Blog Details

WHAT IS DUE DILIGENCE?

Due diligence is an examination and appraisal of a business undertaking to establish its assets, liabilities and compliance status and to evaluate its commercial potential.

A potential buyer primarily conducts due diligences or investor on the target or investee company to understand and verify the full the potential of the acquisition or investment.

You will look at a key market or product problems when carrying out due diligence, including revenues, financial risks, legal risks and non-compliances and all red flags, which could be a deal-breaker.

Due diligence of documentation is always carried out from the inception of a company to check and analyse historical documents and predictions for the future.

Hence, it can be said that Due Diligence is not just data entry but analysis of a company’s compliance and health status and ensuring that it is conducting business in line with applicable law.

HOW TO DO DUE DILIGENCE?

Due diligence by small companies can be a lengthy and complicated process. It requires going through the documents of a company, from its inception, checking references, making sure all documentation is in order and compliance with applicable laws, rules and looking for things that may not have been voluntarily disclosed initially.

Three most important things should be kept in mind while performing Due Diligence: -

1)      Never Conduct Due Diligence alone

Don't carry out due diligence business alone. It always recommended hiring appropriate consultants and experts to aid in the due diligence process such any financial consultants, legal advisors and technical experts who have the know-how and expertise in this field. While you can definitely be interested and look over records, it's best to have experts on your side. They know how to check for red flags you may have overlooked on your own.

2)      Give importance to the confidentiality agreement

You can sign a confidentiality agreement with the other business owner when you begin the due diligence process. By signing, without the consent of the other business owner, you agree not to contact individuals or organisations for further details about the business or product. This stops others from finding out about the sale or investment prematurely until it is finalised.

3)      Read and Re-Read all the documents carefully

To ensure that you fulfil all aspects of the due diligence process, go through a due diligence checklist with your consultants and advisors. There may be a guide from your consultants’ and advisors, but you can build your own.

TYPES OF DUE DILIGENCE

Due diligence applies to many aspects of a business. See how they’re used in some key areas listed below:

1)      Mergers and Acquisitions

A company acquires or purchases the entire share capital of another company (or even part of another company) in an acquisition; Reliance Retails acquisition of Future groups businesses (Big Bazaar, FBB, etc.)is a recent example. Due diligence helps enterprises do the following in any case:

●        Make sure that all information reported by the seller is accurate.

●        Find and mitigate any risks.

●        Ensure compliance with legal and regulatory requirements.

●        Allow the deal to be priced based on facts, not assumptions.

Doing due diligence allows the buyer to decide if the transaction is really going to be made and how much it should cost and what are the risks and red flags, one must be aware of and how they can be tackled or remedied.  

Acquisition by or of a listed entity has to follow processes and rules laid down by SEBI (market regulator), which can be delved in to in a different article.  

For a merger, companies have to go through a court process to give effect to the merger; however, till the companies proposing to merge comes to the final stages of obtaining the court order, they need to do their due diligence to weigh in the pros and cons of the merger and whether such the merger will be beneficial to the interest and growth of the company and also beneficial interest to the shareholders of the companies.

To understand in layman terms, a merger is an agreement that unites two existing companies into one new company. Mergers and acquisitions are commonly made to expand a company's reach, expand into new segments, or gain market share. All of these are done to increase shareholder value.

In the M&A world, the ideas of soft and hard due diligence often come up. The typical method mentioned in this article is harsh due diligence; on the other hand, soft due diligence focuses on the fitness of society and other aspects of how individuals function together. If it seems like the two cultures of the acquiring and target companies do not mix well, then the companies will have to adjust staff decisions, especially with top executives and influential staff.

 2)      Securities Investment (Private Equity or otherwise)

Investment in the shares and securities of a company by an investor, whether an individual or an angel investor or even a private equity fund (both domestic and international) requires thorough due diligence of the investee company.

By way of the due diligence, the investor can determine the risks in the investee company and how to safeguard themselves against such risks under the investment agreements.

 3)      Business Transfer or Asset Purchase

A buyer may not essentially at all times look at acquiring securities of a company but may look at acquiring only part of the business of another entity, without having to buy the shares and taking on the liabilities in the books of the seller company.

In the case of a business or asset purchase, the due diligence in most instances is limited to the business or assets being proposed to be acquired. The diligence throws open the nuances of that business/asset and gives the buyer a better understanding of the potential of such acquisition. 

 4)      Initial Public Offering (IPO)

Before a company prepares to go in for an  IPO, its attorneys, underwriters, and the company itself have to prove to SEBI that the declarations the company made when filing are true. The company has to provide a whole gamut of information about their organization, including those of its subsidiaries, group entities, key employees, promoters, etc. The lawyers and underwriters have to conduct a detailed audit and due diligence of the company to provide all information statutorily required to be disclosed under the offer document and more, including but not limited to risk factors. The complete disclosure enables subscribers to the IPO to make an informed decision about the company before making their investment.

It must be noted that SEBI as the regulator reviews the draft offer documents with a fine comb and reverts with its observations and such observations have to be taken on record by the underwriters and lawyers and the offer document has to be updated and then only can the company go public.

When a company is looking to list itself on the stock exchanges, it must start doing its internal due diligence, much before, to get its records and paperwork in order. 

5)      Banking Activities

To ensure that potential customers are not involved in criminal activities that could bring legal action against the institution, banking and financial services companies may conduct due diligence on them.

6)      Enhanced Due Diligence

Due diligence is not always enough. In such cases, organizations perform enhanced due diligence, which is required when a potential banking customer poses a higher risk of being connected to money laundering, terrorist financing, or other financial crimes. A customer may run a higher risk due to their business activity, ownership structure, or anticipated or the actual amount and types of transactions (this includes transactions that involve higher-risk jurisdictions).

7)      Due Diligence Simplified

Simplified due diligence means doing a less stringent version of regular due diligence, unlike enhanced due diligence. When the client runs a shallow risk of money laundering, terrorist funding, or other financial crimes, the company should enforce simplified due diligence. In the European Union and a few Asian nations, this word is more common than in The United States.

8)      Contingent Due Diligence

Contingent due diligence is a term used in real estate to designate one of the status periods before the deal is final. During the contingent due to the diligence phase, the buyer can terminate the deal without penalty (generally for any reason).

9)      Internal Due Diligence

Every company must from time to time conduct legal, financial and technical audits and diligences internally to ensure that its company is compliant with all laws, rules and regulations and is always investment or IPO ready.

WHY IS DUE DILIGENCE IMPORTANT?

The due diligence process plays multiple roles in a merger or acquisition that favour both buyers and sellers. Such advantages include the following:

●  Enables a buyer or investor to confirm the seller's or target company’s financial, contract, consumer, and other relevant details

●  Paints a complete picture of the transaction's reach, including the identification of previously undisclosed issues and properties

● Leads to more detailed pricing (depending on what due diligence shows, the original bid could rise or fall) because decisions are better informed.

● Allows a buyer or investor to reconsider or step back from a proposed investment deal if the due diligence shows red flags that are too onerous or high on liability or which are difficult to remedy.

● It provided the buyer and the investor with greater understanding, clearer perceptions and improved the comfort of what is required of them to close the deal with the target company.

● Reduces the purchaser-seller, investor-investee awareness divide, leading to better (and better-informed) decisions.

1.       SET OUT A DUE DILIGENCE PROCESS

Once you decide on an acquisition or investment target, it’s vital to do due diligence before completing the purchase or investment. The acquisition or investment process typically starts with the buyer/investor and seller/investee company agreeing to a letter of intent that outlines a framework for arriving at a final definitive agreement. The buyer should be sure to include provisions for due diligence as part of the letter of intent.

The provisions generally include a timeline for completing the due diligence (one to two months is common) and a process for the seller to provide access to records, premises and, in some cases, key employees for the review.

Records are often made available either at the premises of the seller or through a secure online portal. These generally include:

● the company’s strategic plan, articles of incorporation, bylaws, ownership information, organizational chart and marketing and sales strategies

●  financial statements and tax returns for the past three years

●  budgets and financial projections

● breakdowns of sales, expenses, gross margins, accounts receivable and payable, product lines, inventory, liabilities, customers, markets, competitors, assets, intellectual the property, equipment leases and insurance coverage

●  a description of legal, regulatory, tax and customer issues affecting the company

● details on personnel, outside professionals and third parties working for the company

●  documentation on legal compliances across the business of the seller.

Due diligence often also requires on-site visits to inspect buildings, manufacturing facilities, equipment and interview key personnel.

2.       ASSEMBLE A DUE DILIGENCE TEAM OF YOURS

Selecting eligible individuals for due diligence is important. The financial statements of the organisation should be reviewed by an accountant specialised in business acquisitions.

A lawyer should check legal compliance and disputes involving the business. The legal analysis can include advice from specialised lawyers on some topics, such as labour contracts, real estate assets, intellectual property and licenses and approvals.

Buyers may also want to bring in other experts—market assessment experts; IT specialists to check technology assets, or environmental consultants to study contaminants and hazardous materials or product specialists.

3.       CONDUCT THE DUE DILIGENCE

a.       Study the books

An accounting due diligence review is critical for a successful acquisition. A specialized accountant should review the target company’s financial statements, budget, projections, tax returns and other records to analyze the numbers and the assumptions behind them. The goal is to make sure the figures add up and that the company is worth what you’re proposing to pay.

The accounting review can also uncover important issues such as:

●  tax liabilities

●  an undiversified customer or supplier base

●  poor product profit margins

●  significant needed repairs

●  old equipment

●  sluggish inventory turnover

●  slow-paying customers

●  operational inefficiencies

●  high employee turnover

b.      Carry out legal due diligence

It’s also important to review all legal issues affecting the business. These will include but not be limited to:

●  pending or threatened litigation

●  employment contracts

●  customer and client agreements

●  laws and regulations affecting the company

●  licenses and permits

●  real estate and intellectual property issues

The legal review allows you to quantify any legal risks and understand potential remedies. It also helps structure the definitive agreement that’s appropriate for the company’s legal risks, governing documents, contracts and applicable laws. The findings from legal due diligence enable a buyer or investor to formulate the definitive agreement in a manner to safeguard itself from future liabilities and also take representations and indemnifications from the seller.

c.       Look at the market

An often-overlooked step in due diligence is a validation of the target’s market environment, known as commercial due diligence. This process looks at the company’s market share and positioning, industry trends, assumptions behind projections and future risks and opportunities.

4.       REASSESS THE PURCHASE TERMS

Depending on what your due diligence uncovers, you can revisit your offer price and other terms in negotiations on the purchase agreement. It’s common for the offer price to be revised downward because of the due diligence review and findings and even for the purchase offer to be retracted.

CONCLUSION

This article is a brief write up to understand the different types of due diligence and its merits. However, each transaction has to be dealt with independently, on a case to case basis, to define and understand the parameters of the due diligence and the goal to be achieved from it.

Disclaimer

This article has been written for the general interest of the public and is subject to change. It is not intended to be an exhaustive or a substitute for legal advice. We cannot assume legal liability for any errors or omissions. Specific advice must be sought before taking any action pursuant to this article.

For further clarification, you may write to us at deblina@adventjuris.com