An Overview of the Importance of Due Diligence Evaluation Reports in Investment Transactions

CONTRIBUTED BY EBEKHILE LOVE ELIZABETH

INTRODUCTION

Due diligence became common practice (and a common term) in the United States with the passage of the Securities Act of 1933. With that law, securities dealers and brokers became responsible for fully disclosing material information about the instruments they were selling. Failing to disclose this information to potential investors made dealers and brokers liable for criminal prosecution[1].

Needless to say, due diligence and the activities that make up for it form an important part of every transaction. In common transactions that revolve around the daily interface between humans, there is a need to verify the correct status of a particular position to eliminate doubt and future issues that arise with patent defects.

However, in more serious commercial transactions such as Investment transactions, there is a need to not only conduct an eyeball or face value verification of facts, there is a need to conduct more detailed insights into what is obtainable, and what should also be expected from the transactions. This process is referred to as due diligence.

What then is Due diligence?

Due diligence is a process of verification, investigation, or audit of a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify anything else that was brought up during an M&A deal or investment process. Due diligence is completed before a deal closes to provide the buyer with an assurance of what they’re getting[2].

The Cambridge Dictionary also offers a simplified definition of the concept of due diligence, defining it as an action that is considered reasonable for people to be expected to take in order to keep themselves or others and their property safe[3]. The concept is very simple as it implies that all actions taken by a party in securing their interest or involvement in a particular venture may then be referred to as due diligence.

Having understood the meaning of Due diligence, the following paragraphs shall take into consideration the essence of due diligence in Investment transactions and how it may be conducted.

There are different perspectives held by each of the parties to a transaction as far as due diligence is concerned. However, Research has shown that due diligence-driven transactions tend to have a better likelihood of success as it is known to improve the decision-making process of investment decision-makers owing to the standard of information made available to them. As such due diligence are usually in transactions such as Mergers and Acquisitions, Partnerships, Joint Enterprises and collaborations, strategic alliance, business coalitions, Third party/ outsourcing Agreement, Technology or product licensing Agreement, Venture Capital Assessment etc.[4]

Forms of Due Diligence

There are quite a number of forms which due diligence may take, and they are:

  1. Legal Due Diligence:

Legal due diligence is an essential part of any transaction and a mandatory consideration before entering into any merger or acquisition. It is an exercise in risk assessment to investigate any potential liabilities of the target company that could impact a successful transaction.

Legal due diligence will typically include a careful examination of all material contracts, including partnership agreements, licensing agreements, guarantees, and loan and bank financing agreements[5].

  1. Intellectual Property Due Diligence:

Intellectual Property due diligence is essentially an audit to assess the quantity and the quality of intellectual property assets owned by, or licensed to, a company, business or individual[6]. This due diligence, simply asks questions such as if the desired intellectual property is duly protected in law, and the validity and enforceability of the intellectual property amongst others.

  1. Commercial Due Diligence:

Commercial due diligence (also called market due diligence) is an important step in validating the opportunity strategically. This process looks at the market size, market share, customer base, competitors and potential future returns. Commercial due diligence aims to assess if the deal is financially viable and the likelihood of realizing value from it[7].

The essence of Due Diligence in Investment Transactions

Amongst the many essential reasons that emphasize the need for due diligence exercises in major transactions we shall be examining three (3) to wit:

  1. Funding Security:

Due Diligence is an integral phase of any transaction as it helps an investor make informed decisions regarding the right time to invest and at the appropriate price. Although a Target (the Company/Business to be invested in) may be a good buy due to the face value earnings, reputation or stock price, the timing may not be right considering the economic and industry conditions within a particular jurisdiction at a given time.[8]

The above clearly emphasizes that due diligence helps the potential investor consider the available return options in an holistic manner, which helps to significantly mitigate the losses that the investment might have otherwise incurred if such process was not carried out.

  1. Determination of Transactional Validity

One important aspect of investment, is to ensure that the proposed transaction is in itself valid and not set up for failure at the instance of conceptualization. The role played by due diligence exercises cannot be overemphasized in this instant case. This particular reason strengthens the need for the deployment of both legal overview and administrative sustainability of the proposed transaction amongst others.

  1. Cost Analysis/Assessment

This is also referred to as risk analysis. Due diligence is a kind of risk assessment. Before acquiring a complex purchase item, it makes the advantages and risks associated with the purchase apparent to the buyer[9]. To this end it helps to prevent major issues arising from reputation damage, the economic risks of purchase as well as the financial risks that may arise in existing business relationships.

CONCLUSION

The concept of due diligence is a very broad one, it cuts all areas that may be considered necessary for the commencement and completion of the project. Some require the expertise of certain professionals but overall the investor must take conscious steps towards verifying the position of the other party, in order to mitigate losses that may be considered as patent.

  1. James Chen, “Diligence’ https://www.investopedia.com/terms/d/duediligence.asp> Accessed the 19th April, 2023.
  2. The CFI Team, ‘Due Diligence; Investigation or audit of a potential deal or investment opportunity’ < https://corporatefinanceinstitute.com/resources/valuation/due-diligence-overview/> Accessed the 19th April, 2023.
  3. https://dictionary.cambridge.org/dictionary/english/due-diligence
  4. Diksha Bhardwaj, ‘Overview of Due Diligence’ https://corpbiz.io/due-diligence Accessed 19th April 2023.
  5. Diksha Bhardwaj, ‘Overview of Due Diligence’ https://corpbiz.io/due-diligence Accessed 19th April 2023.
  6. Taylor wessing, ‘The Importance of IP Due Diligence’ < https://www.taylorwessing.com/synapse/ip_duediligence.html#:~:text=IP%20due%20diligence%20is%20essentially,the%20relevant%20company%20or%20business.> Accessed the 19th April 2023.
  7. Ibid 5.
  8. Mayowwa Salami and Oghenemaro Egbedi
  9. IONOS Startup Guide ‘Due diligence: definition and history of precautionary risk assessment’ https://www.ionos.com/startupguide/get-started/due-diligence-procedure/ > Accessed 19th April, 2023.

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