Introduction:
Due Diligence is a process by which parties to a transaction (business) review confidential, legal, financial and other material information required before entering into a business transaction. This helps the buyer to make an informed decision on the basis of the facts. The detailed due diligence explores all kinds of risks and provides information about:
- Financials
- Promoters
- Management team
- Business
- Internal system
- Profitability
- Customer base
- Revenue model etc.,
Due Diligence is a detailed analysis and risk assessment of an impending business transaction. The main object of due diligence is to analyse the target Company and confirm the nature genuineness of the business transactions, strengths and weakness of the target Company, valuation of assets etc.
As a part of the business strategy, the Companies before making any relationship with the other party conduct the background checks of the client, customer, supplier etc. to ensure that the parties to the transaction have the disclosed the information as required to proceed with the transaction and is a process to completely understand a business capability and its past performance.
While exploring any business opportunity, it is the foremost requirement for a corporate to investigate and evaluate the potential and risk associated with such business. The due diligence covers the activities relating to pre-transaction, during the transaction and post transaction exercise with all relevant aspects of the past, present, and predictable future of any business.
After the conduct of the due diligence, a due diligence report prepared to provide information and insight on various aspects such as the risks of a transaction, the value at which a transaction should be undertaken, the warranties and indemnities that needs to be obtained from the vendor etc.
In any transaction, the seller does investigation of a buyer to ensure that the buyer has adequate resources to complete the transaction, as well as other business aspect covering the technical and human resource, cultural, taxation etc. which would affect the company after entering into the transaction. the chapter covers the various types of due diligence performed by the company on voluntarily and for entering to the any business transaction or before going for any corporate action relating to the merger, de-merger, amalgamation, take over, joint venture etc.
TYPES OF DUE DILIGENCE:
- Operational Due Diligence:
Operational due diligence aims at the assessment of the functional operations of the target company, connectivity between operations, technological up gradation in operational process, financial impact on operational efficiency etc. It also uncovers aspects on operational weakness, inadequacy of control mechanisms etc.
- Strategic Due Diligence:
Strategic due diligence tests the strategic rationale behind a proposed transaction and analyses whether the deal is commercially viable, whether the targeted value would be realized. It considers factors such as value creation opportunities, competitive position, and critical capabilities. Strategic due diligence focuses on determining how much adequate, realistic, and attainable is a deal’s value. Strategic due diligence is broader and considers micro and macro-environmental factors of a business, connecting the legal and financial consideration with a long-term focus. Essentially strategic due diligence determines the question, “Whether a business plan can hold up to the market realities?”
- Financial Due Diligence:
The Financial Due diligence also review the company’s projection and basis of such projections, capital expenditure plan, schedule of inventory, debtors and creditors, etc. Also, the process involves analysis of major top customer accounts, fixed and variable cost analysis, analysis on gross margins, customers with high profit margins and their contract period, internal control procedures etc. It will also involve the type of the company’s order book and sales pipeline to better build projections.
The Financial Due Diligence can further extended to tax due diligence which covers the Diligence on various taxes the company is required to pay and which ensure that the proper calculation with no intention of under- reporting of taxes. Status of any tax related case running with the tax authorities. The tax due diligence comprises an analysis of:
- tax compliance
- tax contingencies and aggressive positions
- transfer pricing
- identification of risk areas
- tax planning and opportunities
- Technical Due Diligence:
Technical due diligence can be classified into:
(i) intellectual property due diligence; and (ii)technology due diligence.
Intellectual property Due Diligence:
The company which owns Intellectual Property (IPs) use there IPs to monetize their business. These IPs are something that differentiates their product and service from their competitors. However, the concept of valuation of intangible assets related to Intellectual Property like Patents, Copyrights, Design, Trademarks, Brands etc., also getting greater importance as these Intellectual Properties of the business are now often sold and purchased in the market by itself like any other tangible asset.
Few of the items that need to be seen while conducting due diligence is:
- Schedule of patents and its application.
- Schedule of copyrights, trademarks and brand names.
- Pending patents clearance documents.
- Any pending claims case by or against the company in violation of intellectual property.
Technology Due Diligence:
Technology due diligence help organizations in the decision-making process when acquiring new technologies or lines of business, or when they need a simple evaluation of how their current technology is functioning. Technology due diligence considers aspects such as current level of technology, company’s existing technology, further investments required etc. Technology is a key component of merger and acquisition activities; it’s imperative to look at IT considerations.
- Human Resources Due Diligence:
Human Resource Due Diligence aims at people or related issues. Key managers and scarce talent leave unexpectedly. Valuable operating synergies get disturbed when cultural differences between companies are not understood or are simply ignored. It is crucial to consider cultural and employees’ issues upfront, for success of any venture. Human Resource due diligence includes:
- Analysis of total employees, including current positions, vacancy, due for retirement and serving notice period.
- Analysis of current salaries, bonuses paid during last three years and years of service.
- All employment contracts with non-disclosure, non-solicitation and non-competition agreements between the company and its employees. In case there are few irregularities regarding the general contracts, focus must be given.
- HR policies regarding annual leave, sick leave and other forms of leave.
- Analysis of employee problems for alleged wrongful termination, harassment, discrimination and any legal case pending about the same.
- In case there are labor disputes, requests for arbitration, or grievance procedures currently pending and its financial impact needs to be seen.
- A list and description of all employee health benefits and welfare insurance policies or self- funded arrangements.
- Employee Benefit Schemes and schedule of grants of such scheme.
- Legal Due Diligence:
A legal due diligence covers the legal aspects of a business transaction, liabilities of the target company, potential legal pitfalls and other related issues. Legal due diligence covers intra-corporate and inter-corporate transactions. It includes preparation of regulatory checklists, meeting with personnel, independent check with regulatory authorities etc. apart from the verification of following document:
- Copy of Memorandum and Articles of Association
- Minutes of Board Meeting for the last three years
- Minutes of all meetings or actions of shareholders
- Copy of share certificates issued to Key Management Personnel • Copy of all guarantees to which company is a party
- All material contracts
- Copies of all loan agreements, bank financing agreements, line of credit to which company is a party.
- Status of the order, awards issued by the various regulators and courts
- Status of Pending litigations
- Competition Law due diligence