Impact due diligence is crucial in impact investing. While the practice of impact measurement and management (IMM) has become increasingly. Performing due diligence on potential investee companies is a crucial component of successful fund management, and funds should have a pre-determined. finance, due diligence describes the process of assessing possible investments using information gathered from intermediaries or directly from a potential. MEGAN BETTINGER

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Referring back to Theranos, it did not raise any money from any renowned life sciences VCs, instead, raising money from mostly private individuals, without relevant industry backgrounds. Types of Investment Due Diligence As I mentioned, investment due diligence does not have a strict formulation; it should be designed to address the specific circumstances. The matters which will be investigated depend on the structure of the contemplated transaction — what the investor will receive in exchange for its investment.

If the transaction is structured so that certain assets, liabilities or segments of the business are excluded, there is no reason for the investigation to cover them. Certain areas of investigation which are critical in some scenarios, e. Notwithstanding the differences in scope due to different investing scenarios, a typical due diligence will include commercial, legal, financial and tax due diligence.

Legal due diligence covers a wide scope of legal matters, including proper incorporation and ownership, contractual obligations, ownership of assets, compliance, and litigation. It seeks to confirm the validity of the rights being acquired by the investor and the absence of legal risks which could undermine the value of the investment.

Tax due diligence could be viewed as an extension of the financial due diligence, where the focus is on identifying potential additional tax liabilities arising from non-compliance or errors. Further types of investment due diligence are technical, environmental and regulatory, performed when the impact of these areas on the business is significant. Depending on the situation, the due diligence may need to address very specific and narrowly defined topics, as long as they are factors for the valuation and assessment of the risks of the investment opportunity.

How Does it Actually Work? Investor due diligence typically takes a center position along the timeline of the investment process, as illustrated by the figure below. However, to serve its purpose, investment due diligence must be performed in coordination with the other activities within the process and the due diligence team needs to actively communicate with the other participants.

There are actually no clear-cut boundaries between the due diligence and the other phases of the process. To illustrate how this works we summarize below the usual sequence of activities and events. Before the Due Diligence The potential investor has expressed its interest in the opportunity presented by the investee founder, business owner, supplier, etc. The two sides have met and established a relationship, discussed the opportunity, and agreed in principle on the key terms of the investment transaction.

The key terms agreed in the preliminary stage typically include transaction structure what does the investor receive? Frequently such terms are laid out in a non-binding document called Letter of Intent , Term Sheet or Memorandum of Understanding. Due Diligence Kick-off The investor typically introduces a wider team into the process, including external advisers which may be assigned to perform due diligence in specific areas e.

The investor and the investee agree on the terms of access to information about the target business, including confidentiality undertakings, scope, and limitations of the investigation, communication protocol and points of contact. Access to information can be arranged through a virtual data room VDR facility which takes care of most aspects of the information exchange protocol.

The cost of using a VDR by an external provider is usually justified in larger processes involving multiple bidders. A timeline is established including deadlines for receiving the information, issuing the investment due diligence report s and returning to the negotiating table. The investor reads and discusses the reports of the different work streams. It considers the implications of the findings for the valuation of the investment and the additional terms and conditions which need to be negotiated to properly secure its rights and fend against undertaking undesired exposures.

The investor puts the investment due diligence findings on the table in order to negotiate the changes or additions to the terms of the transaction. Investment Due Diligence Challenges For the most part, the due diligence investigation is carried out on information provided by the target business. Hence, a sufficient level of cooperation by the investee or its owner is critical for a successful due diligence.

This is commonly the case where a larger, more developed business invests in a smaller business, or where an institutional investor funds an entrepreneur. Here are some examples of how this could happen during investment due diligence: Scenario Problem Resolution The target business has the information, but it is difficult to extract and present in a meaningful manner as required by the investor.

The business cannot provide a rigorous analysis of what part of turnover growth is due to sales volume and what to price increases The due diligence provider can assist with this. A financial adviser can process the granular sales data generated by the accounting system to produce an appropriate analysis. The detailed information provided does not fully support the claims made by the investee at the initial stage of negotiations because the investee itself did not have a good understanding of its finances.

Management was focused on managing the cash flow, but investment due diligence uncovers significant unbilled payables to suppliers of the business which had not been accrued and hence the business's costs were understated. Interviewing suppliers is an effective way of getting a clearer picture. With this in place, the financial statements can be restated correctly.

The business does not allocate its production costs by product correctly, resulting in misleading profitability indicators by market segment. A financial adviser can quantify the errors and produce adjusted results for the purposes of the negotiations. In certain situations, this may be critical for the success of the transaction. The Willingness to Disclose Information By disclosing a large amount of internal information about its business, an investee exposes itself to leakage of sensitive data and trade secrets to the outside.

In many cases, investees will limit their risk by putting restrictions on the information they will provide for the purposes of a due diligence. Restrictions frequently cover areas such as customer and supplier lists, prices and benefits provided to key talent. Organizing the due diligence in two stages where restrictions are imposed on the information at the first stage and are lifted at the second stage after the investor makes a binding commitment to the transaction. I would like to highlight that, notwithstanding the use of the above tools, a certain level of trust and commitment to the transaction between the negotiating parties is a prerequisite for a successful due diligence.

Or, are they American depositary receipts ADRs with another listing on a foreign exchange? This information along with market cap should help answer basic questions, such as whether you can own the shares in your current investment accounts. Look up the revenue and net income trends for the past two years at a financial news site that allows you to easily search for detailed company information using the company name or ticker symbol.

You should also review profit margins to see if they are generally rising, falling, or remaining the same. You can find specific information regarding profit margins by going directly to the company's website and searching their investor relations section for their quarterly and annual financial statements. This information will come into play more during the next step.

Step 3: Competitors and Industries Now that you have a feel for how big the company is and how much money it earns, it's time to size up the industries it operates in and with whom it competes. Compare the margins of two or three competitors. Every company is partially defined by its competitors. Just by looking at the major competitors in each line of the company's business if there is more than one , you may be able to determine how big the end markets are for its products. You can find information about the company's competitors on most major stock research sites.

You'll usually find the ticker symbols of your company's competitors along with direct comparisons of certain metrics for both the company you're researching and its competitors. If you're still uncertain about how the company's business model works, you should look to fill in any gaps here before moving forward. Sometimes just reading about competitors may help you understand what your target company actually does. Step 4: Valuation Multiples Now it's time to get to the nitty-gritty of performing due diligence on a stock.

Make a note of any large discrepancies in valuations between the company and its competitors. It's not uncommon to become more interested in a competitor stock during this step, which is perfectly fine. However, follow through with the original due diligence while noting the other company for further review down the road. While earnings can and will have some volatility even at the most stable companies , valuations based on trailing earnings or current estimates are a yardstick that allows instant comparison to broad market multiples or direct competitors.

At this point, you'll probably begin to get an idea if the company is a " growth stock " versus " value stock. These multiples highlight the valuation of the company as it relates to its debt, annual revenues, and the balance sheet. Because ranges in these values differ from industry to industry, reviewing the same figures for some competitors or peers is a key step. Finally, the PEG ratio brings into account the expectations for future earnings growth and how it compares to the current earnings multiple.

Stocks with PEG ratios close to one are considered fairly valued under normal market conditions. Step 5: Management and Ownership As part of performing due diligence on a stock, you'll want to answer some key questions regarding the company's management and ownership. Is the company still run by its founders?

Or has management and the board shuffled in a lot of new faces? The age of the company is a big factor here, as younger companies tend to have more of the founding members still around. Look at consolidated bios of top managers to see what kind of broad experiences they have. Also look to see if founders and managers hold a high proportion of shares, and what amount of the float is held by institutions. Institutional ownership percentages indicate how much analyst coverage the company is getting as well as factors influencing trade volumes.

Consider high personal ownership by top managers as a plus, and low ownership a potential red flag. Shareholders tend to be best served when the people running the company have a stake in the performance of the stock. Step 6: Balance Sheet Exam Many articles could easily be devoted to how to do a balance sheet review, but for our initial due diligence purposes, a cursory exam will do.

Review your company's consolidated balance sheet to see the overall level of assets and liabilities, paying special attention to cash levels the ability to pay short-term liabilities and the amount of long-term debt held by the company. A lot of debt is not necessarily a bad thing and depends more on the company's business model than anything else. Some companies and industries as a whole are very capital intensive , while others require little more than the basics of employees, equipment, and a novel idea to get up and running.

Look at the debt-to-equity ratio to see how much positive equity the company has. You can then compare this with the competitors' debt-to-equity ratios to put the metric into a better perspective. If the "top line" balance sheet figures of total assets, total liabilities, and stockholders' equity change substantially from one year to the next, try to determine why. The company could be preparing for a new product launch, accumulating retained earnings , or simply whittling away at precious capital resources.

What you see should start to have some deeper perspective after having reviewed the recent profit trends. Step 7: Stock Price History At this point, you'll want to nail down just how long all classes of shares have been trading, as well as both short-term and long-term price movement.

Has the stock price been choppy and volatile, or smooth and steady? This outlines what kind of profit experience the average owner of the stock has seen, which can influence future stock movement.

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