Due Diligence - Importance, Process, Types - Startupfino (2024)

Objective of Due diligence

The objective of due diligence is to check the strategic identification or attractiveness of the target company, valuation, risk associated etc.Following are the objectives of Due Diligence in a detailed manner. :

• Collection of material of information
• Identification of strength and threats and weaknesses.
• To improving the bargaining position.
• Identification of areas where representations and warranties are required.

Generally, The SWOT analysis of any business carried out as a part of due diligence to reveal the strengths and weaknesses of not only the financials but also intangibles. To perform effectively, the potential buyer needs to be clear about the goals and motives for acquiring the target company, as well as the value the buyer is attempting to create with the purchase.

For example, if there is a legal risk, such as an outstanding lawsuit, that will not only jeopardize the financial stability of the company but also the loyalty of existing customers. This will erode the target company’s market of customers by a new and stronger competitor. The target company’s talent is the asset desired, and much of this depends on employee relations and accordingly cultural issues have to be addressed in time.

A thorough due diligence helps to reveal any of the negatives, but the process of due diligence rarely goes smoothly because of one major stumbling block and that is availability of information. The target company is rarely eager to reveal to the other party that it is up for sale and wants to keep this information confidential from its competitors, customers and employees. So getting any information from these sources can be tricky, depending upon what the potential buyer wants to gain from the transaction. The buyer who aims to get new market of customers with the transaction wants to make sure that the target company has a good relationship with existing customers. But, during due diligence, the target company does not want any contact with its existing customers for fear that customers might leave because of the impending sale.

As another instance, a potential buyer sees the employee talent as the company’s main asset, but the target company is nervous about letting the potential buyer talk to key employees because it does not want to let them know that it is going to be sold. Because of the confidential nature of transactions, not all the information that is necessary to make a good decision can be revealed. This is why services of experts are hired in due diligence before beginning the process so the buyer receives reliable guidance. Further it is also critical to meet with trusted advisors - both inside and outside about what has been discovered and brainstorm the different scenarios of what can go wrong before going ahead with the deal.

Once a purchase price is agreed upon the prospective buyer usually enters into a conditional agreement with a due diligence clause with the target business, in which the buyer has a limited period to conduct due diligence. During this time, the potential buyer requests full access to all relevant materials in the target business, customer, vendor, financial and other information in order to conduct a thorough investigation. Here, it is to be ensured that the potential buyer does not use this information for its own benefit if it decides to back out of the deal, hence a confidentiality agreement is usually signed to protect the target businesses’ interests. But a possibility of re-negotiation of the purchase price or cancellation of the agreement on the part of buyer is seen if the information found is not acceptable to the potential buyer. Again after due diligence, the goal is to either reaffirm the purchase price or renegotiate, depending on what was discovered under Due diligence. But the ultimate goal is to make a rational decision based on the facts.

Why is it required to conduct Due Diligence?

The requirement of the due diligence can be summarised as under:

• To investigate the affairs of business as a prudent person.
• To confirm all material facts related to the business.
• To access the risks and opportunities of a proposed transaction.
• To reduce the risk of post transaction.
• To confirm that the business is what it appears.
• To create the trust between two unrelated parties.
• To identify potential deal killers defected in the target and avoid a bad business transaction.
• To gain information which will be useful for valuing assets.
• Representation & warranties for indemnification.
• Negotiation price concessions.
• To verify the transaction complies with investment or acquisition criteria.
• To investigate and evaluate a business opportunity.
• To determine compliance with the relevant laws and disclose about the regulatory restrictions on proposed transactions.
• To evaluate any condition of physical plant and equipment; as well as the tangible and intangible assets.
• To ascertain the appropriate purchase price and the method of payment.
• To determine details which can be relevant to the drafting of the acquisition agreement
• To discover liabilities or risks which can become deal-breakers.
• To analyze the potential antitrust issues which can prohibit the proposed mergers and acquisitions.
• To evaluate all the legal and financial risks of the transaction.

Scope of Due Diligence

Scope of due diligence is transaction based and is depending on the needs of the people who are involved in the potential investments, in addressing key uncovered issues, areas of concern/threat and in identifying additional opportunities. Due diligence is generally understood by the legal, financial and business communities/potential investors to mean the disclosure and assimilation of public and proprietary information related to the assets and liabilities of the business being acquired. This information includes financial, human resources, tax, environmental, legal matters, intellectual property matters etc.

Due diligence would include thorough understanding of all the obligations of the target company such as debts, rights and obligations, pending and potential lawsuits, leases, warranties, all high and impact laden contracts – both inter-corporate and intra-corporate.

Due Diligence Compliance

• Compliance with all the applicable laws
• Regulatory violations or disciplinary actions
• Litigation and assessment of feasibility of litigation
• Financial statements
• Assets such as real and intellectual property, brand value etc.
• Unpaid tax liens and/or judgments
• Past business failures and consequential debt
• Exaggerated credentials/Fraudulent claims
• Misrepresentations or character issues
• Cross-border issues – double taxation, foreign exchange fluctuation, sovereign risk, investment climate, cultural aspects.
• Reputation, goodwill and other intangible assets.

Factors Kept In Mind While Conducting Due Diligence

Following factors are important for Conducting Due Diligence

Purpose and Nature

A key step in any due diligence exercise is to develop an understanding of the purpose for the transaction. The goal of due diligence is to provide the party proposing the transaction with sufficient information to make a reasoned decision as to whether or not to complete the transaction as proposed. It should provide a basis for determining or validating the appropriate terms and price for the transaction incorporating consideration of the risks inherent in the proposed transaction. The following factors may be kept in mind in this regard:

• Be clear about the expectations in terms of revenues, profits and the probability of the target company to provide the same.
• Consider the resources to make the business succeed and willing to put in all the hard work, which is required for any new venture.
• Consider the opportunity to put the skills and experience to good use.
• Learn as much as you can about the industry you are interested in from media reports, journals and people in the industry.

Planning the Schedule

Once it is decided for a particular business, make sure of the following things:

• Steps followed in due diligence process
• Areas to be checked
• Aspects to be checked in each area
• Information and other material to be requested from the seller

Negotiation for Time

Sometimes, it may be the case that sellers want the process to get over as soon as possible. When the seller gives a short review period, negotiations can be made for adequate time to have a complete review on crucial financial and legal aspects.

Risk Minimisation

All the information must be double checked such as financials, tax returns, patents, copyrights and customer base to ensure that the company does not face a lawsuit or criminal investigation. The financials are very necessary and one needs to be certain that the target company must not engage in creative accounting. The asset position and profitability of a company are vital.

However, due diligence exercise deals with the overall business, it is important to consider aspects such as:

• Background Of Promoters
• Performance Of Senior Management Team
• Organizational Strategy
• Business Plans
• Risk Management System
• Technological advancement
• Infrastructure Adequacy
• Optimum Utilization Of Available Resources

Information from External or other Sources

The company's customers and vendors can be informative. It may be found from them whether the target company falls in the most favored clients list. Any flaws that the audit uncovers help to re-negotiate down the sale price. Hence the Due diligence is "a chance to get a better deal".

Limit the report with material facts

While preparing the report it is advisable to be precise and only the information that has a material impact on the target company is required to be included.

Structure of information

Once the due diligence process is over, while preparing the report, information has to be structured in an organized manner in order to have a better correlation on related matters.

Stages of Due Diligence

A due diligence process can be divided into three stages i.e. (i) Pre diligence, (ii) Diligence, and (iii) Post Diligence.

Pre Diligence

A pre diligence is primarily the activity of management of paper, files and people.

• Signing the Letter of Intent (LOI) and the Non-Disclosure Agreement (NDA)/ Engagement letter.
• Receipt of documents from the company and review of the same with the checklist of documents already supplied to the company.
• Identifying the issues.
• Organising the papers required for diligence.
• Creating a data room.

The first and foremost step for the management of the target company, is that the investor is to sign a (LOI) Letter of Intent or a term sheet which underlines the various terms on which the proposed deal is going to be concluded. After the receipt of the LOI the investors sign an NDA with the various agencies who are going to conduct the due diligence, be it finance, accounting, legal or a secretarial diligence. The company would usually receive a checklist from the agency conducting the diligence. The checklist is invariably exhaustive in nature, and therefore, the company may either collate and compile the documents in-house, or outsource this to an external agency. While the data is being collated care should be taken to ensure that there are no loose ends that may probably arise.

Some of the important points that should taken in mind from the corporate viewpoint are the following:

• Do not delay deadlines (leads to suspicion).
• Mark each module of a checklist provided for separately.
• In case some issues are not applicable spell it out as “Not Applicable”.
• Put a single point contact to oversee the process of diligence.
• Keep a register, to track people coming in and going out.
• An overview on the placement of files.

During the diligence, care should be taken to adhere to certain hospitality issues, like:

• Be warm and receptive to the professionals who are conducting diligence.
• Enquire on the Due Diligence team.
• In case of any corrections then admit and rectify.

As regards the process of diligence, professional care should be taken to scrutinize every document that is made available and ask for details and clarifications, since the Due diligence is a time bound activity and needs to be wrapped up at the earliest. However, the company may be provided an opportunity to clear the various issues that may arise out of the diligence.

Diligence

When diligence is conducted, the professionals submit a report, which in common parlance is called a Due Diligence report. These reports can be of various kinds, a summary report; a detailed report or the like; and the findings mentioned in the report can be very significant, in as much as the deal is concerned.

There are certain terms used to define an outcome of the reports:

Deal Breakers: In report the findings can be very glaring and may expose various non-compliance may result into the criminal proceedings or known liabilities.

Deal Diluters: The findings arising out of diligence might contain violations that can have an impact in the form of quantifiable penalties and in turn it can result in diminishing the value of the company.

Deal Cautioners: It covers the findings in a diligence that can not impact the financials, but there may be the existence of certain non-compliances which, though rectifiable, require the investor to tread a cautious path.

Deal Makers: It is those reports wherein the diligence team have not been able to come across any violations, which lead them to submit what is called a 'clean report'.

It may be noted that only after the reporting formalities are over and various rectifications are carried out, the “shareholders agreement” (which is the most important document) is executed. This agreement contains certain standard clauses like the tag along and drag along rights; representations and warranties; condition precedents, and other clauses that have an impact on the deal.

Post Diligence

Post diligence results in rectification of non-compliances found during the course of due diligence. There can be interesting assignments arising out of the diligence made by the team of professionals. It can range from making applications/filing of petitions for compounding of various offences or negotiating the shareholders' agreement, since the investors will be on a strong wicket and may negotiate the price very hard.

Why should you choose Startupfino?

Startupfino Conducts Inquiries, Data Rooms, and Searches for Due Diligence Surveys. We help the clients in preparing the questionnaire, Conducting Interviews, Preparing Internal and External Public Registers. We help in various services related to Due-Diligence.

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