What is due diligence?

Have you been talking about software company acquisitions, and the phrase "due diligence" came up? Are you wondering just what "due diligence" means?

Most legal definitions of due diligence say something like "due diligence is a measure of prudence, activity, or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent person under the particular circumstances; not measured by any absolute standard but depends on the relative facts of the special case." In other words, to a potential acquirer, due diligence means "making sure you get what you think you are paying for."

Practically speaking, for any company acquisition, due diligence would include fully understanding all of the obligations of the company: debts, pending and potential lawsuits, leases, warranties, long-term customer agreements, employment contracts, distribution agreements, compensation arrangements, and so forth. Furthermore, for software company investments and acquisitions, due diligence also includes

"Due Diligence" typically takes the form of the acquirer's list of several hundred questions and/or requests for copies of documents that you, as the potential seller, must answer for the seller on or before some date.

For the owner of a software company, due diligence can be a very difficult and painful experience. It's difficult because you are essentially trying to prove a negative, the absence of any problems. The potential acquirer may keep coming back to you with more and move invasive requests, until you are about ready to scream "do you think I'm a crook? I told you we didn't have anything to hide!" Put yourself in the position of someone who is spending millions of dollars for something they can't see and can't touch, and perhaps you will understand a little better. It's painful because it's hard not to be insulted by questions like "Have any of the principals of the company ever been convicted of securities fraud? List all criminal convictions of the principals of the company."

If you are the owner of a software company, the time to start thinking about due diligence is now. Every decision that you make, test it against the question "how will this look when someone comes along asking hard questions?" Every software company is going to have to go through due diligence someday  — when you are acquired, seek outside investment, or go public — unless you intend to remain small and family-owner forever.

As a seller, you will also want to do your own due diligence on the acquirer. Do they actually have the funds to complete the transaction? If they are paying you with stock, what is the record of the stock? Is it likely to still be worth anything when your lockup period expires? How are they going to treat your employees? Are your corporate cultures compatible? If there is a large "earn out" component to the deal they are proposing, do they have a track record of successfully marketing products like yours? What is their incentive to do so? Are you sure? What happens if they do not? Will the acquisition stretch them — in terms of capital, management or otherwise — to the point that it will reduce their chances of success? Do they have a reputation for living up to the letter and the spirit of their commitments? How will they treat your customers? Will you be proud to be associated with this company?