Rationale and Subject Matter

• If you are considering buying a company or making a major investment, you will need to examine the company's status in exhaustive detail to determine the quality of your investment. If the company goes bankrupt due to a lawsuit that you were unaware of when you made the investment, for example, you may not be able to get your investment returned to you due to corporate limited liability and limited availability of funds. Before making your investment, you should perform five major reviews---a legal review, a financial review, a management review, a marketing review and an operations/technical review.
  
  

Preparation

• The first step will be to gather as much information from the company as you can, from both documents and interviews with company personnel. After that, you must diligently search public records for any missing piece or discrepancies. For the legal review, you should collect information about any pending litigation, examine all contracts to which the company is a party and review all corporate minutes books. For the financial review, obtain all financial statements and tax returns over the past several years, and all working documents retained by the company's auditors. For the management review, learn as much about each manager as you can, and obtain data on management productivity and prior forecasts. For the marketing review, review all marketing materials, obtain a list of major customers and review sales data. Finally, for the operations/technical review, inspect the company's equipment, assess product quality and examine warranties and product return rates.
  
  

Evaluation and Interpretation

• Legal due diligence should focus on finding major legal risks such as lawsuits against the company, substantial regulatory noncompliance, possible corporate fraud and contractual burdens. Financial due diligence should focus on the company's overall debt burden, the availability of working capital and the company's debt/equity ratio. Management due diligence should focus on management turnover, possible conflicts of interest and the backgrounds of key employees. Marketing due diligence should focus on the company's marketing plan, the competition and the potential for the entrance of new competition into the market. Operations/technical due diligence should focus on the expertise and work ethic of lower and mid-level employees, the state of repair of company equipment and safety features. A due diligence investigation of any company will uncover weaknesses in one or more of these areas, so it is important to classify weaknesses using two scales---the magnitude of the risk and the likelihood of its occurrence. Once you have a good understanding of the company's overall risk picture, you can either back out of the deal or use weaknesses to bargain for a lower price.