Due Diligence

By Brad Thomason, CPA

 

Boy, talk about a phrase that shows up everywhere these days.  I’ve overheard people talking about it in every context under the sun, including the selection of fantasy football rosters.  My mom might have even said something about it not too long ago (the memories run together… )

In any event, this now-ubiquitous term really is an important thing.  But if you press people for a definition, you get different answers, or no answer at all (My favorite:  “Well, you know, it’s what you do, I mean all the different things, when you’re doing, like, due diligence.  You know?).

OK, I don’t have a one sentence definition that really describes it either.  But here are a few thoughts on the matter which you might find useful.

  1.  Due Diligence is predicated on the notion that if you can know, you need to know.  That is, we don’t want to make assumptions or take things for granted.  Think your car is parked in your garage?  Fine, walk over to the door and peek out, just to be sure.  Know for a fact that 7 times 6 is 42?  Punch it into your calculator anyway.  Years ago when I was at Ernst & Young we had a letter that we always had the executives of our audit clients’ prepare and send to us.  It stated all sorts of things that anyone would assume to be the case, but for which we needed explicit representation.  Why?  Well, as one senior partner explained to me, if you ever have to testify in a fraud case and the judge asks you whether or not you asked the accused if they were stealing from the company, you do not want to have to reply, “No sir, I didn’t.”  The foundational principle of Due Diligence: if you can know it or confirm, go know it or confirm.
  2. So much for theory.  Now for practice.  Knowing everything that’s knowable can be damned expensive.  What if your counter-party asserts that they do not have a hidden vault full of gold bullion located somewhere beneath the Sahara Desert?  Is it technically possible to confirm this claim?  Most likely.  But at what cost?  Think about it this way: due diligence is a form of insurance.  So the fact that it’s a good idea in principle doesn’t mean you can ignore the cost-to-benefit relationship.  Most everyone thinks that car insurance is a good idea, but would anyone want to pay $20,000 a year in premiums to insure a $25,000 car?  The benefit isn’t worth the cost.  Similarly, when conducting Due Diligence, you have to weigh one against the other.  Even if knowing all of the knowables is good theory, it may prove too expensive in practice.
  3. The middle ground between theory and practice lies in the question, “What can go wrong?”  Now, this is not based on a presumption of omniscience (that is, it’s impossible to enumerate EVERYTHING that could go wrong…); it’s just a common sense question designed to help us articulate the thing(s) we are concerned about.  What are we actually worried about?  For most any transaction there are probably only 3 or 4 major concerns.  I say that, because if the number is significantly greater than that, then in most cases you’ll probably just decide to pass before you ever really get to this stage.  Due Diligence is for people who are looking to justify moving ahead; saying “no” doesn’t really require a fully-formed reason, right?.  So if you can identify the things you’re worried about, you know what to go look for: the safeguards that are in place to protect against those negative outcomes.

Hopefully that gives you some perspective on what to do and what not to do.  The reality is that the specific things you need to look at for any one deal can be so transaction-specific that laundry lists of do-this/don’t-do-that have only limited value.  But I’ve always found that an understanding of the principle goes a long way in helping to know what to do in the given situation.

A final thought.  I come across people all of the time who – under the mantle of “doing Due Diligence” -are asking for documents, building spreadsheets and assembling statistics which have nothing to do with anything.  Just because you can divide one amount by another to come up with a ratio doesn’t mean that the ratio has any informative value that helps to answer the what-can-go-wrong question.  It’s just motion, without any movement.   Don’t make the mistake of thinking that thick files and elaborate cell formulas amount to Due Diligence.  Because if you do, you very well might find yourself relying on something which at base has very little to do with understanding the questions you set out to answer in the first place.  Or the risks involved with the activity being contemplated.

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