What is due diligence and why is it important?

When the term ‘due diligence’ is mentioned, people may assume it relates to the investigation or exercise of care that a reasonable business is typically expected to undertake in advance of an M&A transaction. However, the meaning of the term due diligence is much broader than this and it also incorporates the work (i.e. investigation, audit or view) that a reasonable person should undertake before entering into an agreement or contract with another party.

If you have taken a board of director certification course or looked at steps one should take prior to joining a board, you will be aware that due diligence is expected to be undertaken by a would-be director. Nevertheless, it’s good to revisit what it entails and why it is important.

The due diligence process for a prospective director is typically an evaluation of oneself and the organization. Are you right for the job and is the organization the right fit for you? In our view, there are six broad categories of interest for carrying out due diligence: general information about the company, stakeholders and independent views, strategic direction and sustainability, the board, risk management and other.

Information can be gathered from public sources, private sources, individuals (i.e. headhunters, former board members, current board members and senior management, customers) and the company itself. Some of the information provided by the company may only be accessible to candidates on the short list and accessing it may require signing a non-disclosure agreement.

The information gathering process can be brief or it can comprehensive. Those who have done a significant amount of self-evaluation and who believe they understand an organization intimately may choose to limit their pre-appointment investigation to a few key areas of interest. However, for the majority of directors it probably makes sense to do an extensive review.

Due diligence is important because:

  1. Although limited liability companies and appropriate insurance can remove some risk, company directors have a duty of care towards the business and can potentially be held personally liable.
  2. You are effectively lending your reputation to the organization. If the organization fails or is found to have engaged in activities that caused material harm to individuals or society at large, this could impair the remainder of your career.
  3. It’s not always possible to resign once you have been appointed. There can be instances, albeit these are rare, where resigning may be a breach of a director’s fiduciary duties or may open a director up to accusations of a breach.
  4. It facilitates insightful questions during the interview stage that makes it easier to get a fuller picture than one otherwise might.
  5. To deliver value, one must be in an environment that enables directors to give their best. Thorough due diligence will likely expose how healthy the boardroom is. Joining a dysfunctional board does more harm than good.
  6. It accelerates a director’s ability to add value post-appointment. Not only in terms of allowing for potentially greater contribution in discussions but it can allow a director to specify areas that the post-appointment induction should focus on.