InstructorNathan MahrShow bio
Nathan has taught English literature, business, social sciences, writing, and history for over five years. He has a B.A. in Comparative History of Ideas from the University of Washington.
Learn the definition of due diligence and see what it means in various situations. Review examples and types of due diligence. See how it can be used to succeed.Updated: 10/22/2022
Table of Contents
- What is Due Diligence?
- Types of Diligence
- Lesson Summary
The meaning of the term due diligence generally refers to the investigation of a business, person, investment, or product prior to entering into some sort of transaction, agreement, or commitment. It can apply to a wide variety of scenarios and activities but the goal is always to reduce risk by uncovering information that might not be readily apparent. Examples of times when due diligence may be used include the vetting of employers and employees, various business transactions such as when purchasing stock, and when making a real estate purchase.
While the concept of due diligence is relatively simple, the investigation itself can be quite complex. It may require the use of experts in different fields and can be time-consuming and expensive. However, the potential cost of not conducting due diligence can be much greater. For example, if a business agreement is made without first investigating the other party involved, hidden risks may come to light later on. This has the potential to result in financial losses, legal problems, or even personal safety risks. It is important to note that due diligence is not a guarantee against all risks, but it can help to mitigate them. When conducted properly, it can help inform better decision-making and help reduce the likelihood of negative outcomes.
Due Diligence Definition
There are a few different definitions for due diligence depending on the context in which it is being used. The term can generally be defined as:
- An investigation of a business or person prior to entering into an agreement or transaction with them;
- The research and analysis of a company, investment, or product before making a commitment;
- A process of inquiry that is done in order to confirm the accuracy of information.
In a business context, due diligence is often used in order to assess the potential risks of entering into a transaction. This may involve investigating the other party involved in the deal, as well as any potential legal or financial risks. Due diligence is also sometimes used in the hiring process in order to ensure that a potential employee is qualified and trustworthy. In terms of legal proceedings, due diligence refers to the duty of care that one must exercise in order to avoid liability.
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When conducting an analysis (especially on businesses), a few different types of due diligence exist. These are known as hard due diligence, soft due diligence, and context-specific due diligence. They differ based on the focus of the analysis being conducted as well as the intensity and depth of the research.
- Hard: Hard due diligence is typically used when investigating a business or investment opportunity. It usually focuses on financial factors such as profitability, liquidity, and solvency. This type of due diligence often requires the help of experts such as accountants or financial analysts. When being conducted on a business, elements from the company's financial statements will be compared and analyzed in order to come to a strong understanding of its current financial position, its future earning potential, and any underlying risks. It should be noted that numbers investigated in hard due diligence can sometimes be manipulated to display a picture that is different from reality. Soft due diligence can help to supplement this type of analysis and provide a more well-rounded understanding of the business being investigated.
- Soft: Soft due diligence is often used when investigating a person or company. It usually focuses on non-financial factors such as reputation, culture, and management. This type of due diligence often requires the use of primary sources such as interviews and surveys. When being conducted on a person, elements from their background check will be looked into in order to get a sense of their character and any potential red flags. When being conducted on a company, qualitative factors related to the business will be investigated in order to assess its overall health. Examples of these factors include brand loyalty from its customers, corporate culture, employee satisfaction, quality of management, and the quality of its products or services.
- Context-specific: Context-specific due diligence is diligence that is specific to a particular context or situation. This type of due diligence is conducted in addition to hard or soft due diligence in situations where there are unique risks that need to be considered. An example of this would be country-specific due diligence, which takes into account any political or economic risks that may be present in a particular country. Other examples of context-specific due diligence include environmental due diligence (assessing the environmental impact of a project) and social due diligence (assessing the social impact of a project).
Situations Requiring Due Diligence
It can be helpful to explore a few different examples of due diligence in order to get a better understanding of the scenarios in which it is often used.
Example 1:
John is an extremely wealthy angel investor who often provides seed money to startup companies in exchange for a small stake in the business. Before investing his money, John always conducts due diligence on the business he is considering. This usually includes reading through the business's financial statements, talking to other investors in the company, and conducting market research on the industry in which the business operates. John has found that by doing due diligence, he is able to avoid investing in companies that are likely to fail and, as a result, he has often made significant returns on his investments.
Example 2:
Company XYZ is considering acquiring company ABC. As part of the acquisition process, Company XYZ's management team decides to conduct due diligence on company ABC. To do this, they hire an external consulting firm to investigate ABC's financials, operations, and overall health. The due diligence process takes several months and is very costly, but in the end, it provides Company XYZ with the information it needs to make an informed decision about whether or not to proceed with the acquisition. The consulting firm's resulting due diligence report discovered that ABC had several inconsistencies in their financial statements which led Company XYZ to ultimately decide not to go through with the acquisition.
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Due diligence is the process of investigating a person, company, or investment in order to assess their/its suitability for investment, partnership, employment, or other types of commitment. Due diligence is often used in situations where there is a high degree of risk involved such as when making a large investment or acquiring a company. There are a few different types of due diligence referred to as hard due diligence, soft due diligence, and context-specific due diligence.
Hard due diligence typically centers around qualitative factors such as the investigation of a company's financials. For example, when conducting hard due diligence on a company, an investor might investigate the company's cash flow, profitability, and debt levels. This information would allow the investor to get a better understanding of the company's financial health and any obvious financial red flags that might be present. In contrast, soft due diligence focuses on more qualitative factors such as the investigation of a company's culture, management team, and overall reputation. Context-specific due diligence is conducted in addition to hard or soft due diligence in unique situations which require a deeper analysis such as country-specific due diligence or environmental due diligence.
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Frequently Asked Questions
What are the three types of due diligence?
The three main types of due diligence are hard due diligence, soft due diligence, and contextual due diligence. Each of these types of due diligence has different investigation focuses, intensities, and specific research goals.
What is due diligence and why is it important?
Due diligence is the process of probing, looking into, and investigating a person, company, or investment in order to assess its worthiness for investment, partnership, or commitment. It is important because it can help individuals and organizations mitigate risk and avoid potential losses. It can also help ensure that investments are made in good faith and with a full understanding of all relevant information.
What are some examples of due diligence?
There are many possible examples of due diligence. Some common examples include investigating the financials of a company before making an investment, researching a person's background before hiring them, or reviewing environmental impact reports before committing to a construction project.
How does one use due diligence in a sentence?
One example of how to use due diligence in a sentence is as follows: "Jane always makes sure to conduct due diligence on any potential investment before putting her money in." This simply means that Jane does her research and homework before investing her money to avoid any surprises or losses down the road.
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