Due diligence describes the general duty to exercise care in any transaction. However, it also refers to the process of investigating the condition, value, and other qualitative aspects of the business that is being sold or the acquisition target. Additionally, it gives the parties a chance to discover hidden liabilities and other impediments to the proposed transaction. Thorough due diligence does not become necessary until the parties have agreed in principle that a deal should be pursued and after a preliminary understanding has been reached, i.e. letter of intent.
The amount of due diligence is subjective. The goal is to have enough information so that the parties’ feel comfortable entering the transaction. Factors relevant to determining the amount of due diligence may include, prior experiences, the size of the transaction, the likelihood of closing the transaction, tolerance for risk, time constraints, cost factors, and resource availability. A buyer will want to focus on the assets and liabilities that will be assumed as a result of the transaction whereas a seller will want to investigate the buyer’s solvency particularly if securities make up any of the consideration for the deal. The cost of due diligence is typically regarded as an essential expense because the cost is far outweighed by the anticipated benefits and risks of failing to conduct adequate due diligence.