The Importance of Due Diligence

Wednesday 8 February 2023

Due diligence is an important part of any investment decision. The process allows an investor or acquiror of a business to investigate all aspects of the venture under consideration – commercial, legal, tech and people. This enables them to assess its underlying value based on unpacking the information provided, regarding potential, risks, and future performance, and thus return on investment and future value. It's a bit like having a medical, checking the ‘vital signs’ and everything is in good working order. 

Prospective investors and buyers should undertake thorough due diligence of any target business they are considering. Due diligence offers an independent review and assessment, removing any prejudice, sentiment, and bias in disclosed information, enabling reflective, informed decision-making. Without a deep-dive and thorough due diligence review, expensive mistakes can arise.

Here's a current example. JPMorgan is suing Charlie Javice, the founder of Frank, a college-student lending startup it bought last year for US$175m. JPMorgan says it expected Frank to have more than four million customers, but discovered the company actually had fewer than 300,000 when it began sending marketing emails, 70% of which bounced back. It’s now alleged that after being pressed for confirmation of Frank’s customer base during the due diligence process, founder Charlie Javice used a data scientist to invent millions of fake accounts.

Javice launched Frank in 2017 with the goal of helping students apply for college financial aid.  Now, JPMorgan claims that Frank's inspiring story of helping more than five million students with funding to get into college was largely a fabrication. The allegations are the latest case of a lauded startup millennial founders accused of fudging the truth – Sam Bankman-Fried (FTX), Adam Neumann (We Work) and Elizabeth Holmes (Theranos).

Javice says JPMorgan were provided all the data upfront for the purchase of Frank and she highlighted the restrictions placed by student privacy laws during due diligence. She further asserts that JPMorgan realised post-acquisition that they couldn't work around those privacy laws and are twisting the facts to cover their tracks.

JPMorgan’s lawsuit alleges when they asked Javice for proof that she had more than four million customers, she at first pushed back, claiming she couldn't share the names due to privacy issues. After the marketing campaign, where, only 28% of emails were delivered, and just 1.1% of the delivered emails were opened, the bank reviewed Frank's business, as well as emails, chats, and messages between Javice, the data science professor and Frank's chief growth officer, which the suit claims revealed the issues with Frank's client list. 

A right old dispute is shaping up, and it will be interesting to see where the due diligence report sits in the court documents, the extent that full disclosures were made, and proper follow up enquires were made to verify the customer base. All startups need charismatic, compelling founders who can convince investors to take a chance, but a hot startup isn’t immune to an in-depth due diligence review to raise red flags. How do you miss customer numbers by this margin?!

So, let’s look a little more at what the due diligence process involves.

The time required for a due diligence project varies, depending upon the size of the investment and complexity of the target business. The aim is to run the process alongside the investment contract negotiations, putting it at the very heart of a potential transaction and on the critical path to completion. It’s an agile process, designed to ensure key issues are identified on a timely basis to inform discussions.

The process starts with an information request or due diligence questionnaire, outlining the information the investor requires to facilitate their decision to turn their interest into a tangible investment commitment. This usually follows an agreement ‘subject to due diligence’ which is documented as a ‘Heads of Terms’ signed by both parties which sets down the principal terms on which the investment will be made. 

The output of the due diligence review will highlight issues to be considered before the investment is concluded – for example, ongoing legal disputes, high employee turnover, coatomer churn – or on the upside, confirm sales growth projections, validate new product development and the calibre of the leadership team.

Having completed a well-scoped due diligence review, prospective investors or acquirors will benefit significantly, becoming more informed about their proposed target:

  • It can help deliver a stronger deal and smoother transaction, enabling an active dialogue which improves the relationship between the two sides and facilitates the mechanics and detail of the deal
  • For the investor, it allows you to decide if the target investment is the right fit and value to your portfolio, giving you otherwise unknown insights
  • It will reduce risk post-transaction, by highlighting current and potential future issues in the business which could come to light later down the line, and have an adverse impact
  • Provides expert third party insight into the target company – for example, technical due diligence could highlight issues with technical debt or scalability challenges which may not have been apparent
  • Provides clarity on the underlying financial model of the business, thus giving some comfort on the future performance and return on investment.

You can clearly see why as an investor you would value a due diligence review on a potential target business. However, if you are considering taking investment or selling, then it may be worth undertaking ‘seller’ due diligence before you begin to see if you are ‘investor ready’. This means collecting all the information which a potential investor or buyer will consider in their due diligence. It may highlight any issues that you can tackle prior to investment and will allow you to present your business in the most favourable way possible, ensuring you get the best price for your business.

Opportunities arise frequently, but investors don’t always see them. Due diligence grants you an invisible set of glasses that reveal the many opportunities which surround you. It is not a calculated risk if you haven’t calculated it.

An investment made with prudence, caution, and keeping all the rules of self-discipline and risk management is a better investment.  The more energy, focus and time spent on due diligence, there is a strong correlation with the level of success for an investor. Caveat Emptor, but don’t be fearful of risks. Understand them, manage and minimize them to an acceptable level through an initial due diligence review.



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