Due Diligence: What is it and what is it for?

Knowing in detail the financial situation of a company is essential, especially when strategic movements are going to take place, such as acquisitions or mergers, among others. Therefore, in this article we want to talk about due diligence, what this concept is and why it is important for companies.

What is due diligence and what is it for?

Due Diligence or "Due Diligence", are the procedures applied to avoid third party risks, all in a broad sense. 

In this sense, ISO 37001 defines Due Diligence as: "the process of assessing in greater detail the nature and extent of bribery risk, and to assist organizations in making decisions regarding specific transactions, projects, activities, business partners and personnel". 

However, in common business practice, the term Due Diligence is applied in M&A (mergers and acquisitions) processes, i.e. before, during and after acquisitions, transformations, mergers, spin-offs, and other similar denominations.

What does it bring to companies?

Due Diligence helps potential business partners to avoid unpleasant surprises when investing in long-term businesses, such as: false balance sheets, undeclared labor liabilities, non-existent assets, contracts with hidden defects, undeclared third party lawsuits, tax evasion, among others.

José Ignacio Lobaiza, in his book "Legal and Compliance Audit", states that "the Due Diligence legal audit verifies the background and assets of a commercial company, applying a procedure that includes the analysis of administrative, financial, accounting and legal aspects; the analysis of corporate documents, contracts and judicial processes; with the purpose of allowing the acquirer to know in advance what it is acquiring and how much it is really worth, allowing the preventive detection of tax, financial and labor risks, among others".

Who performs the due diligence?

It is possible to verify, therefore, that Due Diligence is a type of Compliance procedure, which involves multiple actors, from Lawyers, Accountants, Auditors and even Engineers, for example, in the case of Environmental Due Diligence.

‍

Types of Due Diligence

Several main types of Due Diligence can be identified, which must be performed in any M&A procedure, for example: legal, financial, tax and labor. Specific procedures must be applied in each of them, for example:

Legal due diligence

Legal Due Diligence covers, for example, the procedure for analyzing corporate documentation (such as corporate contracts, contracts with customers and suppliers), and ongoing administrative and judicial proceedings, among others.  

Labor due diligence

Labor Due Diligence can focus mainly on the analysis of employment contracts, documentation of employee files, cases of work accidents, labor lawsuits, analysis of the organizational chart, employee turnover, salary costs, among others.

Financial and tax due diligence

Financial and tax due diligence is performed by specialists who analyze accounting books, accounting and financial statements, income and expense projections, business plans, tax planning, tax assessments by tax collection agencies, tax execution lawsuits, among others.

‍

How to do a due diligence?

The complete Due Diligence procedure is a long-term process consisting of three stages: pre-contractual, contractual and post-contractual .

Although most accounting firms offer the service in the pre-contractual and contractual stage, it is also essential to follow up on those administrative and judicial processes that were initiated prior to the M&A procedure. 

In this sense, Azahara Cots, in Compliance Sin Fronteras, comments that: "Due Diligence procedures within companies have become a vital prevention factor for the proper functioning of businesses, the detection of risk situations, provided that they are based on a periodic evaluation and monitoring. Likewise, this exhaustive review in mergers and acquisitions processes is especially relevant, which are no longer only focused on strictly commercial areas, but also on the acquisition of criminal risks, as criminal liability has become an issue that is "inherited" once the main transaction has been carried out".

‍

How long does the due diligence process take?

In terms of duration, the Due Diligence procedure can range from three months, in the case of small investments in SMEs, to years, in the case of large corporations involving several lines of business and operations in multiple jurisdictions.

Compliance Due Diligence

Finally, it is interesting to address the Compliance Due DiligenceDue Diligence, a type of Due Diligence proposed by Rodolfo Papa in Compliance Without Borderswhich "focuses on the detection of crimes that may have been committed in the name, interest or benefit of the target company (by itself or through interposed third parties), prior to the date on which the operation was entered into, as well as Compliance irregularities or vulnerabilities that could be ignored (negligently or deliberately) by such entity, such as not having an adequate and effective integrity program, or, on the contrary, simply being a cosmetic tool".

Rodolfo Papa, also comments that: "a Compliance Due Diligence or anti-corruption due diligence, which was undertaken as part of the course of the conclusion of an M&A transaction, should, in order to meet standards of reasonableness and efficiency, be implemented both before and after the closing of the transaction, in order to detect any non-compliance with compliance (crimes or vulnerabilities that lead to their commission, as the case may be), which may have been performed on its behalf or for its benefit, either directly or through third parties".

‍