Before you buy, merge with, or invest in a business, you need to know exactly what you’re buying, merging with, or investing in. The due diligence process is designed specifically for this purpose.
You and your support team of attorneys, financial advisors, and industry specialists will go step by step through a due diligence checklist to examine each area of a target company’s activities. A lot of that is to find out what risk you might be exposing yourself to.
Due diligence takes time and is exhausting for all parties, but it’s necessary to help you make the best decision. Let’s look at how a due diligence checklist can be beneficial and what you should include on it.
What Is a Due Diligence Checklist?
To perform due diligence correctly, you need a checklist because there’s a lot to get through.
Each tick box on your checklist will reveal information on your target company's assets, liabilities, contracts, benefits, and potential problems. There are standard checklists attorneys use, but they’re subject to modification by industry experts who add extra tests for the target company to pass based on the sector they operate in.
When the results of the due diligence exercise are in, let your business instincts and the advice of your professional team guide you as you come to the decision on whether to proceed with the purchase, merger, or investment.
The 15 Stages of a Due Diligence Checklist
Your due diligence process should be exhaustive. You need to know your target company is in good standing. Most due diligence checklists incorporate variations of the following 15 separate evaluations to help you decide whether or not you give a potential deal the nod.
1. Articles and Publicity
This part of the due diligence process probes your target company’s reputation, its market position, and the value of its brand. Key items to examine include:
- Press releases
- News articles
- Industry reports
- Awards and recognitions
- Product/service reviews
- Social media presence
- Blog posts
- Webinars and presentations
- Conference appearances
- Crisis management responses
- Influencer partnerships
- Advertising campaigns
2. Customer information
You need to take a view of a target company’s customer database to better understand how stable its revenues are and whether there is still growth potential. Important due diligence checklist points of interest include:
- Customer demographics: The age, gender, location, and income of your target company’s different client bases
- Largest customers: Who the largest customers are and how much the target company would suffer if they lost their business
- Top customers: The company's most valuable clients and their contribution to overall revenues
- Customer acquisition: What the current, future, and historic strategies for attracting new customers are
- Customer retention: Details of the programs designed for existing customers to secure future orders, like loyalty cards
- Customer churn rate: Percentage of customers lost over time and information on reasons for churn
- Customer lifetime value: Amount of revenue generated by a customer between first and final orders
- Customer satisfaction: Feedback and ratings from customers on quality and performance
- Customer support: The level of company assistance to customers and its cost
- Sales channels: Promotional channels used to sell products or services
- Payment terms: When and how customer payments are made (also important for cash flow)
- Customer contracts: Governing agreements between the company and clients
3. Human Resources
As part of your due diligence checklist, you’ll want to review:
- Employee headcount
- Organizational chart
- Key personnel and their resumes
- Employee turnover
- Recruitment processes
- Training and development
- Compensation structure
- Employee benefits, including stock options and retirement plans
- Labor union relationships
- Employment contracts
- Employee disputes
- Compliance with labor laws
4. Environmental Issues
As regulatory and consumer pressure mounts, a target company’s long-term sustainability and reputation may be at risk if they do not have a sufficient grasp on dealing with the environmental impacts of doing business. A lack of good-enough control may also lead to future legal liabilities.
Key environmental tick boxes on a due diligence checklist include:
- Environmental permits: Existence of valid and current required licenses and authorizations
- Regulatory compliance: Current adherence to environmental laws
- Waste management: Policies and practices on handling and disposal of waste
- Emissions control: Measures undertaken and planned to reduce air pollution
- Energy consumption: Current and planned usage of electricity and other resources and its renewability
- Water management: Policies and practices on conservation and treatment of water
- Hazardous materials: Methods of storing and handling dangerous substances
- Environmental incidents: Treatment of past or ongoing environmental issues or violations
- Remediation efforts: Actions taken voluntarily or under legal force to address environmental concerns
- Sustainability initiatives: Current and future programs to reduce environmental impact
- Climate change risks: Vulnerability to global warming of internal processes and important third parties
- Stakeholder engagement: Communication with shareholders, customers, employees, and regulators on environmental issues
5. Financial Information
Inspecting a target company’s financial information shows you how tight their cost control has been, how stable cash flow is, and how able they are to fund future growth plans without needing outside investment.
Important financial data to examine as part of your due diligence checklist includes:
- Audited financial statements, including balance sheets, income statements, and cash flow statements
- Revenue-generating customer subscriptions and their churn rates
- Accounting policies
- UCC filings to check for any liens on property owned by the company and liabilities caused by previous regulatory or legal violations
- Off-balance-sheet items, like unrecorded liabilities or obligations that risk current or future financial exposure
- Contingent liabilities
- Prepaid expenses
- Management representation letters
- Revenue recognition
- Cost structure
- Debt and financing, like loan agreements, lines of credit, and other financial obligations that affect credit rating and leveraging ratios
- Capital structure, including equity, debt, and ownership distribution composition
- Financial projections
- General ledger
6. Insurance Coverage
A target company’s attitude to risk can be measured on what it insures and how tightly it insures it. Key areas to focus on for your due diligence checklist include:
- Worker's compensation
- General liability coverage
- Errors and omissions protection
- Product liability coverage
- Vehicle insurance
7. Intellectual Property
A target company’s intellectual property (IP) is often a key factor in determining its value during an M&A process. Important IP factors for a due diligence checklist include:
- Registered trademarks and trade names
- Patents and patent applications
- Licensing agreements
- IP litigation
- Trade secrets
- Domain names
- Liens on intellectual property
- Intellectual property protection measures
8. Licenses and permits
Ownership of the correct licenses and permits is a good way to measure a target company’s attitude toward compliance with regulatory and legal requirements. Look out for the following on your due diligence checklist:
- Business licenses: Required local, state, or federal licenses to carry out a particular business activity
- Occupational licenses: Existence of specific permits, which demonstrates adherence to industry standards and regulations
- Building permits: Construction or renovation documentation relating to both safety and zoning laws
- Environmental permits: Emissions or waste disposal authorizations to demonstrate legal compliance and sustainable practices
- Import/export licenses: Permissions to trade internationally, which is important with respect to sanctions laws and the risks associated with certain jurisdictions, individuals, and sectors.
Some companies attract more legal attention than others, often unwarranted. But a business’s current, future, and historic litigation activity can provide clues on the level of threat to its future financial stability and good reputation.
Important litigation aspects to consider as part of your due diligence checklist include:
- Pending lawsuits
- Past litigation
- Regulatory investigations
- Settlement agreements
- Employment disputes
- Intellectual property disputes
- Contract disputes
10. Material Contracts
Materials contracts are contracts your target company enters into with its customers, suppliers, affiliates, outsourced companies, and more. How those contracts are framed, especially with respect to responsibility for failing to meet obligations, may negatively impact future financial performance and operational abilities.
Investigate the following as part of your due diligence checklist:
- Customer contracts
- Supplier contracts
- Joint venture/partnership agreements
- Settlement agreements
- Franchising agreements
- Accounts receivable
- Accounts payable
- Equipment leases
- Non-compete agreements
- Nondisclosure agreements
- Stock purchase agreements
- Security agreements
- Summary of warranty claims
By examining the target company’s existing corporate structure, you can get an idea of the quality of people running them, internal decision-making processes, and how subject to “bloat” a company is.
Key aspects of the due diligence checklist for organizational structure include:
- Officers and directors
- Organization chart
- Records of stock issuances
- List of stockholders
- Shareholder agreements
- Articles of incorporation
- Voting agreements
- Right of first offer or refusal
- Preemptive rights
- Transfer restriction agreements
- Joint ventures
12. Physical Assets
Physical assets help determine a company’s worth. Assets paid for on existing finance are also liabilities, however, and this also affects a company’s worth.
Consider the following for the physical assets part of your due diligence checklist:
- Real estate
- Furniture and fixtures
- Asset valuation
13. Products or Service Lines
A target company’s current products and services give clues to its competitive advantage, its market position, and its recent growth trajectory. But sometimes their future plans can be more revealing.
Be sure to investigate the following as part of your due diligence checklist:
- Product/service portfolio: A full and comprehensive list of current products and services and descriptions thereof
- Market positioning: A comparative study of the company's current and future products and services against its competitors.
- Unique selling propositions: The distinctive features or benefits of a target company’s products and services that competitors cannot or are not replicating currently
- Product/service lifecycle: A description of the stages of product and service development, growth, maturity, and decline with information on how each retired product or service is replaced
- Revenue breakdown: A full breakdown for each product or service on their share of revenue and profit contribution
- Regulatory compliance: How well a target company adheres to specific rules and regulations relating to its products and services
- Product/service development: What new products and services are planned together with a description of the planning process
- Supply chain: Key suppliers, manufacturers, and distributors involved in delivering the offerings
14. Real Estate
A target company's real estate inventory points toward its ability to expand within its current portfolio. It also lets you know what liabilities you have to pay if you take over with a completely different set of plans for real estate.
In the real estate section of your due diligence checklist, get the following:
- Property list
- Property deeds
- Lease agreements
- Purchase/sale agreements
- Property appraisals
- Zoning and land use permits
- Environmental assessments
- Property tax records
- Maintenance records
- Building permit documents
If you worry about how a target company manages its accounting, how it pays taxes may give you even more cause for alarm. If both are done badly, you might be exposing yourself to future unknown potential liabilities.
As part of your tax due diligence checklist, check the following:
- Tax returns: Get a copy of all tax returns for the last three years (including local, state, federal, and foreign). This includes sales tax returns, excise tax filings, and employment tax filings.
- Audit adjustments: Check for any audit adjustments proposed by the IRS or other tax authorities.
- Tax liens or settlements: Look for documentation around any tax liens or settlements. A tax lien gives the government the right to prevent a target company from selling property until a tax debt is resolved.
- Audit and revenue agency reports: Inspect copies of any audit and revenue agency reports for any current or historic credit rating issues.
- Deferred tax assets/liabilities: Obtain a summary of deferred tax assets, valuation allowances, and deferred tax liabilities from the target company.