Due diligence guide for investors

This guide explains the different types of due diligence investigations that are normally undertaken by investors in private companies, such as angel investors, private equity firms and companies looking to buy or invest in another business.

What is due diligence?

Due diligence is the process of investigating a company that you are thinking of investing in.  The purpose of due diligence is to gain a more detailed understanding of the business, so that you can make an informed decision about whether to proceed with your investment (and if so, on what terms).  The warranties in a share purchase agreement will often be tailored to reflect the outcomes of the due diligence process.

During the due diligence process, you would typically seek to learn more about:

• what the business does and who its key customers are,

• the financial status and history of the business,

• who the key stakeholders are, including key employees,

• the overall health of the business,

• any key risks that the business might be facing, and

• whether, overall, the business is likely to be a good fit for you.

The due diligence process is usually done through a mix of conversations, meetings and written communications. This mix is important. Conversations and meetings will provide opportunities for you to assess the culture of the organisation and understand more about the key personalities involved.  The written communications will provide you with the data and other detail that you will need to undertake a well-rounded analysis of the company.  

It is up to you to decide how far you would like your due diligence investigations to go. The larger your investment, and the less familiar you are with the company and its key stakeholders, the more likely you are to conduct extensive due diligence enquiries.  The more time you spend getting to know the company before you invest, the lower the chances of you being surprised later.

Guide to investing in a private company

Types of due diligence

Detailed due diligence wouldn't normally start until after the parties have signed a non-binding terms sheet. This is because the parties would typically prefer not to spend time and money on due diligence until they have some comfort around the broad terms of the deal.  (Any agreement reached at this point will normally be subject to the outcomes of the due diligence process.)

Apart from the general commercial information discussed above, detailed due diligence would often focuses on areas like:

• commercial (eg services/products, customers, suppliers, sales pipeline, market analysis, forecasts, opportunities etc)
• operations, including human resources and IT,
• financial and accounting,
• tax, and
• legal, including compliance.

Commercial and Operations Due Diligence

Due diligence on the commercial and operational aspects of the business is normally conducted by someone with experience in the market in which the business operates. (This person may well be you.)

The scope of the commercial and operations due diligence will vary from business to business. In broad terms, the aim of the exercise is to find out what the company does, and how well it does it, with a view to then figuring out where its main opportunities and risks may lie.

This aspect of due diligence will typically look at things like the company's:

• reasons for seeking to sell/raise capital;
• strategic plans, including details of major competitors and other market risks;
• likely future financing needs (if any);
• customer base;
• supplier base;
• human resources and operational structure;
• insurance (and often comment will be sought from an insurance broker where the business operates in a high risk environment)

Financial and Accounting Due Diligence

Financial and accounting due diligence is normally carried out by a person with specialist expertise in this area, often being someone with an accounting background with specialist M&A/corporate advisory experience.

This aspect of due diligence is principally focused on normalising the company's accounts, so that you can form a better view about how profitable the company really is (and is likely to be in the future). 

Because different companies adopt different approaches to their accounts, and because different companies will structure their affairs differently, it is often necessary to 'normalise' the accounts. This is done by identifying and understanding the effect of any:

• financing,
• unusual accounting entries or accounting policies,
• non-recurring items,
• related party transactions (such as shareholder loans), and
• material omissions from the accounts. 

Where an established business is concerned, it may be difficult for you to form a view on the company's true profitability without undertaking this type of analysis.

Tax Due Diligence

One of the biggest risks in any investment is that the company has not complied with its obligations in relation to tax.  Three common failings are:

• incorrect tax reporting, 
• incorrect or unsubstantiated claims for tax deductions or tax concessions (for example, in relation to research and development grants), and
• incorrect characterisation of employees as contractors for PAYG and superannuation purposes. (Although not strictly related to tax, the company's compliance with its superannuation obligations is normally reviewed as part of the due diligence.)

A key part of your due diligence process will be to scrutinise the company's accounts to ensure there are no anomalies.  This aspect of due diligence can only be undertaken by someone with specialist tax expertise.  

Legal Due Diligence

Legal due diligence is undertaken for three reasons:

1. Verify information that you have received by the company. This is typically done through searches of Government registers (eg ASIC, real property, personal property, trademark, licensing and court registry searches).  It is also done by reviewing specific documents. For example, if you are keen to ensure the company has good title to specific items of intellectual property, you could brief lawyers to review the company's records to ensure that this is the case.  A review of the Personal Property Securities Register would also normally be undertaken, and inquires would be made in relation to the company's insurance and litigation history.
2. Review key contracts to identify potential risk areas. Examples include key customer contracts, standard terms and conditions, major supply contracts, employment contracts, intellectual property licences, financing documents and leases.
3. Review corporate governance documentation to ensure you understand how the company will be managed, and how key decisions will be made. If you are buying the entire company, this is obviously less of an issue. However if you are only buying part of the company, particularly if you will hold a minority interest, it is critical that you understand how decisions will be made (and who will make them). This will usually be set out in the company's constitution and any shareholders agreement. Read more about what to look for in a shareholders agreement here.

Legal due diligence is normally done by lawyers with specialist M&A or commercial expertise.  Usually these would be the same lawyers you would engage to advise you on the terms sheet and share subscription agreement or share sale agreement.  

Due diligence warning signs

When you engage advisors to conduct due diligence inquiries, you should expect that they will raise flags. You can then use this information in negotiating the detailed terms of the deal. For instance, this may result in you:

• insisting that certain items be addressed before you are required to complete your investment, 
• seeking to incorporate specific indemnities or other protections into the subscription/sale agreement, and/or
• requesting changes to a shareholders agreement, to ensure you have adequate rights to information and rights to participate in key decisions.

However you should also be mindful of other less obvious warning signs during the due diligence process. Due diligence is a normal part of any investment process, and any company or vendor should expect to be asked to provide information promptly, on a completely transparent basis. You should therefore be mindful if the company: 

• refuses to disclose information or documents that you have requested,
• is unwilling to provide you with a reasonable period to conduct due diligence, or is overly anxious to complete the deal, or
• is hesitant to allow you to liaise directly with relevant third parties (eg the company's accountants, any key team members or customers), unless there is a reasonable basis for doing so (eg a company may legitimately prefer for you not to engage with customers until you are closer to completing a transaction).