"Make sure you exercise due diligence" is a common enough phrase, but what does due diligence actually mean?
Due diligence is defined as the appropriate level of care that a business or person should use when entering into an agreement with another party. Essentially, it means you do enough background work and research to be able to make informed decisions.
Due diligence became a common term as a result of the U.S. Securities Act of 1933, which says that security sellers (those who offer assets, stocks, and so forth for purchase) must provide potential investors quality information before a purchasing deal. Today, due diligence has become important in many fields, particularly business, investing, law, and real estate. People and businesses within these fields are expected to audit, verify, or investigate each opportunity presented to them to ensure optimal outcomes.
Due diligence isn’t complimentary. The exact cost will vary based upon the complexity of the issue, as well as the time and scope involved in investigating the opportunity. However, these costs are worth it! By disregarding due diligence, you or your business run/s the risk of entering a faulty deal, which will be exponentially more costly to fix than whatever the price of due diligence may be.
Furthermore, due diligence is beneficial to both parties. It provides each side an opportunity to research the person or business from whom they will be buying/selling from. Should something with the deal go wrong, neither party can be blamed for not exercising reasonable care. In fact, due diligence can even mitigate legal risk. For example, broker-dealers are required by law to conduct due diligence – should they fail to do so, the broker-dealer will be held liable.
Now that we know what due diligence is and why it's important, let's look at some real-life examples. Here are common questions across various fields that are asked in due diligence:
Sometimes, even if a person or business undertakes a due diligence investigation, they might not do enough due diligence. Though a due diligence failure may have many consequences, the most immediate consequence is the cost.
One of the most infamous failures of all time regarding due diligence was a Merger and Acquistion deal in 2002 between Time Warner and AOL, two media companies. Essentially, the companies’ due diligence efforts were inadequate regarding financial forecasts, evolving markets, and the differences between company cultures. The failure cost the merged companies 99 billion dollars within the first year of their deal, and their stock price fell by 90%.
Though due diligence may seem daunting, it's a necessary and important part of conducting business. When done correctly, it will be incredibly beneficial ensuring that all parties involved in a deal are satisfied with the outcome.