When it comes to successful due diligence as part of a merger or acquisition transaction, proper preparation can take weeks if not months.
At this stage, creating a comprehensive, detailed due diligence report is a must. While the purposes of reports may vary — from legal to financial, commercial, and some others — best practices are all the same.
In this guide, we’ll overview an efficient due diligence process through properly built due diligence reports and questionnaires. We’ll examine types of reports, their structure for various business uses, and tools to support their preparation.
What is a due diligence report?
A due diligence report is an internal memo that summarizes key results and procedures of due diligence research. It is also an essential requirement for closing the merger and acquisition deal, which presents a detailed summary of due diligence investigations.
The comprehensive due diligence report aims to provide the party involved in the deal with an accurate understanding of the company’s future operations.
The elements of due diligence reports
For a report to be informative, it should clearly focus on due diligence requirements, be easy to read, and avoid any technical jargon. While the structure of a report may vary depending on the type of due diligence, as a general rule the report contains the following elements:
- Executive summary. This section offers a high-level overview of the investigation, including its process, focus areas, and results. It should also identify any areas of concern uncovered during the research.
- Scope of work. This section describes the scope of the investigation, such as the target company if the research is focused on it.
- Findings. This section summarizes the investigation’s findings, such as the target company’s business valuation and possession of necessary licenses and permits.
- Recommendations. This section offers recommendations based on the investigation’s findings. For example, if the target firm has a history of debt or any compliance issues, the due diligence report may recommend against the acquisition.
- Relevant documents. This section includes copies of the relevant documents reviewed during the investigation, such as financial statements or environmental reports.
- Appendices. This section includes any relevant appendices, such as compliance reports over recent years.
The need for reporting in a due diligence process
From a business perspective, the relevance of due diligence reporting cannot be underestimated, as a properly built report creates circumstances for enhanced due diligence for business partners and members of the executive team.
The primary objective of the due diligence review is to identify any potential risks or issues before finalizing the purchase, thereby aiding in the detection of future dangers.
The detailed information gathered through this report is crucial for a more efficient decision-making process. In the event that the corporation discovers any issues during the review, it may be able to negotiate more favorable terms and thus minimize the due diligence costs.
Furthermore, the due diligence report serves as a tool for the organization to understand how the target firm plans to generate additional profits. For instance, it can provide a comprehensive assessment of the target firm’s current state of affairs at the time of sale or purchase.
Types of due diligence reports
Due diligence can be broadly categorized into three main areas:
Legal due diligence
Legal due diligence is a detailed examination of the legal foundation of a transaction, such as ensuring that a target business possesses or can exercise the intellectual property rights essential to its future success. Other areas typically explored include structure, assets, contracts, loans, property, employment, ongoing litigation, and all other legal documents and aspects.
The legal due diligence report may consist of:
- Audits of compliance issues
- Duplicates of governmentally issues permits and licenses
- Copies of each act, report or document filed with government agencies’ help
- Descriptions of all legal documents and processes, administrative proceedings, and ongoing or past government investigations
Financial due diligence
This report type verifies the accuracy of financial information provided and evaluates the underlying performance of the business. This typically includes a business valuation of a company, review of its financial performance, assets, liabilities, cash flow, debt, and management.
The example of a financial report may consist of:
- List of all state and federal jurisdictions where taxes have been filed over a five-year period
- Act on local, state, and federal tax returns over a five-year period
- Audited financial records and balance sheets for the last five years, including management’s discussion and analysis and accompanying notes
- Correspondence between management and auditors
- A detailed business valuation and all internally generated financial models and forecasts
- All corporate decks presented to the board of directors
Commercial due diligence
Commercial report focuses on the market in which a business operates by engaging with clients, analyzing competitors, and conducting a comprehensive assessment of the assumptions underlying the business plan. The purpose is to find out whether the business plan is viable in current market conditions.
A commercial due diligence report may consist of:
- Market analysis, including market sizing and market trends
- Competitive research, including SWOT analysis on each competitor and strategies to gain market share
- Industry trends overview, focusing on industry drivers, dynamics, challenges, and growth in relation to the company’s performance
- Customer satisfaction (CSAT) assessment results, including the projected correlation between CSAT rates and business profitability
Additional types of due diligence may cover topics such as corporate records, indebtedness, labor and employment, real estate, agreements, and supplier information:
Due diligence report types
- State of incorporation confirmation and a certificate of good standing
- Articles of incorporation and bylaws duplicates
- A list of executives and copies of all written communication with them
- Details on issued shares of stock and overall capitalization
- Confirmation of of any warrants, options, or securities’ existence
- Any company or subsidiary agreement copies
- Joint venture agreements and partnership agreements duplicates
- Copies of any franchise agreements, as well as any marketing or sales cooperation agreements
- Duplicates of all brokerage or investment banker agreements
- Copies of all customer or client agreements
- Licenses and subscriptions copies
- All other types of contracts not belonging to the list above
- Seller and its subsidiaries indebtedness analysis, comprising loan agreements, security agreements, mortgages, and notes
- Copies of written communication with lenders demonstrating compliance with financial covenants
Employment and labor
- Detailed organizational structure description with biographies of officers, directors, and employees of a top and middle-managerial level
- A list of all employees containing detailed descriptions of their job functions, departments, locations, and compensations
- Documents detailing any non-salary compensation or benefits, such as pensions, profit sharing, deferred compensation, stock plans, and other
- Copies of employment, termination, consulting or any other agreements
- Copies of all employee handbooks, policies, and codes of conduct
- Ongoing litigation information related to employment and labor law
- Addresses and descriptions for all property
- Copies of all site evaluations and studies as well as governmentally issued filings and reports related to real estate property
- Copies of all real estate leases
- All appraisals copies
Vendor and customer information
- A list of all clients indicating the volume of sales per each client
- Any written communication with customers or vendors addressing complaints or disputes
- A list of all vendors indicating the volume of purchases per each vendor
Best practices for creating due diligence reports
Now that you know what a due diligence report is and what elements it should consist of, let’s explore some of the best practices for creating it:
- Who should create these reports?
- How to present due diligence findings in an effective way?
- What are the best report preparation practices?
- What steps to follow to complete a due diligence report?
- What tools to use to support a report preparation process?
Who should create due diligence reports?
Typically, due diligence reports are put together by a company’s internal team assigned for due diligence or by a third-party group hired for this purpose. The team may consist of law and finance consultants, investment bankers, and experts from accounting firms.
|Tip: Conducting due diligence, preparing the report, and reviewing it should be a collaborative effort by the diligence team.|
The team’s collective expertise should cover various aspects such as business, legal, technical, and finance matters specific to the deal being pursued. However, for smaller-scale transactions, such as purchasing a small business, even one or two professionals may suffice.
How to present due diligence findings in an effective way?
For an effective visual representation of key points, a due diligence report should include different types of information in varying formats — from Excel spreadsheets to written reports, pie charts, and bar graphs.
The most critical aspect of presenting the information is to make it clear and compelling, with visual aids to help readers understand the data’s relevance. Additionally, the information should be comprehensive, clearly showing the sources of all presented data.
While including all necessary items in a diligence report can make it unwieldy, it’s essential to keep it concise to maintain readers’ engagement. Otherwise, they may overlook the most relevant aspects of the report.
What are the best due diligence report preparation practices?
To prepare a well-structured, legally viable, accurate and informative report, keep the following tips in mind:
- Address any problems that are discovered and describe their potential ramifications. For instance, if the target firm has compliance issues with a specific local legislation, you should discuss the potential consequences of this non-compliance and strategies to address it.
- To avoid potential issues, make sure to create a comprehensive due diligence document list and examine concerns or obstacles that the customer may face due to missing critical issues such as concealed dues or expired licenses.
- To ensure the strong structure of the report, avoid including unnecessary information and focus exclusively on the relevant area of interest or concern.
- Be patient, diligent, and detail-oriented when conducting an investigation and ask questions if something appears to be amiss.
- Seek a lawyer or attorney’s advice if you lack the background for preparing the report.
What steps to follow to complete a due diligence report?
To create a comprehensive report, follow these steps:
- Determine the scope of the investigation. Decide on a type of research you need to conduct and which business transactions you’re looking to investigate.
- Collect all the relevant information. While structure and content of this information will depend on your needs, you’ll most likely need to gather financial statements, contracts, licenses and permits, and any other papers relevant to the analysis at this stage.
- Review all the available data. This step helps to identify any potential risks, missing pieces of information or areas of concern.
- Structure the due diligence report. Now you should arrange the information gathered properly. As mentioned before, the report should comprise a summary, scope of research, key findings, recommendations, relevant documents, and appendices.
- Review the report. At this stage, you should ensure that the report is accurate by approving it with the relevant parties.
- Revise the report as needed. This may be necessary due to new information or changes in the scope of the investigation.
- Finalize the report. Next, you should ensure that all the information in the report is complete and accurate.
- Submit the report. Submit the report to the relevant decision-makers to help them make informed decisions about a business transaction.
By following the steps above, you should create a comprehensive due diligence report answering all your questions and covering all the needs.
What technology tools to use to support a report preparation process?
To streamline the process of report preparation, several solutions may be used:
- Document management software — secure storage and access to sensitive data
- Due diligence software — document collection, organization, and report preparation
- Communication and collaboration software — video conferencing and extensive project management
- Analytics and visualization tools — analysis of large volumes of data in a concise manner
While all the tools above are extremely valuable, they can be substituted by one multi-purpose solution known as a virtual data room. Using it, you can make the due diligence report and the information it contains easily accessible for all business partners. You can also keep track of what documents they have interacted with and for how long, manage documents and access rights, and ask any questions within the files or in a dedicated Q&A section.
That said, due diligence data rooms make communication, analytics, and document management easy — while keeping all processes in one place.
Due diligence questionnaire: Importance + checklist
A due diligence questionnaire, also known as a due diligence checklist, is a comprehensive list of investigative questions that is sent to the selling company, its business partners, vendors, and clients, for generating additional insights on its operations.
Due diligence checklists play a crucial role as an early step in the process. Here’s why:
- Rich tool for generating insights. They serve as a tool for gathering the necessary information and provide a clear understanding of what to expect and how to proceed with the due diligence procedure.
- Clearly defined needs of the process. By utilizing due diligence questionnaires, the parties involved can better focus their efforts and ensure that the most important aspects are not overlooked.
- Focus on each party’s individual requests. Usually, these questionnaires are tailored to the specific research being conducted, which maximizes the efficiency of their usage. For instance, a buy-side due diligence questionnaire will differ from an acquisitions questionnaire.
To conduct effective due diligence, it’s important to ask the right questions. Below are some important due diligence questions to start with when you consider acquiring a firm:
- Why is the business or its unit being sold? This question is critical for potential acquisitions as it can help a buyer understand if the company is worth investment. Knowing the reason for the sale can provide insight into whether the company is facing too many liabilities that the current owner can no longer bear. However, this question may not be relevant for investors or stock purchasers.
- Are the firm’s profits sufficient to continue operating? If not, are there any investment opportunities or ongoing collaborations that can be secured? Acquiring or heavily investing in a company that experiences a plummeting profit line five months later can be devastating. Therefore, it’s important to identify potential partnerships or sponsorships that can keep the company running.
- Is the company focused on growth, and is its growth even possible? It’s crucial to identify areas where the company doesn’t already sell and to understand the chances of expansion in those areas.
- What are the company’s primary commodities? For potential investors, understanding which commodities generate the most income and losses is essential. These insights can help you identify potential weaknesses or areas to focus on to pursue further growth.
- What are the main markets for the company’s primary commodities? It’s important to know the markets that the company operates in to remain competitive. Obtaining this knowledge will help you to build a proper growth strategy, with market trends in mind.
- Are there any unique product features that are crucial to the sales of any products? What intellectual properties need the most reliable protection? What are the main development stages of the final product? Understanding what creates a strong position for the company on the market and what technologies and development stages need to be paid attention to is critical for future sales.
- Are there any current or suspended proceedings associated with this business? Companies that face any legal issues that are almost impossible to recover from can be a significant risk. Therefore, it’s critical to investigate this aspect very carefully before settling on a transaction.
Asking these types of questions can help ensure a well-performed due diligence process and inform the decisions of investors, business partners, and buyers.
Let’s recap key insights from the guide:
- A due diligence report summarizes the procedures and results of due diligence research and is necessary for closing a deal.
- The main types of due diligence reports include legal, financial, and commercial. However, reports can also overview some other aspects of an organization.
- Many tools can be used to aid the report preparation process, from communication to analytics, document management, and due diligence tools. However, a virtual data room serves as a multi-purpose solution that supports all stages of report preparation, delivery, and analysis for a truly enhanced due diligence experience.
- A due diligence questionnaire is critical for report preparation. It must address all aspects of the financial well-being and legal operations of the target firm.