Due Diligence

In general business terms, due diligence refers to the scrutiny used by an individual or a group of individuals considering making a purchase of some sort. Those conducting due diligence do so to determine the degree of risk associated with a particular course of action, such as funding an initial public offering (IPO) or an investment. In the case of an acquisition or merger, the attorneys or accountants working for the purchasing party conduct due diligence when they examine the financial status, competitive position, and management practices of the business under consideration, as well as the legality of the deal. When upstarts and established companies seek funding, one of the main reasons they complete detailed business plans is to assist lenders in conducting due diligence. It is the responsibility of the lenders, however, to verify the data contained in such a document.

In the late 1990s, the dot.com bubble, which continued to grow as highly publicized predictions of astronomical growth in e-commerce began to saturate mainstream media outlets, prompted many venture capitalists considering an investment in a young Internet upstart to relax due diligence standards. The highly successful IPOs of firms like Netscape Communications Corp., Amazon.com, and eBay.com, fueled the investment community's desire to move dot.com upstarts towards IPOs as quickly as possible, despite the fact that obtaining profitability would, in all likelihood, take many years. Venture capitalists tended to overlook the fact that most of these new businesses were based on unproven business models. The examination of things such as the likelihood of long-term success, the experience of executives, and the integrity of financial forecasts became increasingly relaxed. According to an April 2001 issue of Oregon Business, "Many investors, fearful of missing out, seemed to skip the traditional drawn-out due diligence and hardly paused before infusing startups with capital to get a piece of the dot.com action. The message was clear: strike now or taste dust." Formal business plans for dot.com, if they were submitted at all, tended to be much shorter and less detailed than their traditional counterparts. In fact, a March 2000 study of 300 e-commerce businesses in California revealed that most launched operations with no business plan in place.

This lack of planning eventually caught up with many of the fledgling firms when shareholders began pressuring on some of them to achieve profitability. When dot.com stocks began tumbling in 2000, funding sources evaporated in a hurry. Many upstarts, which had relyied on the availability of additional capital for expansion, had no choice but to close their doors, a phenomenon which drove the stock prices of the remaining Internet players down even further. Recessionary economic conditions compounded the problem, and dot.com investors sustained major losses. As a result, venture capital funding by the middle of 2001 was less than half of what it had been during the first half of 2000. In the third quarter of 2001, only 540 companies had raised $6.7 billion in venture capital funds, compared to the 1,634 companies that raised $23.9 billion during the third quarter of 2000. Although investors willing to pour capital into Internet related ventures still exist, the level of scrutiny to which they subject their applicants has substantially increased. As stated by an October 2001 article in Puget Sound Business Journal, "The venture community is witnessing a return to stricter investment criteria, more thorough due diligence and tighter term sheets…venture capital funds can no longer rely upon abundant capital, frothy IPO markets, and a carnivorous mergers and acquisitions market to mitigate lax investment practices."