The Importance of Due Diligence in Financial Transactions

Due diligence, a basic obligation of good finance, mandates that certain steps be taken before a merger, an acquisition, an investment, or some other kind of collective funding – steps aimed at ascertaining the probity, transparency and general likelihood of success of any given enterprise.

Understanding Due Diligence

Due diligence is the process by which you investigate a commercial proposition – a business or a course of action – a vendor’s assets, liabilities and commercial and legal viability, usually by examining its accounts, its good standing, its operational metrics, with the aim of confirming that a sale or purchase is above board and free of red flags.

Risk Mitigation

So the first benefit of due diligence is precisely that it helps limits risk. The parties to a financial transaction run various risks, such as unexpected and unforeseen liabilities that may come with the transfer of an asset. For example, a company can be unaware that the sale of land not actually free of tenancy. Or a company may transfer a great amount of money because the balance sheet is overvalued without taking into account the true market conditions. If due diligence is conducted properly, the subject of a transaction’s risks will be captured, their impact will be evaluated by specialists, and eventually used by the parties to maximize the chances of contract enforceability by saving the parties from future surprises and losses.

Informed Decision-Making

Done well, due diligence is invaluable, giving all the parties good, usable information so that decisions can be made with fully open eyes. For investors and buyers, it should make plain the financial position and prospects of the target. You don’t want to spend all this money unless the accounts, cash flow statement, market projections and other indicators show that it will further your strategic objectives while satisfying your basic investment criteria. So, at the very least, you need to know what you’re getting into. That way the terms and conditions, once agreed, will be clear-cut.

Enhancing Transparency

Since would-be transactors have a lot to lose financially and reputation-wise if they don’t perform well, transparency ensures that they are confident and trust each other. When parties use good faith, and conduct adequate due diligence, they will both know all material facts about the target, and can have confidence that there are no ‘skeletons in the closet’ that could jeopardize the transaction. This increases the chances of a clean closing and makes for a smoother process. Importantly, spreading goodwill through transparent due diligence is likely to make the transaction smoother, and to make the parties friendly towards each other afterwards, not for its own sake, but because maintaining such a relationship is in the interest of both parties. This can also flow over to future projects that the sellers can offer the buyers as opportunities.

Legal and Regulatory Compliance

Then due diligence is employed to verify that all the applicable laws and legal requirements (represented by all the legal documents, which in my case included contracts, agreements, filings, etc.) have been adhered to during the transaction process (including, in the case of financial vehicles like publicly traded stocks, mutual funds, foreign exchange transactions, derivatives and currency trading, failure to adhere to all the regulations in the law will lead to hefty fines and all kinds of legal and other sanctions). Fourth step: check all applicable legal documents (contracts, agreements, filings, etc) and confirm that: 1. the transaction will be in compliance with all the applicable laws and legal requirements 2. that no legal issues exist that could hinder the transaction process.

Valuation Accuracy

Put simply, no financial transaction can go ahead without a fair valuation of the thing being purchased. Due diligence and investigating the value of the target entity or business means probing its assets and liabilities, income stream and market competition and position. It’s how the price of a transaction is agreed in order to protect the buyer from overpayment while securing an investment that has real financial basis.

Protecting Stakeholder Interests

In any transaction involving finance, there are interest-based parties – investors, employees, shareholders, for example. Due diligence protects people’s interest and benefit. It provides stakeholders a complete picture of the profits and risk of an investment. This way, they can make decisions appropriately with their interests and long-term goals in mind.

Facilitating Smooth Integration

Specifically, the due-diligence process is intended to help reduce the transaction risks related to the integration of the target. Understanding how the target works in terms of its operations, finance and culture helps the acquirer plan how to integrate the target with as little disruption to its business operations as possible, while maximizing the value from the transaction.

Conclusion

To sum up, due diligence plays a key role in the whole process of financial transactions, in that it avoids the risk, protects the rights, boosts the transparency, and guarantees the compliance with the laws and regulations, so as to promote the health of MSA, support the parties in making an appropriate judgment on the value of the target entity, and lay a foundation that enables parties to proceed on the basis of sound intent with confidence.