Due Diligence Types and Steps

In 1988, Ferranti — a well-known player in the UK electronics and defence market — decided to purchase the US company ISC. The new acquisition, unfortunately, looked good only on paper. In reality, ISC profited from illegal schemes and passed on significant legal and financial problems to the buyer. Ferranti went bankrupt just a few years after closing the deal.

This case has left its mark on the foundation of modern due diligence. Businesses began to realise the importance of information and fact-checking in the decision-making process. Without it, even market leaders with a century-old history can vanish in an instant.

So what does due diligence mean? To put it simply, this means that the company has full data at every stage and conducts risk assessments based on reliable sources. The process is relevant for many areas: not only when closing M&A deals, but also when hiring personnel, purchasing real estate, and concluding an investment or loan agreement.

What is a Due Diligence Check?

Due diligence definitions may differ from area to area and imply a different set of operations.

We can broadly define due diligence as the collection of information about a person or a legal entity to determine the risks for a certain company. The goal is to minimise all possible negative consequences regarding business relations — either legal, financial, or tax-related.

To give an example, such checks might be relevant when hiring a new employee, concluding a deal with a new partner or a client, or when looking for contractors. Due diligence will help you make confident business decisions and protect your company while verifying information through trusted sources will help you tread lightly in a competitive business environment.

High-profile corruption scandals around the world prove the need to check information about persons and companies. In most jurisdictions, due diligence checks are a legal requirement — and violations are very costly for companies. Furthermore, transparency of business operations is directly related to the reputation of a company, and therefore to its long-term sustainability and profitability.

Here are some more benefits of checks:

• Confidence in new and current partners, employees and contractors.
• Protection from unexpected blows to the business (legal, financial, PR, etc.).
• Optimisation of work processes.
• Optimisation of costs and increase in profits.
• Optimisation of management processes.

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Types of Due Diligence Checks

Depending on the need, there are various areas of comprehensive inspections.

Financial due diligence

Due diligence in finance is dedicated to the financial aspects of the company. It must provide complete and objective information about the financial condition of the enterprise and all the risks that can significantly worsen its market position (and, consequently, the position of business partners).

This analysis examines the assets, debts, and credit obligations of the company, as well as the accounting and tax reports. As a result of the check, it is essential to get answers to the following questions:

1) Is the financial information provided by the company true, or is the company inflating its numbers?

2) Is the company cost-effective and can it be relied upon in the long run?

3) Are there any risks in cooperation and how can they be mitigated?

Legal due diligence

Legal due diligence is an examination of a company's documents, which is often necessary before making transactions and signing contracts.

Documents such as statutory documents, licences, verification of rights to property and land plots, and intellectual property can be subject to analysis. In addition, there may be a general review of how the company complies with legal requirements and whether it is involved in litigation.

Last but not least, the text of the contract that is planned to be concluded with the company is also checked.

Based on the results of the analysis, a report is drawn up on the legal activities of the company. This report will evaluate specific legal transactions and the company’s legal activities and will provide forecasts and recommendations regarding cooperation.

Operational due diligence

In this type of check, enterprises' operational activities are examined, such as the production level and utilisation capacity, as well as the possibility of increasing production or changing the product line.

In M&A transactions, due diligence can shed light on risks and opportunities. If operating capacity is evaluated positively, this could increase the value of the deal. If any problems are found, this can help to eliminate risks and intervene in time.

Tax due diligence

Tax due diligence is dedicated to the analysis of the most significant items of the company's tax records to obtain information about the tax accounting system, and tax burden and assess existing risks. This is an objective assessment of all tax aspects of the company.

The analysis takes into account all taxes applicable to the business, in all jurisdictions the company operates. The key documents for verification are tax declarations, reports, and other information from the tax authorities (for example, audit results).

It is important to note that the audit not only captures the current state of affairs, but also provides recommendations regarding tax optimisation.

Intellectual property due diligence

In our high-tech world, intellectual property is a significant source of capital and a key asset for many businesses. Intellectual property due diligence consists of analysing all intellectual property assets and providing their qualitative and quantitative assessment.

The check analyses patents, trademarks, copyrights and how they are legally protected.

HR due diligence

This type of verification is associated with the key intangible capital of companies — human resources.

Hiring and managing employees presents both many opportunities and potential risks for a business. That is why it is so vital for top management to have a thorough understanding of the personnel processes in the company, to control aspects of salaries, vacations, hiring, quantitative and qualitative composition of the team.

Customer Due Diligence (CDD)

The Due Diligence field is closely related to the concepts of KYC (Know Your Customer) and Customer Due Diligence (CDD).

This is a large group of regulatory requirements for companies — primarily financial institutions — to verify and monitor information about their customers.

Like other types of due diligence, customer due diligence is directly related to expected risks. Accordingly, there are 3 different levels for CDD.

1. Simplified due diligence (SDD) is the most simplified due diligence procedure for clients who pose a minimal risk in terms of financial transactions.
2. Standard Due Diligence or Customer Due Diligence (CDD) is the most common type of customer verification. Most clients of banks and financial institutions can potentially bear ML/TF risks, but the probability of violations is negligible (albeit more than in the SDD category). Therefore, the mandatory steps for banks are only to identify the client and confirm their identity.
3. Enhanced due diligence (EDD) - performed on clients who have a high level of likelihood of being involved in financial crimes (politicians, citizens from sanctioned countries, etc.). They are subjected to a more thorough check at the initial stages of cooperation, and their activities are monitored regularly.

How Is Due Diligence Conducted?

There is no "one size fits all" for the due diligence process. Each check will be different depending on the business type, company size, type of business relationship, and other factors. Furthermore, it should be kept in mind that due diligence is not only relevant for M&A, but also startups, the real estate market, the legal market, and many other areas.

Generally speaking — if we talk about common cases of mergers and acquisitions of companies — the recommended steps can be described as follows:

1. Prepare your system for working with documents

M&A transactions are followed by loads of paperwork and involve many people at the same time. Therefore, it is important to prepare a document package in advance and make it convenient for use — this will save time on checking and reduce the number of errors due to missing important information.

Many companies use secure cloud storage and virtual data rooms to work with documents.

2. Gather as much information as possible about the structure and owners of the company

Start with registration documents, information about the company's owners, income, and financial and tax indicators.

3. Carry out the analysis stage by stage, depending on the purpose of the check

After analysing the financial activity, you can proceed to legal due diligence, followed by an evaluation of the company’s organisational processes. The number of stages will depend on your individual needs. Do not forget about the main purpose of the procedure — to make sure that the transaction is expedient and does not carry risks, i.e.:

• The company is legal, is not on the sanctions lists and is not involved in litigation,
• The company has all the necessary registration documents and licences,
• The company has a transparent ownership structure,
• The company has clear ways to profit, and stable financial performance.

4. Prepare a due diligence report on the state of affairs in the company and possible risks

Provide recommendations to minimise possible negative consequences of the business relationship.

NB! Best practices

• Make a due diligence checklist UK. This is a kind of “cheat sheet” that lists all the indicators and documents that need to be checked concerning the business, step by step. It will reduce the risk of human error and information gaps.
• Use IT solutions to search and analyse company data. LIGA UNITED risk and monitoring solution has information on millions of UK companies, including registration data, ownership structure, presence in the sanctions lists, and negative media mentions. Find all the skeletons in the closet before signing the deal!