expertise accordingly.  The process will feel less like a witch hunt.