What is due diligence?

By M. Henry Heines, Townsend and Townsend and Crew LLP -- Electronic Business, 5/16/2007

Editor's note: Excerpted from Patents For Business: A Manager's Guide to Scope, Strategy, and Due Diligence, by M. Henry Heines , partner, Townsend and Townsend and Crew LLP .

The term "due diligence" originated in Section 11(b)(3) of the Securities Act of 1933, which was enacted to protect the public interest when equities in a company were sold in public offerings. In certain offerings, the value of the equities dropped precipitously soon after the sales took place. The devaluation resulted from unfavorable facts about the company that had not surfaced until after the offering had been made, and in many cases this resulted in disastrous consequences to the buyers. Since the company was rarely in a position to compensate the buyers for their losses, the buyers' only recourse was to file claims against the brokers and dealers who coordinated the sale.

The Securities Act provided a statutory basis for these claims by establishing a standard of behavior for brokers and dealers, requiring that they conduct an investigation into the company before an offering is made and that they exercise "due diligence" in the investigation, i.e., that they conduct the investigation in a manner reasonably calculated to uncover all of the facts an investor might consider important in deciding whether or not to purchase the equities. If the brokers and dealers could show that they met this standard, the Securities Act provided them with a defense against the investors' claims.

The recognition of the need to know all of the relevant facts before closing a business transaction has expanded greatly since 1933, as has the potential liability for anyone dealing in equities. As a result, due diligence is now a recognized standard for investigations preceding almost any transaction that involves the sale or transfer of all or part of a commercial entity or of particular commercial assets, regardless of whether the transferor is an individual or a business entity.

 A due diligence review commonly precedes any transaction in which the value of the asset being sold or the interest being acquired is a factor of any significance in the transaction, or where there is any potential for liability arising from the transfer. In general, any transaction in which the interests of investors, ranging all the way from individuals to multinational conglomerates and including funds and partnerships as well as corporations, may be affected.

The investigation is performed after the parties have agreed in principle to the transaction but before the transaction closes and the parties are fully obligated. If the investigation produces a report that is entirely favorable, the transaction may go forward as planned. If the investigation reveals that the value of the transaction is far below that which was originally contemplated, that there are significant obstacles to obtaining the full value of the transaction, or that certain risks are present that the acquiring party is unwilling to assume, the transaction may be canceled entirely. Alternatively, the report may convince the two sides to the transaction to agree to modified terms.

For example, a low valuation of the assets and a high magnitude of risk can be factored into the purchase price. Risks can also be allocated in accordance with the findings: a particular risk can be assumed in exchange for a concession from the party with which the risk originated; one side can be persuaded to assume risks that are too costly or difficult for the other to assume; or certain assets can be selected for inclusion in the transaction and others excluded.

When properly done, the due diligence review is conducted by independent outside counsel who has no interest in the transaction or in either side. The outside counsel is commonly engaged, and paid, by the investigator, i.e., the party that will be injured by any misrepresentations made or unfavorable facts discovered during the course of the transaction.

The entity or asset being investigated is commonly termed the "target," and targets can vary as widely as the transactions themselves. In a stock offering, the target is the company whose shares are being offered and the investigator is the potential buyer or the buyer's representative. In a merger of two corporations, either corporation can be the target, and in many cases, each acts as an investigator and conducts a due diligence review of the other. In an acquisition of one business entity by another and often larger business entity, the acquired entity is the target and the acquiring entity is the investigator. In a joint venture, either partner to the venture can be a target of an investigation by the other. When a venture capitalist seeks to make an investment in a startup or any company seeking capital, the venture capitalist is the investigator and the startup or company is the target.

Due diligence investigations can also be conducted by lenders prior to making a loan, with the borrower being the target. In any acquisition of rights to intellectual property, either by option, license, or purchase, the target is the intellectual property asset(s) to which rights are being acquired, and the investigator is the acquiring party.

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