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Due Diligence - How Investors Screen Your Company

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“Due diligence” means “due care” or “due diligence”. The term is now mainly used in the context of the purchase of a company and refers to the careful examination of the target company by the prospective buyer.

The seller, for his part, would do well to subject his own company to due diligence beforehand. The primary aim of due diligence is to uncover financial risks for the buyer. On the other hand, the buyer also hopes that due diligence will reveal opportunities, for example, synergies with his existing business areas. This makes due diligence the most important instrument for decision-making and determining the purchase price.

The 5 Aspects of Due Diligence

Depending on the industry, the individual characteristics of the company and the goals of the investor, the due diligence process is carried out in different ways. Basically, however, it covers these 5 areas and topics:

  • Financial situation: The balance sheet and income statement as well as the cash flow statement are examined, assets and equity are evaluated and a forecast of income and cash flow is prepared. The financial structure is also carefully examined and evaluated.
  • Market and competitive environment: What is the company's position within the industry, how is the market developing, and how fit is the company for future business?
  • Business model and value chain: Here, not only the risks around supplier and customer relationships are evaluated, but also the opportunities to increase efficiency, save costs and use synergies.
  • Legal aspects: This involves conducting a comprehensive review of the relevant company documents, such as articles of incorporation and registration in the commercial register, as well as significant contracts like supply agreements and employment contracts. Additionally, it includes evaluating the potential risks associated with liability and ongoing legal disputes.
  • Tax aspects: What are the tax implications of the business acquisition, what is the current tax assessment, are there ongoing tax audits, open appeals, outstanding tax payments?

In addition, the condition of machinery and equipment, the rights to use patents or licences, as well as ecological factors and cultural challenges can also be the subject of a due diligence review. The question of how sustainable the company is in the environmental, social and management culture areas is also becoming increasingly important.

Discretion is the Highest Priority

To be able to examine a company with due diligence, the prospective buyer needs extensive documentation, which the seller makes available to him as soon as he has placed his interest in buying the company. Visits to the business and discussions with management and key employees are also part of the due diligence process.

Much of the information required for due diligence is confidential. For example, innovations from product development can sustainably improve business prospects and thus the company's value. To prevent such data from falling into the hands of competitors, all employees of the investor who work on the due diligence should sign a non-disclosure agreement (NDA).

Seller's Preparation for Due Diligence

A great deal of detail is asked for during a due diligence review. Incomplete documents or incorrect information cast a bad light on the seller and affect a positive business valuation.

It is therefore advisable for an entrepreneur to first carry out a due diligence on his behalf. In this way, he ensures that all the necessary information, correct and complete, is compiled and filed in the (virtual) data room. It significantly simplifies and shortens the subsequent review process in the context of an actual sales process—both for the seller and for potential buyers. In addition, a pre-due diligence may reveal weaknesses in the company that can advantageously be eliminated before negotiations begin. Basically, the better an entrepreneur prepares for the due diligence of a potential investor, the stronger his position in the negotiations.

Expertise is Essential

Due diligence is a time-consuming undertaking and also requires some specialised knowledge. A buyer who has to take care of his own business as a managing director will not be able to avoid delegating due diligence tasks to competent employees or external specialists. What is needed is an entire team consisting of industry specialists, auditors, lawyers, tax experts and financial analysts. Professional financial investors usually employ such experts; a founder who has built up a company and now wants to sell it does not.

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