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What is Due Diligence: Types, Meaning & Purpose

in legal, Tax

Due diligence generally means the careful analysis of an object in a business context. Due diligence checks are carried out in particular in the context of forthcoming transactions, such as company acquisitions. Customer due diligence or the careful examination of new and existing business customers are central components of due diligence obligations fulfilment.

Understanding Due Diligence

Due diligence is an examination process in which strengths, weaknesses, opportunities and risks are analysed concerning economic, legal, tax and financial circumstances. The aim is to uncover all potential risks that may arise in connection with a business relationship.

​​Reasons For Due Diligence

Due diligence is a complete background investigation that companies use to protect themselves against potential contractual partners using various sources of information. It helps companies protect their interests and identify potential risks. Reasons for conducting due diligence can be:

Prevention of money laundering and white-collar crime

Checking the business partner (customer due diligence) is the central component for fulfilling the due diligence obligations.

Mergers & Acquisitions

Before M&A activities, such as the purchase of companies, company takeovers or participations, a due diligence check is usually carried out by an external consultant. This makes sense for both the buyer and the seller. 

In buyer due diligence, the buyer initiates the examination to assess and evaluate the risks and opportunities of the purchase. The findings are usually included in the purchase price proposal. 

In the case of vendor due diligence, the seller commissions a systemic analysis to eliminate any weaknesses in advance and also to prepare for the sales negotiations.

Avoiding reputational damage

Companies often check business partners for ethical and legal standards when selecting potential business partners before cooperation. The aim is to detect incorrect actions in advance to avoid reputational damage.

Specific recommendations for further action can be derived from the results of due diligence: For example, the entrepreneurial risk with the client can be reassessed or advice can be given against establishing a business relationship.

Types of Due Diligence

Depending on the purpose of the due diligence audit, the areas to be audited vary. 

According to this, functional forms/types of due diligence arise. These include:

Financial Due Diligence

Examination of all commercial areas, such as bookkeeping, annual financial statements, controlling, financial relations and cash flows.

Financial due diligence is the part of the audit that no buyer will do without, whether it is a medical practice or a steelwork.

Roughly speaking, it can be divided into three sub-areas. The analysis of the past, the analysis of the corporate planning provided and the revised planning, based on the knowledge gained in the course of the commercial due diligence or other due diligence sub-areas.

Financial due diligence is usually carried out together with commercial and tax due diligence, as there are overlaps in the audit procedures.

Commercial due diligence

An examination of business activities and relations to the business environment and market.

It helps you to see whether you are achieving the strategic goal you are pursuing with the company purchase. It provides answers to the following questions:

  • Are there synergies on the buyer’s side that make a purchase interesting, e.g. combining locations, sales or administration?
  • Obtaining strategic advantages. What makes more sense for an intended market entry: buying an existing company and thus opening the door to the market or building up the market yourself?
  • Are there any “red flags” or “deal breakers” that prevent you from pursuing these objectives (e.g. country-specific or competition law restrictions)?

Legal due diligence

An examination of all internal and external legal relationships to identify legal risks to the company’s results.

The buyer and seller will also not be able to avoid legal due diligence, because contracts form the framework for action.

Legal due diligence is about the legal examination and assessment of the company. Legal due diligence covers a wide range of legal areas:

  • Corporate law
  • Contract law
  • Labour law and collective bargaining law
  • Trademark law and other protective rights
  • Antitrust law
  • Environmental law
  • The findings of legal due diligence can have a considerable influence on financial due diligence, for example, if legal risks are assessed differently than currently reflected in the financial figures.

Tax Due Diligence

Tax due diligence, for example, is the main focus of audits in corporate taxation and is usually carried out as part of financial and legal due diligence.

The following serves as a basis:

  • Tax assessment notices and latest tax returns,
  • Tax audit reports or information from ongoing tax audits
  • Audit orders,
  • tax balance sheets from previous years,
  • pending tax court cases, etc..,
  • Information on related parties and “hidden profit distributions”.
  • Use of existing tax advantages (see also the article on tax incentives for research and development expenses).

With the help of these documents, an attempt is made to assess the tax risk of additional tax payments.

Human Ressource Due Diligence

In times of a shortage of skilled workers, some company acquisitions are only geared towards taking on trained personnel. This applies, for example, to research departments or companies where many software developers or nursing staff work. The personnel is then the value-driving factor (one therefore also speaks of “walking assets”).

HR due diligence focuses on the employees: What skills do they have? Which key players must be retained after the acquisition?

The following points should therefore be part of every HR due diligence checklist:

  • Employee lists
  • Organisational charts
  • Qualifications
  • Salary data and salary development over several years
  • Salary models
  • Salary indicators, such as staff turnover, sickness rate, age average, gender distribution
  • Assessments of corporate cultures and their differences
  • Contractual issues (but also in the context of Legal DD, see above)
  • Identification of key players
  • During and after a company acquisition, the risk of losing key players is particularly high: many are uncertain how things will continue and therefore look for a new job. Others have difficulties with a different corporate culture.

The result of HR due diligence should always be a target picture:  How can the two companies be positioned in terms of personnel in the future? If key players know what their future will look like, they will usually stay.

IT due diligence

IT due diligence is about the IT systems used by the target company.

This is particularly important if the IT significantly influences the business model or even forms the basis for it. This is the case, for example, with e-commerce or platform providers.

IT due diligence looks at things like:

  • Software and hardware architecture of the systems used.
  • IT security: data security and protection, for example, backup routines and external and internal access protection
  • IT team and responsibilities
  • Software development process and release cycles
  • Audit reports from external auditors, for example in the context of software certifications or audits of control systems, investigation reports of hacker attacks, etc.
  • Examination of external software or open-source software in use
  • Scalability
  • Code reviews

Technical Due Diligence

Technical due diligence or asset due diligence is about production, technical plant and machinery:

  • Does the equipment even exist at an international location?
  • What is the technical and technological condition of the plants?
  • What investments are necessary for maintenance and repair?
  • Technical due diligence is therefore mainly found in very production-intensive or plant-intensive industries.

Specialists from the engineering field often take over the examination here.

Due Diligence in the context of “Corporate Social Responsibility” (CSR)

The term “Corporate Social Responsibility” can be used to summarise a wide range of checks about the social responsibility of a company.

As a rule, however, the aim is to prevent reputational and associated financial damage to the purchasing company.

Parts of the CSR DD can be:

  • Environmental aspects (Environmental Due Diligence).

This is about the general compliance with environmental standards and the assessment of environmental damage, e.g. through soil contamination of production sites, leakage of pollutants, deconstruction obligations, reforestation, etc.). There may also be a feedback loop to financial due diligence if environmental damage has to be remedied and these costs have not yet been anticipated in the books.

Environmental aspects can also play an important role elsewhere, even if regional environmental standards are complied with. For example, a general waste of resources, such as drinking water and pollution of the environment through emissions, can lead to damage to a company’s image and reputation, and thus possibly to damage to its own brand and external image.

  • Social aspects

Are social standards adhered to at all production sites and by the suppliers used? These are in particular working conditions (child labour, working hours, occupational safety and fire protection, co-determination rights, etc.).

  • Political aspects

Are there known cases of corruption, “nepotism” and other political influence?

These aspects can have a significant negative impact on a large company if they only become known after the company has been acquired. One example is the inclusion of the company in a so-called “ban or sanctions list”, i.e. a list of companies with which companies from specific other countries are no longer allowed to do business (e.g. the sanctions list of the USA).

It is often sufficient here if, for example, only suppliers can be brought into direct connection with the company.

CSR DD should therefore not be underestimated.

Who carries out due diligence?

If due diligence reviews are carried out as a basis for strategic decisions in the area of M&A activities or business initiations, companies usually engage external consultants such as auditors, management consultants, lawyers, appraisers, etc.

Customer due diligence checks to fulfil money laundering requirements are carried out internally within the company. Depending on the group of obligated parties and internal structures, money laundering officers, compliance managers or persons responsible at the management level are responsible for the examination of new and existing customers.

Depending on how complex the corporate structures of the potential new or existing customer are, even the research work can be very time-consuming and complex.

Conclusion

As you can see, many special areas and audits can be found under the term due diligence.

The types presented here are not even exhaustive and can include further areas (e.g. asset or real estate, customer and supplier due diligence).

If you are preparing for a classical corporate due diligence yourself, focus your energy on the most important three types of due diligence and choose for yourself which of the areas described above might have further relevance for you and should therefore be subjected to a more in-depth examination.

In the case of complex audits, involve specialists who come from within your own company and/or are commissioned externally. These can be, for example, auditors, tax advisors, lawyers or specialised consultants.

You can contact our lawyers and tax advisors in Barcelona by email or phone to have due diligence consulting.