Due Diligence is a commonly used term in the world of private funding and equity.
But what exactly does it mean?
Why is it important, and what is entailed in due diligence processes?
Most importantly, why are up front fees the norm in the private funding industry?
Clients perform due diligence on their consultants or investment bankers, investors perform due diligence on their clients, and attorneys perform due diligence on clients, brokers, project principals and many other legalities of projects, people, funding mechanisms and tax structuring.
People perform “due diligence” all of the time, whether in the financial arena or not. For a simple analogy to relate to the private funding world, consider the home purchasing process.
When a couple goes to purchase their first home, they do a certain amount of due diligence to make sure the home is in the right price range, the right school district, is close enough to the shopping centers or far enough in the country (depending on their preferences). They hire home inspectors to uncover potential problems so they are not surprised by an expensive or unsafe underlying issue. They often purchase a home warranty to cover the replacement of major mechanicals if they happen to fail after the purchase. They also hire a professional realtor or broker to help guide the process and represent them so their purchase is legal, safe, and fair. The buyer and seller can expect to sometimes pay up front fees for inspections and remedies, in order to be sure the home, and the transaction, is a wise choice.
Why are they doing all of this due diligence just to purchase a home?
To protect their investment, of course, and to mitigate risk and remedy any hazards or issues that could cost them a small fortune after the purchase, if overlooked.
While the majority of people understand home-purchasing processes, inspections, and other things as normal “due diligence” that must be performed before purchasing a home, many “green” or novice entrepreneurs or private funding clients are not prepared for due diligence processes that must occur before a private investor, investment banker, or hedge fund can draft terms and release funds for project funding or an acquisition.
If due diligence processes occur during home purchases, then they will certainly occur for major, private financial transactions and agreements.
Some would define due diligence as “reasonable steps taken by a party or company to satisfy the legality and legitimacy of a transaction”. Others might define it as “a comprehensive appraisal of a business, asset and/or it’s management team”. In the investment world, it can also be defined as “a thorough investigation of a potential investment” or “the research, process and care taken before entering an agreement, investment or financial transaction”.
Before an investor, investment banker or hedge fund decides to invest millions of dollars in a start-up, acquisition, natural resource foray or business expansion, they must perform due diligence on the company, the plan, the management team, the performance history, and the future proforma, specifically the likelihood that they will receive their return on investment.
Since they will be investing millions of dollars, there will be significant costs, time and professional analysis and verification of facts by 3rd party sources in order to be sure that the investment is sound, and also structured properly.
It is normal for investors and funds to expect the client to pay for these due diligence processes in order to gain access to the private funds. No legitimate investor will pay out-of-pocket to hire the needed professionals to perform due diligence to verify if a client and his or her plan is a solid investment, or to structure an investment properly so that it is an investment-grade vehicle.
However, the amount of due diligence fees vary greatly depending on the complexity of the project, the number of funding sources needed to fund the project, the number of stages the project needs for development, the location, the source(s) of funds and necessary processes and legalities, and many other variables.
The investor, fund or investment banker must have some kind of commitment from the client in order to be sure their time and resources are going to be used wisely, and that the client will not walk away during the process, or balk at the signing table.
When applicants put a team and a business plan together to submit for private funding, all they usually have is a set of documents, they do not have an actual business, unless they are acquiring one.
That being said, before any wise private investor or fund manager would invest in that client and his or her team’s plan (because they essentially are investing in the applicant’s competence to carry out a successful plan), they must verify everything. In order to verify the facts pertaining to the project and its team, they often must pay staff or outsource professionals to do this verification for them. This costs time and money.
Attorneys are hired, appraisals are ordered, geological studies and feasibility studies are sometimes developed. Financial professionals such as accountants, analysts and underwriters are often hired to structure the funding mechanisms in order to make the funding possible. These professional man-hours can cost thousands of dollars before a project can be funded legitimately. Additionally, depending on the project, insurance wraps are needed in order to secure the investment.
The bottom line is, all of this costs time, money, and professional man-hours in order to verify and structure a plan or project into a palatable investment-grade vehicle that will satisfy the comfort level, tax considerations, as well as the guidelines for the funding mechanism in order for successful funding to occur.
Additionally, the investor or fund board is considering entering into a short to medium term business, financial or fiduciary relationship with the client. In essence, they are becoming a part of the business team, creating the funds to fuel the success of the project. To reach a level of comfort and to ensure the best possible success for all parties involved, it makes more sense to incur a few thousands in expenses up front, in order to ensure that several millions will not be mishandled or lost from a poor investment, faulty management, or improper investment and tax structuring.
Additionally, private investors, investment bankers and fund managers are approached with literally dozens of potential projects and pitches to fund every week. Most of those projects are not ready to be funded because either the project is not structured properly or the team is not ready to handle the finance and the business project.
However, those principals and projects that are ready to handle the funds are those who are mature and seasoned enough to be willing and able to pay due diligence fees to prove their commitment to the process and to see the project to success and full fruition. The due diligence process and fees that investors and investment bankers employ act as a gate-keeper, filtering out those projects and applicants who are neither serious nor prepared for financial success.
Those principals who are truly prepared to engage and handle millions of dollars from a fund or investor understand that a few thousand in due diligence fees is a drop-in-the-bucket to gain access to millions of dollars to fund a successful project.
In addition to the funds, principal applicants and entrepreneurs will also gain relationships with wealthy individuals, investment bankers and other fund managers who are capable of funding future projects. Long-term thinking and relationship building in the private funding world do not always guarantee success, but they are certainly necessary for success.
5th Avenue Capital has access to private funds and equity to fund projects across many industries in the USA, Canada, and abroad. To see if your acquisition, or project and team is properly structured and prepared for successful funding, contact us today to begin a relationship and your path to private funding success.
