The Process of Due Diligence

By: Sam Vaknin, Ph.D.

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A business which wants to attract foreign investments must present a business plan. But a business plan is the equivalent of a visit card. The introduction is very important - but, once the foreign investor has expressed interest, a second, more serious, more onerous and more tedious process commences: Due Diligence.

"Due Diligence" is a legal term (borrowed from the securities industry). It means, essentially, to make sure that all the facts regarding the firm are available and have been independently verified. In some respects, it is very similar to an audit. All the documents of the firm are assembled and reviewed, the management is interviewed and a team of financial experts, lawyers and accountants descends on the firm to analyze it.

First Rule:

The firm must appoint ONE due diligence coordinator. This person interfaces with all outside due diligence teams. He collects all the materials requested and oversees all the activities which make up the due diligence process.

The firm must have ONE VOICE. Only one person represents the company, answers questions, makes presentations and serves as a coordinator when the DD teams wish to interview people connected to the firm.

Second Rule:

Brief your workers. Give them the big picture. Why is the company raising funds, who are the investors, how will the future of the firm (and their personal future) look if the investor comes in. Both employees and management must realize that this is a top priority. They must be instructed not to lie. They must know the DD coordinator and the company's spokesman in the DD process.

The DD is a process which is more structured than the preparation of a Business Plan. It is confined both in time and in subjects: Legal, Financial, Technical, Marketing, Controls.

The Marketing Plan

Must include the following elements:

• A brief history of the business (to show its track performance and growth).
• Points regarding the political, legal (licences) and competitive environment.
• A vision of the business in the future.
• Products and services and their uses.
• Comparison of the firm's products and services to those of the competitors.
• Warranties, guarantees and after-sales service.
• Development of new products or services.
• A general overview of the market and market segmentation.
• Is the market rising or falling (the trend: past and future).
• What customer needs do the products / services satisfy.
• Which markets segments do we concentrate on and why.
• What factors are important in the customer's decision to buy (or not to buy).
• A list of the direct competitors and a short description of each.
• The strengths and weaknesses of the competitors relative to the firm.
• Missing information regarding the markets, the clients and the competitors.
• Planned market research.
• A sales forecast by product group.
• The pricing strategy (how is pricing decided).
• Promotion of the sales of the products (including a description of the sales force, sales-related incentives, sales targets, training of the sales personnel, special offers, dealerships, telemarketing and sales support). Attach a flow chart of the purchasing process from the moment that the client is approached by the sales force until he buys the product.
• Marketing and advertising campaigns (including cost estimates) - broken by market and by media.
• Distribution of the products.
• A flow chart describing the receipt of orders, invoicing, shipping.
• Customer after-sales service (hotline, support, maintenance, complaints, upgrades, etc.).
• Customer loyalty (example: churn rate and how is it monitored and controlled).

Legal Details

• Full name of the firm.
• Ownership of the firm.
• Court registration documents.
• Copies of all protocols of the Board of Directors and the General Assembly of Shareholders.
• Signatory rights backed by the appropriate decisions.
• The charter (statute) of the firm and other incorporation documents.
• Copies of licences granted to the firm.
• A legal opinion regarding the above licences.
• A list of lawsuit that were filed against the firm and that the firm filed against third parties (litigation) plus a list of disputes which are likely to reach the courts.
• Legal opinions regarding the possible outcomes of all the lawsuits and disputes including their potential influence on the firm.

Financial Due Diligence

• Balance Sheets;
• Income Statements;
• Cash Flow statements;
• Audit reports (preferably done according to the International Accounting Standards, or, if the firm is looking to raise money in the USA, in accordance with FASB);
• Cash Flow Projections and the assumptions underlying them.

Controls

• Accounting systems used;
• Methods to price products and services;
• Payment terms, collections of debts and ageing of receivables;
• Introduction of international accounting standards;
• Monitoring of sales;
• Monitoring of orders and shipments;
• Keeping of records, filing, archives;
• Cost accounting system;
• Budgeting and budget monitoring and controls;
• Internal audits (frequency and procedures);
• External audits (frequency and procedures);
• The banks that the firm is working with: history, references, balances.

Technical Plan

• Description of manufacturing processes (hardware, software, communications, other);
• Need for know-how, technological transfer and licensing required;
• Suppliers of equipment, software, services (including offers);
• Manpower (skilled and unskilled);
• Infrastructure (power, water, etc.);
• Transport and communications (example: satellites, lines, receivers, transmitters);
• Raw materials: sources, cost and quality;
• Relations with suppliers and support industries;
• Import restrictions or licensing (where applicable);
• Sites, technical specification;
• Environmental issues and how they are addressed;
• Leases, special arrangements;
• Integration of new operations into existing ones (protocols, etc.).

A successful due diligence is the key to an eventual investment. This is a process much more serious and important than the preparation of the Business Plan.

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