Due Diligence means ‘reasonable care‘. In relation to transactions / dealing with other entities, due diligence implies taking reasonable care to ensure that an entity has knowledge of those facts (disclosed and undisclosed) which can influence its decision to deal with the other entity.
To illustrate – If you are a supplier who is looking forward to enter into a contract with a company (‘ABC Limited’) to sell goods to it for next three years. Then you should try to know the following –
- Does ABC Limited exist?
- Would ABC Limited use those goods for legitimate purpose?
- Could it disappear with the goods provided without making your payment.
- If you are offering credit terms, then how regular is ABC Limited in making payments to its other suppliers? Does it pay its suppliers on time?
Depending on the amount involved, you could go deeper into the company’s credibility in the market, dealings with other parties, etc.
Now that is a simple example. But what if you are considering acquiring ABC Limited? Say you have calculated the benefit that this acquisition would give you. Should you just buy it at the value of benefits you will derive? Or should you take a look at the following?:
- Is there a bank loan which has not been paid yet, which you would have to pay if you acquire it.
- Have all its suppliers, creditors and employees been paid what is due to them?
- Who are the directors of ABC Limited? Are they directors in other companies? Is the reputation of those other companies good in the market?
- Has ABC Limited paid all its taxes? Or would you have to pay them when you acquire it.
- Is ABC Limited involved in any legal dispute which is still pending in courts? If yes, then are you ready to deal with this. What are the chances that ABC Limited would win this legal suit?
- And many more things.
So Due Diligence is taking this reasonable care before entering into any transaction – so that you clearly know what you are getting into! And you can decide the terms accordingly.