What Due Diligence Really Means Or Not

October 13, 2010       Thomas McLaughlin      

There are certain management phrases that roll off the tongue easily and suggest authoritativeness. “Cost/benefit study” is one. “Business model” is another. But the all-time favorite phrase in this unofficial competition is the phrase “due diligence.”

There is something so responsible-sounding and business-like about the term that it conveys instant credibility on the speaker. It also tends to put the listener on the defensive. Yet rarely does anyone actually describe what is meant by the term.

Many people who use the term due diligence assume that there is no need for spelling it out because others already know in detail what they mean, even if they themselves don’t know. Listeners don’t ask what is meant by the term because they assume the speaker must know. The result is that the term lives in a kind of fog that never lifts because for most people the term is nothing more than a code word for “acting responsibly.”

It also conveys a sense of complexity far better than the equally valid “research and analysis.”

The reason for all this confusion about what “due diligence” means is because . . . it means different things depending on the context. None of this diminishes the importance of due diligence wherever it is needed. But to develop a clearer picture of what this means requires some, well, due diligence.

As with any good due diligence investigation, you start with history. The term was first used in the Securities Act of 1933 as a legal defense against investor lawsuits that securities brokers could employ. If the brokers conducted “due diligence” in their research into a company whose stock they sold, and if they told buyers about what they found, the brokers would not be held liable if the trade went bad.

Not surprisingly, this practice quickly became standard in the securities industry since it rationalized procedures and made life more predictable for equity broker/dealers. Later it came to be associated with for-profit mergers and acquisitions. Today it is creeping into for-profit companies’ international business partners because of the Foreign Corrupt Practices Act.

Although nonprofits don’t, by definition, issue shares to be sold on the secondary market, the term is firmly embedded in all kinds of nonprofit collaborations, particularly mergers. Those in fundraising circles use it occasionally, and it is also drifting into casual governance and management circles where it means nothing more than “do your homework.”

This is all to the good, but those wanting to be responsible and do their ‘due diligence’ in any nonprofit context must still start with a blank sheet of paper. To narrow that focus constructively, we will identify some of the key components of a nonprofit due diligence investigation. We will also implicitly assume that the due diligence process occurs in the context of some form of collaboration.

* It’s about risk. The due diligence process is about reducing risk. In this way they are consistent with the historic origins of the term, minus the exchange of equity. It is little recognized that the institutional effects of responsibly managed funding sources such as foundations and government entities are a major source of risk reduction. Foundations’ “risk” of losing money on a grant is 100 percent, so the real risk they must avoid is picking the wrong grantee. Proposals, review committees, and program officers are essentially due diligence/risk reduction mechanisms for foundations, and governments usually have comparable processes and functionaries.

A good due diligence process will start with the expected sources of risk. A strong alliance will operate via contractual agreements, and so the due diligence will be mostly around the projected profit and loss (financially or otherwise), not on the assets and liabilities of the participants. In nonprofits reputational risk can translate quickly into dollar losses, so the streetsmart manager needs to be very confident about the partner’s good name.

* Materiality counts. The intention in a good due diligence process should be to identify factors that are material to the project’s success. The standard financial definition of materiality applies: a factor is material if a reasonable person would think or act differently were they to know of the existence of that factor. ‘Materiality’ here has two elements, scale and process. The scale of a fact in relation to the size of an organization is what is important. Is it material that the organization accidentally paid a $35 invoice twice?

Unlikely. But in an organization with revenues of $150,000, a $35,000 mistake would be material. Process adds a different dimension to the materiality question. Would it be material that the small organization paid 10 different $35 invoices twice? Still the answer should be no when considering financial impact ($350 is not material in even a small organization), but the pattern could be a concern here, and that’s what should be investigated.

Materiality is usually spoken of in a financial context, but those involved in a due diligence process would do well to apply the same principles to all aspects of the mutual learning process. Material facts about governance and brand strength are every bit as important as financially material items.

* Topics should be wide-ranging. While the aura of due diligence processes is that they are either financial or legal, important facts don’t necessarily fit into either category. Things such as the culture of governance, a CEO’s personality, and the value of a particularly unique program could all be legitimate areas of inquiry. Moreover, a due diligence process in connection with an alliance or a merger would naturally focus on areas quite different from a due diligence process in connection with a possible fundraising partner.

* Results transparency. A good due diligence process is transparent. It’s not enough that the work was done and the facts were identified, the power of the process comes from the knowledge that the findings will be shared. Often board members and executives involved in a major transaction learn as much if not more about their own organization than about the other one.

This is one of the areas where nonprofit transactions, especially mergers, are vastly different from the for-profit sector. In the for-profit environment, managers may succumb to pressure — explicit or implicit — to hide bad news from a partner because it could harm individual egos, outsized bonuses, and stock prices. In the nonprofit sector we only have to worry about the first of these. This can still be a substantial barrier, but at least it’s more focused in nature.

* Analyses. There is a great temptation among many licensed professionals to simply document their findings. This is usually helpful — but only to a point. Doing so simply takes raw data and re-works it in such a way that it produces information. The real benefit, however, comes from answering the “so-what” question. What does a particular situation mean, and what are the implications for one or both organizations? This moves the dialog beyond mere information and into understanding and knowledge.

* Range of inquiry. One of the largely unacknowledged aspects of due diligence investigations is the range of the investigators. Legal investigators will concentrate on legal matters, financial investigators will concentrate only on financial matters, and so on. How does one know where to start and when to stop?

The most pressing unanswered questions of the transaction will usually determine the starting point, but in practice there is no way of knowing when to stop. Since there is no one-size-fits-all “due diligence check list” the finish line will be drawn by a combination of leadership preference and available funds. The logical endpoint is when leaders on both sides feel similarly reassured that they have covered a reasonably full range of topics in a responsible fashion.

Nonprofits have little to do with the sale of investment vehicles, but they are an investment of a higher order. When they are involved in a transaction of any significant scale, leaders of both nonprofits have a fiduciary obligation to do their homework. This is what’s really due. ****Thomas A. McLaughlin is vice president of consulting services, Nonprofit Finance Fund, and a member of the faculty at the Heller School for Social Policy and Management at Brandeis University. His email is tom.mclaughlin@nffusa.org.