This is the sixth in a series of articles.  This was published in Venture Capital Focus magazine in February 2005.

To Do or Not To Do: the Joys of Due Diligence

Due What?

Companies that approach financiers will at some stage be confronted with a need for due diligence. What this means is usually poorly understood. The phrase may sound fuzzily familiar but many people are puzzled by it. In this article I will try to reduce the fuzz and explain the puzzle.

Prudent Men

First, some legalistic background. The term "due diligence" is rooted in 19th century trust law. It is defined in Black's Law Dictionary as "such a measure of prudence, activity or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man ...". This paternalistic standard is relevant because we manage funds on behalf of our investors. As a result, we owe a fiduciary duty of care to them. We cannot just invest their money on the basis of a handshake and reliance on the wonderful plans presented to us. That would be careless or negligent on our part. Diligence is the opposite of negligence. As professional investors, therefore, acting as reasonably prudent men (or women) it is our duty to conduct our own diligent investigations.

Diligence Topics

Due diligence can cover a wide range of topics. Distinctions are sometimes made for separate legal, technical, market and financial due diligence exercises. A variety of checklists can be found for different types of DD investigations.

In our business we usually need to cover all the bases. This means we perform a wide-ranging exercise. I won't go into the details, but some of the main areas and topics we cover include the following.

• People: staff composition and demographics, staff turnover, employment contracts, remuneration and benefits, executive compensation, training, skills gaps
• Markets and Customers: growth patterns, customer base, customer satisfaction
• Competitive Strategy: competitor positions, supplier base, market shares, pricing strategies, product and service development
• Financials: management accounts, capital expenditures, ratios, debt capacity
• Risks: environmental issues, health and safety issues, insurance policies, internal controls
• Operations: purchasing procedures, inventory management, production technology, resource requirements, IT systems
• Legal: statutory records, tax filings, property titles, contracts, corporate registers

The laundry list above is only a summary of highlights. We do use checklists and our standard list is six pages long. However, this does not mean we only need to tick the boxes on our list. At the start of every DD exercise we try to determine the most critical issues for the particular investment under consideration. We then customize our checklist and - without eliminating all the standard items - spend most of our time on those issues.

How to Do DD

The DD process consists of document reviews, desk research, field inspections and interviews. Document review is the least time consuming of these activities. Therefore, the DD exercise can be completed in the fastest possible manner if the company already has all the necessary information documented and has all its records in order. Unfortunately, this is rarely the case. Many of the companies we deal with have a rather informal approach to maintaining corporate records. Many companies also have only sketchy information on items that are relevant for their business plans. That means we then have to go to the next step to find information that is not documented.

The next step is desk research. The Internet now makes it easy to gather information from around the world. We can also gain understanding from trade magazines. And we may be able to gather information from agencies such as the Central Statistical Office or trade organisations. A dedicated, persistent and clever hunt for information can usually provide much more than might seem obviously available.

Finally, we come to inspections and interviews. These are the most time consuming items. We may conduct interviews in person or over the telephone. We usually interview as many parties as we can, including customers, suppliers and even competitors. The latter are usually delicate, but often provide the most interesting perspectives. Inspections can be combined with interviews at the company. We like to kick the tires, so to speak. However, there is only so much kicking we can do, because we are not technical experts. Therefore, technical type of inspections are usually contracted out to other parties.

The Experts Weigh In

Some elements for due diligence need to be performed by outside experts. A typical example is a property surveyor, in order to establish the value of a company's property assets. Another example is an environmental consultant if a company undertakes a new development that will require an environmental impact assessment. Those are not things we do ourselves, but we will ask the company to retain the necessary experts if necessary.

Pains and Joys

It is probably clear by now that due diligence is a serious exercise. It represents a major investment of time and resources by us and by the company being investigated. It can also be painful. Companies that have been economical with the truth, or that have skeletons in their closets, will usually find themselves exposed. Almost certainly, a company will never before have experienced so much outside scrutiny of its affairs. Opportunities to create frictions and frustrations are abundant.

At the same time, the exercise allows the company and its future investors to deepen a mutual understanding and relationship. For this reason alone we tend to do as much of it as we can ourselves, instead of contracting it out to other parties. The exercise may also turn up early opportunities for improvement. Like a diagnostic consultancy, the DD exercise may indicate opportunities at the company or in its environment. It can even lead to better understanding of customers and suppliers, and strengthen those relationships too. In the right circumstances, the trials and tribulations from a DD exercise can form the basis for a beautiful friendship.

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