From Financial to Legal: The Essential Types of Due Diligence

Due diligence becomes a pivotal process when the organization is contemplating the process of acquisition, merging or rather a major investment with another company. It is like having a physical of the businesses: albeit, focusing more on reviewing its financial and operational well-being, legal risk, culture fit, etc., as well as the checking vitals (blood pressure, pulse, heart rate, etc.), of course. However, due diligence is not a blanket exercise since it has various types of due diligence in business each relating to a particular risk segment and scrutiny.

In terms of financial and operational to legal, tax and commercial due diligence, they are all important in ensuring that the stakeholders are able to make informed decisions that will not leave them caught off guard once the transaction is closed.

Types of Due Diligence in Mergers and Acquisitions (M&A)

With regards to M&A, due diligence would guarantee the buyer what exactly they are venturing into. It is much more than the analysis of profits and losses. Most common types of due diligence in M&A deals are:

1. Financial Due Diligence – This involves analysis of the financial statements of the target company, their sources of revenue in terms of transactions and projects, debt, working capital and financial controls.
   
   

2. Operational Due Diligence – Looks at daily operation of the company; its systems, logistics, supply chain and company efficiency
   
   

3. Legal Due Diligence – An evaluating of contracts, legal risks, intellectual property rights, on-going litigation and compliance.
   
   

4. Tax Due Diligence – Examines the target in terms of tax position, liability, structures and filed history..
   
   

5. Commercial Due Diligence – Evaluates market positioning, customer base, competitive environment and growth chances.
   
   

6. IT Due Diligence – carried out to examine the technology infrastructure of the company, its software contracts, cybersecurity, and the ability to scale digitally.
   
   

7. HR Due Diligence – searches into the contracts, pay structures, relationship with unions as well as the corporate culture of employees.
   
   

Such kind of due diligence enables the investors, buyers and advisors to have a 360 degree profile of the target business before committing to it.

Financial vs Operational Due Diligence Explained

Financial and operational due diligence are both very important, and they have different purposes.

Financial due diligence takes place where the numbers are concerned. It makes sure that the financial information given is accurate, complete, and fair and based on the generally acceptable accounting principles. This can be used by buyers in validating earnings, determining the profitability, and identifying the hidden liabilities.

Operational due diligence, in its turn, focuses on the manner in which the company operates. It is a question of whether this firm can grow. Are its operations effective? What are the bottlenecks and threats in day to day things? The financial analysis will take care only of the financial concerns and factors, this is why it ought to be complemented with operational due diligence which measures the non-financial considerations which might influence the level of performance of the business after the deal is closed.

In short:

• Financial DD = "Is the business profitable?"
  
  

• Operational DD = "Can the business continue to run smoothly and grow?"
  
  

Key Components of Operational Due Diligence

The knowledge of the main aspects of operational due diligence aids buyers and investors in the disclosure of the incurred problems and highlights the possible enhancement. Some of the fundamental areas looked into are:

• Supply Chain and Logistics: To what level are sourcing and distribution? Do there exist any risks of disruptions?
  
  

• Technology and Infrastructure: Are the Information Technology systems current? Can the business be technology scaled?
  
  

• Process Efficiency: Are key business processes processed efficiently or manual and old fashioned?
  
  

• Quality Control and Compliance: Is the business in compliance to the safety, engineering or industry standards?
  
  

• Management and Human Resources: Is leadership effective? Do you have succession plans?
  
  

• Customer Service and Experience: What do clients think about customer service? How are complaints or feedback handled in place?
  
  

These factors inform how well the business will be resilient and ready to face the future in a case where the identity of the business changes ownership or change of the strategy.

Importance of Operational Due Diligence in M&A Deals

Frequently dismissed vis-a-vis financial due diligence, operational due diligence has the potential to be a deal maker, or deal breaker.

Consider a situation of purchasing a business with strong balance sheets only to find out after the deal that their supply chain is weak or their customer service systems are not working. These operations' weaknesses may have profound influence on profitability, integrity of the brand and success of integration.

Operation due diligence also:

• Detects the risk and integration challenges at an early stage.
  
  

• Releases skinned expenses (e.g. equipment or improper systems that are outmoded).
  
  

• Helps in valuation because it is able to relate the strengths and weaknesses of operations to future performance.
  
  

• Provides value in planning synergy after the merger.

Due to these facts, operational due diligence is not only a supportive procedure, but a stratagem of understanding that may help to avoid expensive failures.

How to Conduct Operational Due Diligence for a Company

Operation due diligence does not just imply a perusal of reports. It needs organized study, field work and probing.

This is a simplified procedure:

1. Preparation and Planning
   Provide a definition of the scope of review. Is it supply-chain-focused, technology-focused or HR-focused? Customize the due diligence checklist as such.
   
   

2. Data Collection
   Gather documents: SOPs, vendor contracts, system reports, HR policies, and so on. Interview important operational executives.
   
   

3. Site Visits (if possible)
   Take a personal inspection of the working process, employee interaction, production lines, and customer service arrangement.
   
   

4. Gap Analysis
   Detect any inefficiencies, regulation compliance or risk of scalability and performance.
   
   

5. Operational Risk Assessment
   Answer how both risks would affect the value of the deal and the integration plan.
   
   

6. Recommendations and Integration Planning
   Give improvement plans or mark deal-breakers. Recommend measures that can be taken to reduce post-deal disruptions.
   
   

Such an organized way helps not to leave any stone unturned, and provide a realistic view of the performance of operations to the acquiring party.

Final Thoughts

Financial figures may present a good picture but the operational basis is the one that keeps a business on its feet and developing. In any corporate deal, especially operational due diligence is a very important process in understanding what type of due diligence is used in business and also to reduce the risk and to guarantee future success.

Whether you want to learn more about due diligence as a practitioner, finance professional, investor or business owner or in-house finance professional, immersing yourself in the practice and/or taking courses with a deeper focus on due diligence procedures can provide you with an unrivaled competitive advantage in deal making and strategic decision-making.