The Art and Science of Due Diligence

Due diligence is usually divided into two parts and handled by separate teams: the financial and strategic part, handled by the venture investor’s accountants and management; and the legal part, conducted by the venture investor’s counsel. Both teams compare notes throughout the process on open issues and potential risks and problems. Business due diligence focuses on the strategic and financial issues surrounding the deal, such as confirmation of your past financial performance and the future potential of your business plan; confirmation of the operating, production, and distribution synergies; and economies of scale to be achieved by the acquisition and gathering of information necessary for financing the transaction. Legal due diligence focuses on the potential legal problems that may serve as impediments to the transaction and outlines how the documents should be structured.
Effective due diligence from the investor’s perspective is both an art and a science. The art is the style and experience to know which questions to ask, and how and when to ask them, and the ability to create feelings of both trust and fear in you and our
team. (This encourages full and complete disclosure.) In this sense, the due-diligence team is on a “search and destroy” mission, looking for potential problems and liabilities (the search) and finding ways to resolve these problems prior to closing (destroy) or to ensure that risks are allocated fairly and openly among the parties after closing.
The science is preparing comprehensive and customized checklists of the specific questions that will be presented to you, maintaining a methodical system to organize and analyze the documents and data you provide, and being in a position to quantitatively assess the risks raised by the problems that the advisers to the
prospective investor or source of capital uncover.
In business due diligence, venture investors will be on the lookout for issues commonly found in an early-stage company. These typically include undervaluation of inventories, overdue tax liabilities, inadequate management information systems, related-party transactions (especially in small, closely held companies), an unhealthy reliance on a few key customers or suppliers, aging accounts receivable, unrecorded liabilities (for example, warranty claims, vacation pay, and sales returns and allowances), and an immediate need for significant expenditures as a result of obsolete equipment, inventory, or computer systems. Each of these problems poses different risks and costs for the venture investor, which must be weighed against the benefits to be gained from the transaction.
Due diligence must be a cooperative and patient process between you and the venture investor and your respective teams. Attempts to hide or manipulate key data will only lead to problems for you down the road. Material misrepresentations or omissions
can (and often do) lead to post-closing litigation, which is expensive and time-consuming for both parties. It’s also common for entrepreneurs to neglect the human element of due diligence. I can remember working on deals where the lawyers were sent into a dark room in the corner of the building without any support or even
coffee. In other cases we were treated like royalty, with full access to support staff, computers, telephones, food, and beverages. It is only human for the investor’s counsel to be a little more cooperative in the negotiations when the entrepreneur was helpful and allowed counsel to do the job at hand.