‘Due diligence’ is a fairly common term that we apply to a variety of circumstances. In truth, it is a financial term originally created to describe the obligation securities brokers have to their clients. It is a term that investors of all types are familiar with. Indeed, due diligence is the foundation of successful investing.
Though due diligence originally applied mainly to trading securities, the concept has since been expanded to include traditional securities, cryptocurrencies, angel and equity investing, and even mergers and acquisitions. The smartest investors never put a dime into new projects without first doing due diligence.
Due Diligence in the 1930s
As a concept, due diligence was developed in response to the 1929 stock market crash and subsequent Great Depression. The Securities Act of 1933, a piece of legislation written explicitly to address the fallout from the stock market crash is responsible for codifying due diligence as a matter of law. The legislation was written with two primary goals:
- Introduce financial transparency to allow investors to make better decisions.
- To establish legal means of going after brokers engaged in misrepresentation or outright fraud.
More than 80 years after the fact, we can see that the Securities Act has done what it was intended to do. Along the way, companies like Utah-based Mezy, Inc. have risen to the occasion by developing complete due diligence-as-a-service platforms. Investors use these platforms and their associated products to make informed decisions.
Basic Due Diligence Concepts
The fact that due diligence has been expanded to include more than just securities suggests there are different ways to apply it. In terms of mergers and acquisitions, due diligence involves a sophisticated process that looks into a company’s current valuation and future potential. It also looks at a company’s past history.
One company looking to acquire another might order a comprehensive evaluation report as part of its due diligence. A highly detailed report that concentrates on discounted cash flow could be the determining factor.
Due diligence applied to securities works a little differently. Brokers practice due diligence in order to guarantee they are representing products truthfully and according to the law. But investors also practice their own due diligence. They look at things like:
- company offering
- executive management
- financial statements
- future forecast.
The whole point of due diligence, from the investor’s standpoint, is to know what you are buying before you spend any money. The interesting thing is that there are never any guarantees. Every form of investing has some inherent risk. A broker’s due diligence is no more a guarantee than a comprehensive evaluation report.
Due Diligence Is Relative
What must be understood about due diligence is that it is relative. Yes, a big part of it is hard facts and figures. But as any savvy financial advisor will tell you, past performance is not indicative of future returns. Hard and fast data showing a company’s success never guarantees equal success down the road.
How do investors overcome concerns about future performance? They look at the intangibles. Above and beyond hard numbers, they look at a company’s executive management team. They want to fully understand the team’s track record. They also look at the company’s business model, particularly its future plans for continuing to make a profit.
In the end, due diligence is about combining hard data with the intangibles. Get it right and an investor will keep their risk under control. Get it wrong and high-risk investments could eventually spiral out of control. That is why due diligence was important enough to codify more than 80 years ago.
