DUE DILIGENCE

Definition

Due diligence is a systematic investigation or audit of a potential investment, business, or legal agreement to assess its risks, value, and viability before finalizing a transaction. It ensures that all material facts and liabilities are known to support informed decision-making.

In essence, due diligence is the "trust but verify" step in high-stakes business decisions.

Origins

The term was formalized in U.S. securities law through the Securities Act of 1933, where underwriters were required to exercise "due diligence" to avoid liability for false statements. Since then, it has evolved into a multi-disciplinary process used in M&A, financing, partnerships, and regulatory reviews.

Usage

Industry Applications:

• Mergers & Acquisitions (M&A) – Evaluate target company’s operations, finances, risks, and value.

• Private Equity / Venture Capital – Assess investment suitability, scalability, and legal exposure.

• Real Estate – Investigate title, zoning, leases, and physical conditions.

• Lending & Credit – Underwrite borrower risk and collateral validity.

• Strategic Partnerships / Licensing – Verify IP, compliance, and alignment.

• Public Offerings (IPO) – Review financials and disclosures before market listing.

How Due Diligence  Works

Typical Due Diligence Process:

1. Preparation:

   • Define scope (financial, legal, commercial, etc.).

   • Create a due diligence checklist or data request list.

2. Information Collection:

   • Access to data room, documents, contracts, financials.

3. Review & Analysis:

   • Deep-dive by relevant experts (accounting, legal, tax, HR, tech).

4. Reporting:

   • Red flags, valuation impact, integration risks, deal adjustments.

5. Decision & Negotiation:

   • May lead to purchase price revision, reps & warranties, or deal termination.

Key Takeaway

• A risk mitigation tool to uncover material issues before closing a deal.

• Spans multiple domains—finance, legal, tax, operations, environmental, IT, HR, and more.

• Can delay, reprice, or terminate transactions based on findings.

• Essential for ensuring regulatory compliance, valuation accuracy, and deal success.

Types of Due Diligence

Context in Financial Modeling

Due diligence informs:

• Adjusted EBITDA – Remove non-recurring or non-operating items.

• Working Capital Normalization – Define closing net working capital peg.

• Capex Forecasts – Identify maintenance vs. growth capex needs.

• Debt and Cash Adjustments – Validate net debt for equity value bridging.

• Synergy Models – Confirm achievable cost/revenue synergies.

• Purchase Price Allocation (PPA) – Determine fair value of acquired assets and goodwill.

Nuances & Complexities

• Materiality Thresholds – Focus on risks that can significantly affect value or deal terms.

• Virtual Data Rooms (VDRs) – Secure platform for sharing and tracking documents.

• Third-Party Advisors – Specialist firms often engaged (Big 4, legal counsel, tech auditors).

• Limited Timeframe – Competitive deals may require accelerated “light-touch” DD.

• Buy-Side vs. Sell-Side DD – Buyers investigate; sellers prepare disclosures to preempt issues.

Mathematical Formulas

While due diligence is qualitative, some quantitative outputs include:

1. Adjusted EBITDA:

$$\text{Adjusted EBITDA} = \text{Reported EBITDA} + \text{Non-Recurring Items} - \text{Owner Adjustments}$$

2. Net Working Capital (NWC) Peg:

$$\text{NWC Peg} = \text{Average NWC} \text{ over trailing 12 months (T12M)}$$

3. Enterprise to Equity Value Bridge:

$$\text{Equity Value}=\text{Enterprise Value}-\text{Net Debt}-\text{NWC Adjustment}\pm \text{Other Adjustments}$$

Related Terms

• M&A

• EBITDA Adjustments

• Working Capital Peg

• Reps and Warranties

• Virtual Data Room

• Quality of Earnings (QoE)

• Synergies

• SPA (Sale and Purchase Agreement)

Real-World Applications

1. Private Equity Buyout

PE firm performs financial, legal, and IT due diligence before acquiring a $200M SaaS company. Findings lower valuation due to overestimated revenue retention.

2. Real Estate Transaction

A buyer commissions environmental and structural due diligence before acquiring a commercial building. Discoveries of asbestos lead to negotiation of remediation costs.

3. IPO Preparation

A startup engages auditors, legal counsel, and consultants to perform due diligence and verify disclosures in its S-1 filing to the SEC.

4. Strategic Merger

A multinational manufacturer uses due diligence to assess regulatory overlap, anti-trust risk, and integration complexity before merging with a competitor.

References & Sources

• Damodaran – Cost of Capital by Sector and Country Datasets

• Modigliani & Miller – Capital Structure Theory (1958)

• FASB/IFRS – Discount Rate Disclosures in Impairment Testing