Why Is Due Diligence Important?

Why Is Due Diligence Important?

Due diligence has become one of the buzzwords of the 21st century. And there is a good reason for it. After all, we live in an age of data explosion where information is easily available, but its veracity itself is in question. In such a situation, due diligence and due diligence mechanisms are essential tools in the digital economy.

 But what exactly does due diligence mean, and how it is it carried out? Are there different kinds of due diligence that apply in different situations? These are some of the questions that we'll attempt to answer today.

What Is Due Diligence And Why Is It Important?

Due diligence is a process that involves checking the validity of a position, action or status. It is the opposite of negligence, or the accepting of things at face-value.

 The origins of the term "due diligence" can be traced back to US legislation that sought to protect investors against misinformed investments. Here, investment brokers were required to disclose all essential information about the business being invested in. In case they failed to do so, they could be held liable and faced prosecution.  However, brokers raised concerns regarding the fact that they themselves might not always have access to the required information, and in such cases, they should not be held responsible for withholding the same.  To protect brokers from wrongful lawsuits, the legislation was adapted such that so long as they exercised "due diligence" in their investigations, then they were not liable to be prosecuted for not disclosing any information they were not privy to.

 Due diligence plays an important role not just in business but, as you will see, in the overall proper functioning of the economy.  We will take a brief tour through a few of the areas that you may have encountered due diligence and in doing so, you will understand what it is and begin to see the outsize role this process has in everyday life.

 The most obvious is in the context of employment; a reference or background check is an example of due diligence.  For example, a prospective employee claims that they graduated from a prestigious university and have extensive work experience in a certain area.  The employer would verify this information with the university as well as former employers.  This type of due diligence may also involve criminal background screening. 

 In some industries criminal background screening is compulsory.  The human resources department of the potential employer, for example, conducts due diligence in this respect so as to verify the criminal status of the candidate. 

 A bank also conducts due diligence for loan applicants to make sure that they have not defaulted on previous loans or that they are not over-stretched financially and at risk of defaulting.

 Another example is that of a client who conducts due diligence on potential suppliers to check that they will be able to perform the expected services or deliver the goods at the required quantity and quality levels.  This due diligence may entail verifying references or researching a supplier’s track record or their reputation in the market.

 But due diligence is not only directed at others. Introspective due diligence is also an important part of company management and operations.  A company who has set principles for sustainable growth would want these applied at all times and across the board.  In conducting its own due diligence, it will check that:

  • it has appropriate policies and processes in place to comply with regulations, grow the business in a healthy and sustainable manner, maintain a culture of ethical business dealings, show that it is serious about what it represents and expects in terms of ethics and behavior,
  • its policies and processes are properly implemented on an ongoing basis, and
  • relevant information about the organization is gathered and stakeholders are aware of any issues.

Company due diligence is also essential when dealing with other businesses.  For example, clients will often expect that their suppliers or subcontractors abide by the same kind of principles as they themselves adhere to.  Why define standards and principles if these are not applied consistently across the supply chain? 

 Another important aspect of due diligence is its status as a recognized defense in litigation.  For example, in the context of an Initial Public Offering (IPO), certain parties who participated in the preparation of the IPO documentation, including the registration statement, may be able to use a due diligence defense if the registration statement contains misleading information or material misinformation. 

 Underwriters, lawyers, accountants, officers, and directors will try to show that they conducted a reasonable investigation of the information contained in the registration statement and that it was their belief, following such investigation, that such document contained no material misinformation or misleading statements. Demonstrating that such due diligence was indeed conducted will enable them to avoid liability. 

Finally, due diligence is sometimes imposed by law, and failure to conduct effective due diligence in accordance with legal guidelines can trigger liability.  For example, the US Bank Secrecy Act requires financial institutions to adopt an anti-money laundering program which is basically a due diligence policy and process.  Financial institutions need internal systems and controls, including policies and procedures, designed to help employees detect and prevent money laundering activities, a compliance officer in charge of monitoring the implementation of the program, training and awareness raising exercises and certification for senior employees, independent third-party audits to check, with impartiality, that the program is fully implemented.

As you have seen from the various examples above, in today’s world, due diligence has become a necessary aspect of conducting any business transaction. Whether you're hiring a new employee or looking to acquire a company, due diligence is an essential part of the process.

And due diligence need not be restricted to business alone. In every aspect of life today, we need to exercise due diligence in order to ensure that the required safeguards are in place to protect our interests. Whether to secure investments, perform a security risk assessment, or undertake vulnerability tests, the appropriate due diligence processes must be used to ensure the veracity of the operation.

Here, the question arises: is all due diligence the same? The short answer is: yes and no. While the basics of conducting due diligence remain the same, the exercise takes on different meanings and objectives in different settings. In the following section, we're going to look into some of the common types of due diligence that can be performed in various business situations.

What Are The Different Types Of Due Diligence?

Are you looking to open a new bank account? Or maybe you're interested in digital investments? Whatever the case, due diligence is either required or useful. In the sections that follow, we're going to introduce you to the many types of due diligence that are required to get the task done appropriately.

1. Acquisition Due Diligence

Acquisition due diligence is necessary when one business entity is looking to take over another business. This is a matter of common sense. After all, if you're buying something as substantial as a large business, it is essential that you perform the required background checks.

 Acquisition due diligence involves investigating the financial as well as technical prospects and viability of the business you're looking to acquire. This itself has multiple dimensions, such as:

  • Financial due diligence
  • Legal due diligence
  • HR due diligence
  • Technical due diligence

And this is just the tip of the iceberg. Mergers and acquisitions are complex processes that require caution on multiple levels. Not only do you, as the acquirer, need to be sure that you're making a sound investment, you also have to make the seller comfortable and get as much information as possible from them. Acquisition due diligence aims to help you do just that.

2. KYC Due Diligence

Everyone who has a bank account has, knowingly or not, experienced KYS or Know Your Customer due diligence.  When providing the bank with detailed and personal information in order to open an account, the customer is helping the banks to “check the box,” so to speak.  The information provided is required in order for the banks to comply with regulations and demonstrate to regulators that they have done their “homework” in performing effective due diligence.  Banks take the information provided and check it against databases of known criminals or sanctioned persons such as the UN, OFAC, AUSTRAC and EU. The KYC information is proof that they have been diligent in ensuring that they checked who their customers are. 

 KYC due diligence is good business practice but it is not voluntary. 

 In today's complex business landscape, it's not sufficient to know just the financial side of your dealings. You also need to keep a close watch on who you're dealing with. Not performing the right background checks on business partners and customers can expose some businesses to hefty fines and lawsuits.

 That's exactly where KYC due diligence comes into the picture. This is a process aimed  at ensuring that you're entering into a business transaction with the right person. Especially in the case of financial institutions such as banks and insurance firms, KYC due diligence takes on a vital role. KYC due diligence is usually performed by financial entities when opening a new account or investment portfolio. KYC due diligence lets you know more about the person you're dealing with, their past business records, and financial performance. All this information can come in handy when assessing whether a customer is indeed a reliable entity or a risk.

 However, KYC due diligence goes beyond mere regulatory requirements. It helps your business gain greater insights into the customer and their unique needs and requirements. In this way, you can better serve your customers and enhance your business in turn.

 Another type of due diligence that must be mentioned here is enhanced due diligence. It's a stricter form of KYC due diligence and involves deeper background checks.

3. IPO Due Diligence

Also known as pre-IPO due diligence, this is a form of due diligence that involves checking whether a business is ready for its Initial Public Offering. It's essential that a financial institution carries out complete, rigorous, and thorough due diligence in order to understand the maturity status of the market before a business launches its IPO.

In IPO due diligence, experts conduct a detailed analysis of the business's legal, financial, and tax-related status. The emphasis is  on operations, IT, and HR aspects. Seen in this light, IPO due diligence is similar to acquisition due diligence.

Further, in this form of due diligence, it's important to conduct a detailed analysis of the company's business model so as to understand its feasibility and long-term sustainability. The entire process also needs to take into account the competition levels, risks, and strengths. In other words, a thorough SWOT analysis.

IPO due diligence is an essential part of the IPO process, as it helps the business understand whether they are ready for the IPO or not. It's also important for proving to the regulatory authorities, such as the SEC, that the claims made by the business are legitimate.

4. Director's Due Diligence

This form of due diligence is vital for candidates who are about to accept a position on a company board of directors. While it's no secret that joining the board as a director is a massive responsibility, with commensurate professional returns, still in recent times, top executive roles have come under intense public and legal scrutiny. As a result, it's important for any candidate to the board to conduct the required due diligence into the background of the company they're joining.

Thorough due diligence will help potential board members understand more about the role they are going to take on. It will also help them gain a detailed understanding of the company culture, business model, and general knowledge of how the board functions. Some important questions to ask include:

  • What do the company documents reveal?
  • What is the experience level of the board, and what's their work culture?
  • How is the board's relationship with its investors?
  • How often does the board meet?
  • Why are you being asked to join the board?

The very last question on the above list shows that the director's due diligence should not be focused only on the board but also on the candidate. Potential directors should perform a detailed self-assessment to understand how they can contribute to the board, what their limitations are, and whether they are ready to join the board at all. All this will help them to perform the role better.

5. Investment Due Diligence

Investment due diligence refers to the investigation that you should do in order to understand whether a particular investment instrument is right for you. Here, the potential investor needs to assess the product to understand its viability. This can include detailed steps such as reviewing the performance of the business in the long and short terms, taking stock of their financial records, and also public perception.

Investment due diligence is essential for corporate as well as individual investors, as it helps them understand whether to go forward with the investment. It also lets them get a clear idea of the returns they stand to gain in the short and long term. For digital investments, as well as any technology investment, due diligence is vital.

Investment due diligence, in the international context, will also involve looking at political risk and corruption issues. 

6. IP Due Diligence

IP due diligence is usually conducted as part of acquisition due diligence. This involves assessing a business's intellectual assets before acquisition or investment. Particularly in tech-driven industries, a company's IP assets go a long way towards determining its value. These include copyrights, patents, and trademarks, among others.

7. Environmental Due Diligence

This type of due diligence is vital in the context of today's environmental impact awareness. It involves assessing the health, safety, and environmental issues associated with the business. Other aspects that should be taken into account are environmental regulatory compliance, sustainability assessment, and contamination studies.

Apart from the above-mentioned types of due diligence, different industries may have additional and different forms of due diligence. Due diligence can also be divided into hard and soft due diligence.

Hard due diligence is where the entire exercise is dependent on factual and quantitative data. This is the kind of due diligence that's traditionally carried out, and the most significant portion of due diligence exercises fall under this bracket.

Soft due diligence, on the other hand, is more people-centric and concerns the human segments of a business. Recently, this has become an integral part of the due diligence process and looks at the cultural and organizational structure of a company.

Final Words

Due diligence is no doubt one of the essential aspects of any modern business transaction. However, it requires expertise, experience, and insights that a regular team of professionals might not always possess. While it's always an enticing option to conduct due diligence yourself, the best and most objective results can only be obtained from an independent agency.

Companies specializing in due diligence services can help with background check screening, supplier checks, and credit checks. 

Vaultinum is a provider of a specific type of due diligence service.  As a technology company, Vaultinum has developed a due diligence platform to help:

  • private equity investors evaluate potential investment or acquisition targets,
  • clients evaluate suppliers, and
  • companies perform self-checks.

Vaultinum’s Know Your Software (KYS) solution is a due diligence tool focused on helping clients to understand a digital asset from a variety of perspectives, including sustainability, corporate governance, software sustainability, IP protection and management, and security. 

With a dual expertise in IT and Legal, and over 40 years of experience, Vaultinum is here to help you with all your technology due diligence needs.    

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