9 Types of Due Diligence: What You Need to Know

Effective due diligence is a key factor for the success of mergers and acquisitions (M&A) for 25% of deal-makers, according to Statista.  

But do you know that due diligence is a broad term encompassing different areas of the target company’s operations? There are many types of due diligence, each focusing on a specific area of a sell-side. 

This article lists 9 main types of due diligence, explaining their peculiarities and importance for the deal’s success. Additionally, you’ll learn how virtual data rooms (VDRs) can make the due diligence process much more straightforward and effective.

What is due diligence?

Due diligence is a thorough review of a target company that the acquiring company performs before purchasing or investing. The main goal of due diligence is to verify that the target company’s financial statements, legal data, and other important documents and processes are in order and that the business is worth investing in.  

Companies need to know exactly what they’re getting into when they buy or invest in another business. Due diligence helps uncover hidden risks, confirm financial details, and ensure there are no legal or operational red flags. Skipping this step can lead to overpaying, legal trouble, or unexpected losses.

In broad terms, due diligence can be soft and hard:

• Hard due diligence looks at the measurable, concrete details of a business, such as financials, legal business, and operations.
  
• Soft due diligence focuses on the human side of a business, such as company culture, reputation, or future potential.

Even if the numbers look great, a toxic culture or bad reputation can be a warning sign. That’s why it’s essential to perform both soft and hard due diligence to get the full picture before making a decision.

Types of due diligence

Now, let’s review the 9 main types of due diligence in more detail.

Due diligence type	Focus	Hard or soft
Financial	Verify financial health, assess financial records, revenue, debts, and profits	Hard
Legal	Identify legal risks, review contracts, lawsuits, and compliance	Hard
Operational	Evaluate daily business functions, supply chain, and logistics	Hard
Commercial	Analyze market position, customer base, and competition	Soft
Tax	Ensure tax compliance, uncover unpaid liabilities	Hard
Human resources	Assess workforce, salaries, contracts, and company culture	Soft
IT	Check technology infrastructure, cybersecurity, and risks	Hard
Environmental	Identify environmental liabilities and regulatory compliance	Hard
Strategic	Ensure alignment with long-term business goals and synergies	Soft

1. Financial due diligence

Financial due diligence is about verifying a company’s financial health before making a business transaction. 

The goal is to confirm that the numbers are accurate and there are no hidden risks. This includes analyzing revenue, profits, debts, cash flow, and financial statements. Investors and buyers check if the business is profitable, whether it has outstanding loans, and if past financial performance matches future projections. 

For example, if a company claims to be growing rapidly, financial due diligence will reveal whether that growth is real.

2. Legal due diligence

Legal due diligence is about ensuring a company is playing by the rules and doesn’t have any legal skeletons that could come back to haunt it. 

This means examining contracts, intellectual property rights, any ongoing legal disputes or lawsuits, regulatory compliance, and ownership structures. The goal is to uncover any legal issues that might throw a wrench in the deal. 

For example, if a business is involved in a lawsuit that could cost millions, buyers need to know about it before they make an offer. It also confirms that contracts with employees, suppliers, and clients are solid and legally binding.

3. Operational due diligence

Operational due diligence looks at how well a company runs on a day-to-day basis. 

This includes supply chain efficiency, production processes, inventory management, and logistics. The goal is to assess whether the business is operating smoothly and can continue to do so after an acquisition. 

For example, if a manufacturing company has outdated equipment that slows down production, this could be a major issue for a buyer. Knowing about these issues beforehand helps investors determine if improvements or additional investments are needed.

4. Commercial due diligence

Commercial due diligence focuses on the company’s market position, customers, and competitive landscape. It helps buyers understand if the business can stay profitable in the long run.

This includes analyzing market trends, customer satisfaction, pricing strategies, and potential growth opportunities. If a company relies too heavily on one customer for most of its revenue, that’s a risk.

5. Tax due diligence

Tax due diligence ensures that a company’s tax records are in order and that there are no hidden tax liabilities. 

It involves reviewing past tax returns, tax structures, potential unpaid taxes, and compliance with tax laws. The goal is to avoid unexpected tax bills or legal issues after an acquisition. 

For instance, if a business has been taking advantage of aggressive tax loopholes that might not hold up under government scrutiny, this could lead to financial penalties. And buyers want to be sure there are no such tax surprises after taking ownership.

6. Human resources due diligence

Human resources due diligence examines the people behind the business. 

It includes employee contracts, salaries, benefits, workplace policies, and company culture. The goal is to understand the workforce’s strengths, potential risks, and any issues that could affect the company’s future. 

For example, if key employees are underpaid and likely to leave after an acquisition, that’s a major concern. This is especially important considering the statistics — 37% of employees leave the combined company after the acquisition. A motivated and skilled workforce can be a company’s biggest asset, so HR due diligence is crucial.

7. IT due diligence

IT due diligence assesses a company’s technology infrastructure, cybersecurity, software systems, and digital risks. 

The goal is to ensure that IT systems are reliable, secure, and scalable. Buyers check whether the company’s technology is outdated, whether it has strong data protection policies, and if there are cybersecurity vulnerabilities. 

For example, if a company’s customer database is not secure, this could lead to data breaches and legal problems. Considering that the average cost for a data breach is $4.88 million, that’s definitely something to take into account before proceeding with an acquisition.

8. Environmental due diligence

Environmental due diligence identifies any environmental risks or liabilities a company may have. This is especially important in industries like manufacturing, energy, or real estate, where pollution, waste management, and regulatory compliance play a big role. 

The goal is to ensure that the company meets environmental laws and does not have hidden liabilities, such as contamination on its property. 

For example, if a factory is releasing harmful chemicals into the water supply, the new owner could be held responsible for cleanup costs and fines.

9. Strategic due diligence

Strategic due diligence focuses on whether the deal aligns with the buyer’s long-term business goals. 

It goes beyond financials and operations to evaluate whether the company being acquired fits into the buyer’s overall strategy. This includes looking at synergies, potential cost savings, market expansion opportunities, and long-term profitability. 

For example, if a tech company buys a startup to expand into a new market, strategic due diligence ensures that the acquisition adds value. It helps buyers avoid deals that look good on paper but don’t make sense in the bigger picture.

How to prepare for due diligence in 8 steps

If you’re a company undergoing due diligence, follow these recommendations to ensure an effective and straightforward review process:

1. Organize data early. Gather all important documents, financial reports, legal contracts, tax records, and operational details, in one place. Use a structured folder system so that information is easy to find.
2. Set up a document management system. Since due diligence involves sharing sensitive information, use a virtual data room for secure storage and controlled access. This prevents unauthorized viewing and ensures smooth collaboration. Assign different access levels to manage confidentiality.
3. Use a due diligence checklist. An M&A due diligence checklist helps ensure no critical information is missed. It outlines all required documents, from financial statements to employee contracts, and helps to keep the process organized.
4. Review and update key documents. Make sure all records are accurate, complete, and up to date. Double-check financial reports, legal agreements, and compliance documents to avoid inconsistencies.
5. Communicate clearly with your team. Due diligence involves multiple departments, so ensure finance, legal, HR, and operations teams know their roles. Hold regular meetings to keep everyone aligned. Assign a single point of contact to manage questions and requests.
6. Prepare for common questions. Buyers and investors will ask additional questions if something isn’t 100% clear. Anticipate their questions and prepare clear, well-documented answers. A FAQ document can help streamline responses.
7. Be transparent and honest. Disclose any business challenges or risks upfront rather than letting buyers uncover them later. Transparency builds trust and shows professionalism. If there are issues, present a plan to address them.
8. Stay flexible and responsive. Due diligence can take weeks or months, so be prepared for follow-up questions and extra document requests. Quick responses keep things moving and show your company is well-prepared. Have backup copies of essential files ready.

Challenges and best practices in due diligence

The due diligence process can come with certain challenges. Here are the most common ones and possible solutions to them:

• Time constraints. Due diligence can be a long and complex process, but tight deadlines often add pressure. Rushing through it increases the risk of missing critical details.
  Solution. Start preparing documents early and use a structured checklist to stay organized. Assign a dedicated team to manage the process and ensure everything stays on track.
  
• Incomplete or disorganized data. Missing or unorganized documents slow down due diligence and create doubts for buyers or investors. If key records are hard to find, it can lead to delays or even deal cancellations.
  Solution. Set up a virtual data room with a clear folder structure. Keep all financial, legal, and operational records updated and easily accessible.
  
• Legal complexities. Understanding contracts, regulatory requirements, and potential liabilities can be challenging, especially for businesses operating in multiple regions.
  Solution. Involve experienced legal advisors to review all contracts and compliance documents. Conduct a pre-due diligence legal audit to identify and fix potential issues before the process begins.
  
• Poor communication between teams. Due diligence requires input from multiple departments, and lack of coordination can cause misunderstandings and slow responses.
  Solution: Use dedicated project management tools like Asana or Trello to assign tasks and track progress or collaborate over documents right inside VDRs via Q&A sections.
  
• Cybersecurity and data privacy risks. Sharing sensitive business information online comes with potential risks. A data breach during due diligence can harm the company’s reputation and lead to legal consequences.
  Solution. Use a secure virtual data room with different levels of access controls. Limit document permissions to authorized users and track all file activity.

How VDR simplifies due diligence processes

A virtual data room is a secure online platform that helps businesses store, organize, and share sensitive and confidential documents during due diligence. 

Here’s what virtual data rooms have to offer for a faster, safer, and more efficient due diligence process:

• Centralized document storage. A VDR keeps all your important documents in one place, making it easy to organize and access everything you need for due diligence. Instead of searching through emails or physical files, you can quickly find financial reports, contracts, and other critical records in a secure, centralized location.
  
• Enhanced data security. VDRs provide high-level encryption, multi-factor authentication, watermarking, built-in redaction, Fence View, and much more to ensure that only authorized users can view or edit documents. This minimizes the risk of data breaches or unauthorized access.
  
• Access controls. Virtual data room administrators set access permissions for who can view, download, or edit each document. For example, you may want to restrict access to specific financial data to only certain users. This level of control ensures that your sensitive information is protected and only shared with the right people at the right time.
   
• Collaboration features. A VDR allows multiple deal participants to work together via Q&A sections. You can leave comments, request documents, and ask questions directly on the platform. This keeps communication clear and organized, reducing the need for endless email chains and meetings
  
• Reporting and analytics. VDRs offer detailed audit trails to track how users interact with documents. You can see who has viewed, downloaded, or printed files, giving you insight into what’s being reviewed and by whom. These analytics help keep the process on track, identify any roadblocks, and ensure that all critical documents are being properly reviewed.
  
• Easy document management. Managing documents in a VDR is straightforward. You can upload, categorize, and organize files with just a few clicks. The platform also allows for easy version control, so you won’t have to worry about outdated documents being reviewed.

Key takeaways

• Due diligence refers to the process of reviewing the target company’s operation and key documentation to ensure it’s worth investing in or purchasing.
  
• The due diligence can be hard and soft. Hard due diligence looks at the measurable, concrete details of a business, while soft due diligence focuses on the people side of the business.
  
• The main types of due diligence are financial, legal, operational, commercial, human resources, IT, environmental, tax, and strategic.
  
• Using a virtual data room for due diligence can make the process much faster, smoother, and more efficient.

FAQ

What is the main purpose of due diligence?

The main purpose of due diligence is to assess the value and risks of a business before making important decisions like a merger, acquisition, or investment. It helps verify information, uncover potential issues, and ensure a well-informed decision-making process.

Which type of due diligence is most important in M&A?

Financial due diligence is usually the most important in M&A because it helps assess the financial health of the target company. This includes reviewing financial statements, liabilities, and any potential issues that might affect the deal’s value.

How long does a typical due diligence process take?

A typical due diligence process can take anywhere from a few weeks to a few months, depending on the complexity of the deal. Larger companies or more complicated transactions tend to require longer due diligence periods.

Can due diligence uncover hidden risks?

Yes, due diligence is designed to uncover hidden risks such as financial irregularities, legal liabilities, or operational problems. Thorough due diligence helps identify these risks early, allowing companies to make informed decisions or renegotiate terms.

What tools are best for managing due diligence processes?

Virtual data rooms are the best tools for managing due diligence, as they allow secure document storage, easy access, and efficient collaboration. Other tools like project management software can also help keep the process organized and on track.