WHAT IS DUE DILIGENCE?
Due diligence, in its broadest definition, relates to the amount of judgement, caution, prudence, resolve, and action that a person would be reasonably expected to exercise under certain circumstances. It encompasses of exhaustive research of a corporation as one of the first steps in a proposed merger or acquisition in corporate law. For a business acquisition, it entails of completely comprehending all of the company’s obligations: debts, ongoing and possible litigation, leases, warranties, long-term customer agreements, employment contracts, distribution agreements, compensation arrangements, and so on.
WHAT IS THE PROCESS OF DUE DILIGENCE?
Due diligence is the process of gathering objective and trustworthy information on a person or company ahead to a certain event or decision. It is often a methodical research effort intended to obtain the crucial facts and descriptive information most useful to reaching an informed decision on an important matter.
Due Diligence for a company-
For a company, it can be said that due diligence is a vital analysis process that companies go through before making massive business decisions such as corporate mergers/acquisitions or major product purchases/sales. The due diligence process, whether outsourced or carried out in-house, is essentially an attempt to provide company owners with accurate and complete background information on proposed business transactions so that they can make informed decisions about whether to proceed with the corporate transaction.
This process essentially involves everything from reading the fine print in corporate legal and financial documents like equity vesting plans and patents to interviewing customers, corporate officers, and verifying, investigating, or auditing a potential deal or investment opportunity to confirm all relevant facts and financial information and to verify anything else that was brought up during a Mergers & Acquisitions deal or investment process and key developers. It is conducted prior to the closing of a transaction with the ultimate purpose of ensuring that there are no hidden downsides or traps associated with the transaction under consideration.
WHY UNDERGO DUE DILIGENCE?
A merger or acquisition is the most significant corporate transaction that any company will undertake. In layman’s terms due diligence helps companies to enter into these agreements with confidence. It may bring substantial value for the buyer by uncovering the target firm’s flaws (or red flags) as well as opportunities that the target company was previously unaware of.
Furthermore, purchases that go through a due diligence procedure have a better likelihood of succeeding. Due diligence helps decision-makers make more informed judgments by improving th quality of information accessible to them.
WHAT ARE THE TYPES OF DUE DILIGENCE?
Financial due diligence: it involves concentrating on the company’s financial performance up to the current day and ensuring that the statistics provided in the financial statements are correct and sustainable.
Legal due diligence: This type is dedicated to the legal elements of the business and its connections with its stakeholders. Licenses, regulatory difficulties, contracts, and any outstanding legal responsibilities are common areas of analysis.
Operational due diligence: it entails of concentrating on the firm’s operations - essentially, how the company converts inputs into outputs. This is often regarded as the most advanced sort of due diligence.
Tax due diligence: It manages the company’s tax affairs and ensuring that all tax payments are paid in full on time. Tax due diligence considers how a merger may affect the tax liabilities of the new firm formed by the transaction.
WHAT ARE THE AREAS COVERED IN LEGAL DUE DILIGENCE?
The Legal Due Diligence process, when conducted in Company, investigates the following areas:
Intellectual Property- The Intellectual Property includes patent, trademark, trade secrets and copyright. The analysis of licenses, contracts and pending litigations of Target Company related to Intellectual Property is done.
Corporate and Legal Structure- The acquirer should understand the structure of the Target Company. The Memorandum of Association (MoA) and Articles of Association (AoA) are analyzed to get information regarding Corporate and Legal Structure of the Target Company.
Commercial Contract- The Commercial Contracts of Target Company is analyzed to identify the risks involved in these contracts. Commercial Contracts includes vendor contracts, service contracts, rental agreements, etc.
Employee Contracts- To understand the risks and liabilities towards the employees, the Employee Contracts of the Target Company are analyzed. Employee Contracts include wages and salary, employment terms, employment duration, pension plans, etc.
Tax Liability- The deferred Tax Liabilities of a Target Company are analyzed to look into any discrepancies related to it. If there is any liability related to tax liabilities, then in future there will be enormous liabilities for the acquirer.
Regulatory Compliance- The Target Company should be doing everything in adherence to the law and Regulatory Compliance of the Company.
Litigations- The Litigations of the Target Company, whether past or current all are looked into. Even the future Litigations are also being looked into to avoid any problem in future. Litigations can come through employees, customers, vendors and government.
Health and Safety Standards- The compliance with Health and Safety Standards of Target Company is checked. The workplaces these days should be secure for working. The employees are more concerned about their health. There should be a check on the safety gear and proper ventilation in the office of the Target Company.
Environment Laws- Compliance with environmental laws has become a vital issue nowadays. The acquirer should check for any matter related to non-adherence of Environment Law.
WHAT ARE THE STEPS INVOLVED IN DUE DILIGENCE?
Due Diligence is a lengthy process which involves multiple steps and phases. Listed below are general due diligence process steps:
Analyze the purpose of the project
The first stage, like with every project, is to define company goals. This assists in determining the resources needed, what information you need to gather, and ultimately ensuring alignment with the firm’s overall strategy. This includes introspective inquiries about what you want to accomplish from this inquiry.
Pre- Analysis of Financial business case
This is a thorough audit of financial documents. It guarantees that the documents described in the Confidentiality Information Memorandum (CIM) are accurate.
Furthermore, it aids in assessing the company's asset health, assessing overall financial performance and stability, and detecting any red flags.
Among the items examined here are:
Balance sheets and income statements
Inventory schedules
Future forecasts and projections
Revenue, profit, and growth trends
Stock history and options
Short and long-term debts
Tax forms and documents
Valuation multiples and ratios in comparison to competitors and industry benchmarks
Thorough inspection of documents
This stage starts with a two-way dialogue between the buyer and seller. The buyer requests relevant documents for audit, interviews or surveys with the seller, and site visits.
The seller's responsiveness and organization are critical to expediting this procedure. Otherwise, it may make the buyer's experience difficult.
The buyer then examines the information gathered to ensure proper business practices as well as legal and environmental compliances. This is the most important aspect of the due diligence procedure.
Overall, the buyer acquires a greater grasp of the company as a whole and can more accurately assess long-term worth.
Thorough analysis of the business plan and its model
Here, the buyer focuses on the target company's business strategy and model. This is done to determine viability and how well the firm's model would merge with theirs.
Final offering of formation and ongoing monitoring
Individuals and teams collaborate to discuss and assess their results after gathering and analysing information and documents.
Analysts use the data they acquire to undertake valuation procedures and processes. This validates the final dollar amount you are willing to offer during the negotiation.
Risk Management
Risk management entails taking a comprehensive look at the target firm and projecting any hazards linked with the acquisition.
CONCLUSION
Since this is more of a diligence procedure than compliance effort, there is no explicit regulation governing it. As a result, there is relatively little information accessible on this technique. It is a vital and critical step that each company must take when investing and determining the health of the company. This makes it even more crucial for entrepreneurs to educate themselves and attempt to conquer this stage of the cycle. Checklists tell target firms about the next step. Legal specialists with the necessary corporate and legal skills normally curate and maintain the process.
Witten By,
Paarth Chanchlani,
Partner, Chanchlani Law World
Comments