Due Diligence

Abstract

Due diligence is common practice prior to the execution of corporate transactions. We propose a model of the due diligence process and analyze its effect on prices, the division of surplus, and efficiency. In our model, if the seller accepts an offer, the winning buyer (the acquirer) has the right to gather information and chooses when (if ever) to execute the transaction. Our main result is that the acquirer engages in “too much” due diligence relative to the social optimum. Nevertheless, allowing for due diligence can improve both total surplus and the seller’s payoff compared to a setting with no due diligence. The optimal contract involves both a price contingent on execution and a non-contingent transfer, resembling features such as earnest money or break-up fees that are commonly observed in transactions involving due diligence.

Keywords: Learning, Dynamic Games, Asymmetric Information

JEL Classification: D82, D86, G34