October 29th, 2012 / Insight posted in

Due Diligence – How much do I need?

BS writes: I am thinking of investing in a company that supplies my business. I have known the company for some time but my lawyers are advising me to do due diligence before I invest. This could be expensive, so I need to understand what should be covered.

Due diligence allows you to investigate the company before making a commitment to invest, writes Jon Sutcliffe, partner at Kingston Smith LLP. The level of due diligence will vary, depending on the size of the investment, the nature of the business and its trading history.

It will commonly cover some or all of the following.

Legal — checking that the company has been properly incorporated; reviewing big commercial contracts; checking if employees have contracts; and ascertaining the ownership of intellectual property.

Financial — ensuring there are no black holes in the accounts and assessing the company’s forecasts.

Commercial — understanding the company’s market and possibly speaking to key customers.

When money is tight, many businesses are tempted to spend less time addressing financial and legal matters. This can be a false economy because any shortcomings are likely to be flushed out in the due diligence process. If problems are revealed, they could affect the willingness of an investor to proceed.

Your existing knowledge of the company will provide some comfort on its ability to generate profits. However, you will still need to understand the company’s cost structure, liabilities and forecasts. You should consider how much flexibility there is in the cashflow forecasts, otherwise the company may find itself short of funds.

You should also think carefully about having a shareholders’ agreement. This will set out how the company will be run, directors’ remuneration, and what might happen in the event of a disagreement, sale or subsequent issue of shares.

To contain the costs of the due diligence, it is common to limit the work to specific areas of risk. Your accountant should be able to handle most of the due diligence.