Due Diligence: The What, The Why & The How
So, you want to invest in a StartUp or SME, but you’re not sure if it’s the right choice for you. What do you do? Due Diligence!
Welcome to our part of the internet at Kudade, where we are empowering Nigerians to create wealth by connecting them to funding & profitable investment opportunities in StartUps & SMEs.
In this blog, we’ll be doing a deep-dive on what it means to carry out proper Due Diligence on a company you want to invest in, so you can make the right investment choice.
First, what does it mean to carry out Due Diligence in a company?
Doing due diligence on a company before investing in it means conducting a comprehensive and detailed investigation of the company's financial, legal, and operational status so that you can be fully aware of the potential risks and rewards involved. The goal is to gather as much information as possible to make an informed investment decision.
There are 4 different parts of carrying your proper due diligence in an organisation. Here are the 4 basic parts:
Financial Due Dilligence: This is a crucial assessment of the financial health/status of a company. Your goal is to understand the profitability of the business and make sure that you're not putting your money in the wrong place. It helps you understand the company's performance criteria (their profitability ratio, leverage ratios, efficiency ratios, and so on). You can do this by looking at the historic financial trends of the company. Take a look at their audited financials of at least 3 years. Analyze their ratios, look at what the trend has been, and ensure that based on your predictions for how long you will invest, the company is able to pay you back your money and you'll also get the passive income you're interested in. Specifically, look at these documents:
- 3 to 5-year Audited Financial Statements (including Balance Sheet, Income Statement, Revenue/MRR Documents)
- Bank Statements (at least a year)
- Tax Returns
- Budgets & Forecast of at least 2 years
- Capitalization Table
Legal Due Dilligence: This comes into play mostly when the investment has to do with mergers and acquisitions. It's also important when it comes to investments generally. If they lose a case in court for example, and the payment is a huge sum, there's a potential that the company cannot afford it and will run into bankruptcy. Examine the company's legal status, including its legal structure, ownership, and any pending legal disputes or regulatory issues. Take a look at important Legal documents such as contracts, leases, and agreements that the company has entered into, because they can provide insight into the company's operations, liabilities, and obligations. You can also carry out an evaluation of the company's management team, their experience and track record, and their plans for future growth.
Operational Due Dilligence: This refers to making sure that the operational environment is suitable enough for the growth & profitability of the business. You want to find out what government policies influence or regulate that sector in that country. Lok at any regulatory filings the company has made, such as with the Securities and Exchange Commission or the Corporate Affairs Commission, which can provide information on the company's compliance with applicable regulations. You also want to consider insurance policies or any documents that contain information on the company's insurance coverage and can help assess the company's risk management practices. Other areas that may be reviewed during due diligence include
Commercial Due Dilligence: This speaks to the company's ability to fulfill a need. Is there a demand for the product they're producing or the service they are providing? What's their market share? Who are their competitors? What makes them stand out as a business, and why would the customers who have this problem or need choose them over their competitors? Take a look at their SWOT analysis. If the threats to the business are more than the opportunities prevalent for them, then it may not be a good choice. The due diligence process may also involve conducting interviews with customers, suppliers, and industry experts to gain insights into the company's reputation and potential for growth.
But that's not all. Here are a few insider tips for you as you carry out your next Due Diligence:
- Make sure the financials you're looking at have been audited by a chartered accountant. Be careful to not accept just any random financial documents.
- Pay very close attention to the financial ratios because they are more in-depth than the numbers (The EBITDA margin & Return on Equity). Also, look at the Solvent & Liquidity ratios.
- If you can, run credit checks on the company to see what their character has been. Have they had loans before? Have they been defaulting or do they repay?
Overall, carrying out due diligence will provide you with a complete and accurate understanding of the company you are considering investing in, enabling you to make an informed investment decision based on a thorough analysis of the company's strengths, weaknesses, opportunities, and risks.
So don't even consider skipping it.
