Due Diligence: The Precautionary Principle in Business

Due diligence is a risk assessment tool used prior to an acquisition or investment of various forms. This duty of diligence is mainly present in the acquisition process of target companies. In the context of these large-scale transactions, it is necessary to implement an in-depth audit in order to limit the acquisition risks inherent to this operation. This due diligence scrutinizes the entire life of the target company and permits the validation or adjustment of the value. This audit must be carried out ethically and independently.

What is due diligence?

Due diligence is the process by which a company verifies the financial, legal and administrative status of each business to be acquired or assimilated in the context of a merger. The audit carried out takes into account the target company's history, its current actions, and also its projections.

Due diligence is a precautionnary principle. The acquisition of one or more companies is a complex process involving different parties with possibly divergent interests. Moreover, the in-depth study of heterogeneous elements requires particular attention from the parties involved. Respecting the due diligence process is therefore crucial for the acquirer who will not be able to rely on his ignorance to protect himself legally in case of a post-acquisition problem. This principle echoes the notion of "caveat emptor" which requires the buyer to be prudent.

Although due diligence process is not a legal obligation,it is nevertheless part of a precautionary strategy to better secure the capital invested in a major transaction.

Due diligence, a strategic tool

Beyond the duty of diligence of any company that engages in a transaction that mobilizes a high level of capital, due diligence is part of a global strategic action. The audit carried out allows for better visibility of the state of play and the projections of the target company and whether they correspond to the reality on the ground. One may also conduct a social audit to determine the strength of the human capital, or a financial due diligence to examine the key elements of the target company's economy. The audit should also cover the assessement of assets and liabilities, results and the level of debt. If some elements are not consistent with the information provided during the previous negotiations, this will open the door to a price reduction.

Ideally, due diligence should include an industrial audit of technological risks and the risk of an intellectual property right infringement. This establishes whether the company is the owner of the intangible assets, and allows appropriate measures to be taken if this is not the case (transfer, assignment, etc.). Intellectual property rights have a central role in most companies and as such, their protection is essential.

Let's take the example of a company whose main asset is software. The acquisition of such a business requires a thorough study of the software, particularly its content, the use of open-source licenses, ownership of the source code and its maintenance. To assist in this complex assessment, Vaultinum has developed a series of solutions to audit software, "Know Your Software".

Due diligence, an extensive application

Banks and credit institutions

Originally used for the acquisition or merger of companies, due diligence now also covers other areas such as banking and credit institutions.

Before granting credit, a lender must, among other things, ensure the solvency of its client. In most countries, it is mandatory for financial and banking institutions to be vigilant about the origin and destination of the funds they handle. The objective of the duty of vigilance is to reduce the rate of toxic credits, as well as the risks of money laundering and the financing of criminal organizations.

Industrial property rights and copyrights

Due diligence also applies in the field of intellectual property (IP), whether to assess industrial property rights (trademarks, designs and patents) or literary and artistic property rights (copyright covering software in particular).  All of these rights constitute considerable intangible capital for a company, which is often difficult to evaluate. Due diligence therefore makes it possible to highlight the IP rights of a target company and to anticipate any difficulties arising from poor management. The audit makes it possible to identify problems that can be solved through, for example, a transfer of rights, in order to prevent any litigation.

The security of information systems

The due diligence procedure must also determine whether the target company has set up a system to secure personal and professional data. Verification of the security of information systems is nowadays an unavoidable step in any due diligence procedure. Failure to do so can have legal and financial consequences for the new entity. The analysis of risks related to the security of information, particularly confidential information, is therefore essential.

Due diligence, an audit to be carried out by an independent entity

To be fully exploitable, the due diligence audit must be performed by an entity that is totally independent from the companies involved. Depending on the size of the organization to be audited, the procedure sholuld be carried out by a consultant or a specialized firm. The auditor must not have any link to the structure audited. If so, there would be a conflict of interest and the conclusions would be deemed biased.

The choice of auditor is essential in order to have a report that reflects the reality as faithfully as possible. It is essential to consult the auditor's previous work to ensure that their field of expertise is in line with that of the company being audited.

What is the price of a due diligence audit?

The cost of due diligence depends on the scope of the areas to be audited. The price can vary considerably depending on the complexity of the assignment and the number of departments covered (financial, legal, human resources, information system, cyber security, etc.). If the due diligence audit is multidisciplinary, the cost can quickly increase. The quote presented by the service provider must be detailed. However, this cost must be put into perspective with the economic, possibly catastrophic, consequences of a merger or acquisition that could have been avoided by such audit.