The basic function of due diligence, in any merger or acquisition, is to assess the potential risks of a proposed transaction by inquiring into all relevant aspects of the past, present, and predictable future of the business to be purchased. The term is also used in securities law to describe the duty of care and review to be exercised by officers, directors, underwriters, and others in connection with public offerings of securities.
Although the term due diligence is applied in securities law—statutory law set by legislatures—the term itself originated in common law, also known as case law—the law that develops through decisions of judges in settling actual disputes. The common-law system arose in medieval England after the Norman Conquest, and is still in use there as well as in the United States, among other countries. In this type of law, as opposed to law passed by legislatures, judges use the precedents of previous case decisions in order to render their own decisions. Much of US common law has been codified in the statutes of individual states, and in the U.S. Uniform Commercial Code (UCC).
The due diligence effort in a merger transaction should include basic activities to meet diligence standards of common law and best practices. These activities include the following:
- Financial statements review—to confirm the existence of assets, liabilities, and equity in the balance sheet, and to determine the financial health of the company based on the income statement, paying attention to the quality of earnings. The review may also include analysis of the cash flow statement.
- Management and operations review—to assess the quality of leadership and human capital in the company, to determine reliability of financial statements based on the strength of management’s internal controls, and to gain a sense of risks and contingencies beyond the financial statements.
- Legal compliance review—to check for potential future legal problems stemming from the company’s past.
- Document and transaction review—to ensure that the paperwork of the deal is in order and that the structure of the transaction is appropriate.
Careful scrutiny in all these areas can prevent problems after the transaction is over and the new company’s life begins. So let’s get started!