‘Caveat emptor’, Latin for ‘buyer beware’ is a term used to warn the buyers before they buy any goods. Caveat emptor means that the buyer is responsible for the purchases he is making; this is an example of due diligence. Due diligence in layman’s language is a review of a company's financials and other records before it gets into an agreement with another party. A buyer and seller can both perform due diligence, as a buyer might be interested in knowing the product better. Similarly, the seller would like to make sure that the buyer has enough funds to complete the transaction. This is the gist of a very complex concept: to understand this better, let's focus on some key points.
History of Due Diligence
After the introduction of Securities Act, 1933 in the US, brokers and security dealers were compelled to disclose full legal details and facts to investors before a deal. The onus to ensure that no material information is missed fell on the brokers and security dealers. Failing to adhere to these guidelines would result in a criminal prosecution of these brokers. The lawmakers thought of this as unfair towards the brokers as during the period of a deal a broker may not be aware of a critical fact and might find out about it after the agreement, thus making the broker liable. To curb this problem, a provision was added that as long as the brokers exercised ‘due diligence’, they won’t be held responsible for not disclosing any material facts. Thus, the concept of due diligence was born.
Understanding Due Diligence
To understand due diligence, a person must first understand why due diligence is necessary. The idea is to follow a company in and out and then after, analyzing the key facts and figures, decide whether to invest in the company or not. Due diligence is done even before mergers and acquisitions to understand whether the two companies can function together or not. Statistically, more than 50% mergers fail because proper due diligence is not exercised. There are two forms of due diligence; hard and soft. Hard diligence relates to all the facts and figures of the company concerning finance, capital, and legal.
On the other hand, soft diligence is the study of work culture, environment, and how employees function. Soft diligence focuses on the human element in companies. Thus, the implementation of due diligence should be done with the right amount of both hard and soft diligence. Due diligence is a tool for self-assessment as well, for companies undergoing a merger due to diligence can yield positive results. Professionals provide due diligence audit services as they take the responsibility of vetting a company for due diligence.
Advantages of Due Diligence for Business Investors
1. Prevention of Fraud
The most apparent advantage of due diligence is that it reduces the chances of fraud by a significant amount. By going through the books of a company, an investor can make out if the financials of the company are reliable or not. It provides vital information about the bookkeeping policy of the company. Also, due diligence checks for outstanding legal cases and liabilities on the company, thus providing a clear picture to an investor. Due diligence acts as a risk management tool for investors.
2. Operations Due Diligence
During mergers and acquisitions, companies tend to incline towards operations due diligence. By this process, an audit team figures out how the transactions of the company are handled. Everything from management to work environment is assessed. This provides an idea to the investor how the new company or people will adjust in a merger. This is a necessary procedure which investors ignore, and thus, according to Forbes, statistically, more than 83% mergers fail to achieve their set goals. Operations due diligence creates debt elimination strategies for the post-merger period if there is any outstanding debt on the merging company.
3. Internal Assessment
Due diligence plays more than one vital role for a company. It scouts for hidden information or facts in the books of second party. However, internal due diligence can be equally useful and beneficial for a company. It reveals unknown constraints within a company and thus provides time for a company to sort out the issues. A timely internal due diligence can make sure that there is no bad-paperwork within the company. Internal audit sweeps for other minor problems which do not hamper the flow of the company but are present in the company. The process of internal due diligence is like cleaning the house – essential and necessary.
Tax Due Diligence
Similar to due diligence, tax due diligence finds out the different taxes that a company is liable to pay. In the UAE, the taxation system is a bit strange. Since there are free zone and mainland companies, free-zone companies do not have to pay any income tax apart from VAT. There are three layers of tax in any country: federal, state, and local. Since there are so many layers of tax, a company can never be sure if they are paying the appropriate tax or not. To check this, there is federal tax authority in the UAE. Hence a tax due diligence catalogues all the taxes that are needed to be paid by the company. Also, when a merger or acquisition occurs, the new taxes must be calculated along with the addition and reduction of assets and liabilities. Thus, a tax due diligence is an excellent tool for companies and investors.