Due Diligence
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Introduction
Due diligence is a process of :
Analysing various aspects to estimate an entities commercial potential
Assessing the financial viability of the entity in terms of its assets and liabilities at a comprehensive level
Examining the operations and verifying the material facts related to the entity in reference to a proposed transaction
Importance of Due Diligence
Transactions that undergo a due diligence process offer higher chances of success. Due diligence contributes to making informed decisions by enhancing the quality of information available to decision-makers.
Reasons For Due Diligence
There are several reasons why due diligence is conducted:
To confirm and verify information that was brought up during the deal or investment process
To identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
To obtain information that would be useful in valuing the deal
To make sure that the deal or investment opportunity complies with the investment or deal criteria
Transactions covered for Due Diligence
There are several reasons why due diligence is conducted:
To confirm and verify information that was brought up during the deal or investment process
To identify potential defects in the deal or investment opportunity and thus avoid a bad business transaction
To obtain information that would be useful in valuing the deal
To make sure that the deal or investment opportunity complies with the investment or deal criteria
From a buyer’s perspective
Due diligence allows the buyer to feel more comfortable that their expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.
From a seller’s perspective
Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.
Partnership:
Due diligence is done for strategic alliances, strategic partnerships, business coalitions and such other partnerships.
Joint Venture and Collaborations:
When one company joins hands with another the reputation of the company is a matter of concern. Understanding the other company’s stand and measuring the adequacy of resources at their end assumes importance.
Public Offer:
Aspects included during making a public offer are decisions on public issues, disclosures in a prospectus, post issue compliance and such other matters. These would usually require due diligence.
Drafting of the Due Diligence report
While drafting the due diligence report the 3 W’s have to be addressed. These are:
Who is your target audience?
What is your objective?
Which are the aspects that will be key to decision making?
Superfluous information should be avoided to make the report brief.
Types of Due Diligence
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1. Business Due Diligence:
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It involves looking into the parties involved in the transaction, prospects of the business and the quality of investment.
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2. Legal Due Diligence:
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It mainly focuses on the legal aspects of a transaction, legal pitfalls and other law related issues. It covers both inter-corporate transactions as well as intra-corporate transactions. Various regulatory checklists form a part of this diligence along with the already existing documentation.
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3. Financial Due Diligence:
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Financial, operational and commercial assumptions are validated here. This provides a huge sigh of relief to the acquiring company. Review of accounting policies, audit practices, tax compliances and internal controls are done in detail here.
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Limitations of Due Diligence
The due diligence gives a superficial understanding of the target company to the acquiring company. As a result of which the businesses may not always succeed.
The workforce, the competencies and the work culture remain a mystery to the acquiring company which are quintessential to a smooth running.
The due diligence report should provide the desired level of comfort about the potential investment and also the inherent risks involved. The report should be able to provide the acquiring company with information such that no onerous contracts are signed which could potentially harm the existing return on investment.
Drafting of the Due Diligence report
While drafting the due diligence report the 3 W’s have to be addressed. These are:
Who is your target audience?
What is your objective?
Which are the aspects that will be key to decision making?
Superfluous information should be avoided to make the report brief.
Areas of Focus in a Due Diligence Report
Technology: A very important factor to consider is the assessment of the technology available with the company. Such an assessment is necessary as it helps decide future actions.
Environment: No business operates in isolation. Hence, it is necessary to look into the macro environment and its impact on the target company.
Monetary Aspect: Key financial data and a ratio analysis would be necessary to understand the complete picture
Existing & Potential Liabilities: Any kind of pending litigations and regulatory issues should be taken into account.
Effect of synergy: Creation of synergy between the target company and the existing company serves as a tool for decision making.
Viability: Accessing the viability of the target company can be done through a thorough study of the company’s business and financial plans.
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