The Difference between Legal and Financial Due Diligence and How to Efficiently Coordinate the Two

It’s a difference that ChatGPT can’t clearly explain. It’s something that any professional M&A player knows by heart but still – struggles to define. What exactly is the difference between legal due diligence and financial due diligence? And what is the best way to coordinate the two?

CPA (Adv.) Gilad Finkelstein

Preface

When it comes to transactions, due diligence is critical to ensure that what you see is what you get. Two critical types of due diligence are legal and financial. Let’s take a closer look at what each of these mean and how they differ. Finally, we’ll wrap up with the best way to coordinate the two.

The Legal Due Diligence – A Search for Authority

Legal due diligence is the mission to assert the target company’s powers and weaknesses. It is called legal because of the search for authority: authority to hold and transfer the company’s shares; authority to own the company’s assets; authority to smoothly participate in the economic environment; and, of course, the potential authority of third parties to demand assets from the target company.

In this search for authority, the legal team will thoroughly review everything from corporate documents and contracts to compliance with laws and regulations. The legal team will typically not look for performance indicators but rather use actual results as hints as to where they should focus their attention.

The Financial Due Diligence – Investigation into Performance

Financial due diligence is the investigation of the target company’s performance. It is the review and analysis of actual results. It is, at its core, a quantitative task, summed by the following questions: does the story of the target’s financials – which is supposed to represent the target’s performance over time – is (a) true, (b) coherent and (c) economically represents the target company results.

This investigation into performance requires a drill-down analysis of everything from revenue and expenses to assets and liabilities, usually through the target company’s financial records, such as trial balances and internal accounts. It also includes a review of the target company’s operational mechanism to ensure everything is noticed.

Where Do Financial and Legal Teams Meet?

The financial due diligence team needs a legal standpoint to set its investigation: every performance inquiry must benchmark itself to specific ground rules. For instance, when analyzing revenue, the financial team must be aware of any legal obligations (that is, the authority of a third party to demand assets) concerning the collected/not yet collected revenue.

These legal obligations might eventually reflect lower or higher performance than initially recorded. In other words, it’s usually the case where the financial team uses certain legal assumptions to properly adjust performance for analysis.

From the legal team’s point of view, it is interesting to note how legal specialists are often “blind” to certain material aspects of performance. A legal due diligence report often discusses immaterial issues of the business and, at the same time, fails to expand on relatively material topics. This blindness happens because the legal team is detached from the performance element of the business and therefore might lose context.

How to Coordinate the Legal and Financial Due Diligence Teams

Coordinating the financial and legal due diligence teams, as established, can make the deal smoother and safer. Here are a few ways to coordinate the two teams effectively:

  1. Set clear objectives at the Engagement Letter stage: Before starting the due diligence process, share both the financial and legal due diligence teams with each one’s scope of work. Let each team leader acknowledge the goals of the parallel team to avoid misunderstandings.
  2. Appoint a point person: There’s nothing like personal touch and direct communication. As we always recommend, a project manager or an M&A advisor can facilitate mandatory communication between the teams and even set up face-to-face meetings.
  3. Use a virtual data room the right way: storing and sharing documents and information with both teams using a secured cloud environment with advanced marking and tagging protocol reduces the risk of overlooking material aspects of each team .
  4. Debate key topics mid-process: Don’t wait for a draft. Debate with the specialists on key topics they are finding, even before they start drafting reports. Overall, the name of the game is to brainstorm with a joint goal in mind.

To conclude, legal due diligence is an authority voyage concerning the target company, while financial due diligence is a performance inquiry. The interesting thing is that they serve each other’s findings. We at Finkelstein Financials believe that all M&A professionals should think about efficiently coordinating the two.

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