Due diligence is an opportunity for an Investor to confirm their investment expectations, uncover risks in the transaction, and learn more about the recipient of the investment funds, its management team, and the industry in which the business operates. Due diligence in an impact investing transaction involves an investigation of the social enterprise key individuals for the purpose of identifying risks, and is an important opportunity to confirm mission alignment and set impact related expectations. The scope of diligence will depend on:
The nature of the transaction – What are the funds going to be used for?
The size of the transaction – How deep of a dive is warranted for the given transaction?
The structure of the investment – will the funds be loaned or invested in exchange for equity in the business?
The location of the investee – What are the relevant local law considerations for enforcing a lender's or investor's rights?
Depending on the nature of the transaction, there may be several different types of due diligence efforts undertaken by different parties at the same time. In most cases, the investor's business team will perform business, financial and accounting due diligence on the investee. Counsel will perform legal due diligence.
Key Items to Consider
Due diligence budget
Scope of review
Whether any outside consultants will be required
Whether there are any sensitivities that should be a primary focus of inquiry
Whether are any threshold issues exist that could make or break the deal ("deal breakers")
Impact on the Transaction
Due diligence is a necessary part of any significant investment transaction. The results of the diligence investigation can impact the transaction in the following ways:
Purchase price. If a due diligence finding affects the valuation of the target company, the investor may need to adjust the purchase price. For example, if an investor discovers a liability that was previously unknown, the investor may reconsider its decision to invest, or amend their offer to reflect the greater liability.
Representations and warranties. An investor often uses the representations and warranties as protection against unknown liabilities. If, for example, during diligence the investor discovers that certain permits are very important to the operation of the business, the investor may insist on a full representation and warranty that the target business is in compliance with all permits. If this representation and warranty turns out to be false, the investor may seek indemnification post-closing.
Deal termination. In extreme situations, due diligence findings may cause a party to terminate the transaction ("deal breakers"). There may be certain issues which either drastically affect the value of the target business or otherwise impact the investor's desire to make the investment. For example, if an Impact Investor is investing in a company primarily on the basis of its social impact performance record, and then discovers that none of the impact can be verified, or that the company has significant other non-mission aligned activities, the investor may choose to terminate the deal and pursue different opportunities. It is important to identify any deal breakers early in order to focus on these issues.
Pre-closing covenants. The due diligence findings may raise issues that the investor wants the company to correct prior to the closing of the investment. For example, an investor may require the management team to commit certain resources to mission-aligned activities, and to impact measurement prior to closing.
Due diligence is essential to all deal making because it allows a party an informed decision as to whether it should enter into a transaction, and if so, on what terms. In an impact investing transaction, due diligence also ensures that public statements are not based on incorrect information and do not provide incomplete or misleading disclosure. If conducted effectively, due diligence is an extremely valuable tool for uncovering risks that can either serve as bargaining points for negotiating the terms of an agreement or as reasons to withdraw from the deal. Failing to recognize these risks can cause significant problems for an investor, ranging from an unfavorable business transaction to missed opportunities to create or drive impact, to liability and damages.
Lending transactions for impact investors
Equity investments for impact investors