Due diligence is the investigation of a potential product or investment to confirm the facts surrounding it. The process may include assessing past company performance, reviewing financial records and anything else deemed relevant. While performing due diligence on a potential stock investment is voluntary for individual investors, it’s highly recommended.
Asking the Right Questions
Asking the right questions is a key element of proper due diligence. Potential investors should consider how well they understand the business, whether they can estimate what its financial position and characteristics will look like in a decade’s time, and what investment opportunities the company has.
Other important questions include whether the company’s balance sheet can withstand temporary adversity, whether its management is competent and honest, and the opportunity cost of the investment. The latter refers to the other investments (including those in the future) that the potential investor may have to forego to make an investment in the target company.
Reviewing Assets
The due diligence process should also incorporate a review of the potential investment business’s assets. For fixed assets, this means identifying their location and – ideally – viewing each for physical verification. Mortgages, real estate deeds, lease agreements, title policies and other important documents should be included, and a complete inventory (along with related documentation) of office and manufacturing equipment, raw materials etc. should be requested.
When it comes to assessing intellectual property, the potential investor should verify these assets’ ownership and status, obtain a valuation and determine liability in the case of infringement. A list of existing contracts allowing others to use the business’s assets should be sought – and confidentiality agreements studied – to ensure the investment business has exercised proper caution and prevent trade secrets from being disclosed. It’s important to make sure that business records match with those details kept on public record, where relevant.
Considering Customers and Supplies
Experienced entrepreneurs like Volker Hartzsch know that the nature of a target business’s customers and suppliers should also be carefully interrogated as part of due diligence. The former can give an investor invaluable information about the company’s customer base, the size of the potential market, and how easy (or otherwise) it would be for a competitor to enter the market and poach customers.
In terms of a business’s suppliers, potential investors should look at who these suppliers are and how dependent the business is on them. This provides insights regarding the business’s bargaining power and the likelihood of impactful suppler disruption.
Hard vs. Soft Due Diligence
Based on the approach used, due diligence can be classed as ‘hard’ or ‘soft’.
Hard due diligence is more concerned with the data and numbers found on financial statements such as the income statement and balance sheet, and it can also be used to identify red flags and accounting inconsistencies.
Meanwhile, soft due diligence is more qualitative in its approach, looking at aspects such as the people within a company, the quality of the management and the loyalty of the customer base. This is useful, as many drivers of business success cannot be fully captured by numbers alone, including leadership, employee relationships and company culture.
