Knowing what you are getting into is the first step to being a street-smart business owner. Due Diligence (“DD”) is an investigative activity undertaken to assess the risks and the business viability by evaluating assets and liabilities. The growing economy is always eager for consolidation, and hence, Mergers & Acquisitions can be rewarding and the first step to this, involves a DD.
The meaning of DD can be said to be synonymous with research, investigation, and precaution.
Objectives of DD
Primary objectives of DD, broadly involves ascertaining the health of business and include –
- Establish compliance with applicable laws, including industry-specific laws
- Estimate the condition of tangible and intangible assets, especially land, plant, and machinery
- Determine suitable purchase price and method of payment
- Verification of details significant to drafting the acquisition agreement under the SEBI Takeover regulations and application filed under the Companies Act, 2013 for seeking regulatory approval
- Ascertain risks and liabilities which may be deal-breakers
- Assess the legal, financial, and reputational risk of the transaction
Different types of DD
There are various types of DD performed for accessing different relevant information, viz., Business, Accounting, Legal, IT, Environmental, and Financial.
- Business DD:
Business DD aims to verify whether the target company’s revenue and cash flow are sustainable as a long-term investment. It also helps identify whether the business has the potential to grow, achieving the acquisition’s objective. - Accounting DD:
The agenda to perform Accounting DD is to ascertain if all financial information shared is correct. This is one of the time-consuming DD because it involves the verification of historical data as well. - Legal DD:
You do not want to accept contingent liabilities without knowing their extent. Hence, Legal DD is an excellent way to ensure that you are made aware of all pending and contingent litigations which could have a bearing on the deal. - IT DD:
In the digital age, IT security is one of the vital checks. Before merging operations, it’s critical to identify any security risks, frequent downtimes, or cyber breaches. These could lead to increased cost incurrence. - Environmental DD:
With companies focussing on meeting SDG 2030 and achieving rankings based on their environmental efforts, this DD will ensure the long-term objectives of the companies involved are aligned. - Financial DD:
Looking to understand how the target company is expected to perform in the near future? Get the Financial DD done and uncover the potential with budgeted future cashflows and clarity on investments.
Due Diligence can be initiated only after the letter of intent (LOI) is signed between the parties to the merger.
Popular methods of performing DD
Now that we have covered the types of DD available to the parties in a merger let’s dive deep and see what popular methods the professionals use to undertake the DD. These commonly include –
- Questionnaires – used for checking out the basic details of any target company
- Representations and Warranties – these are clauses integrated as a part of the agreement signed between parties. Refer to our note on the Co-founders’ Agreement, and you will find necessary clauses to be covered in your contract to protect from any unforeseen risks while undertaking a new business activity.
- Review – this method involves analysis of all risks involved, often seen as a holistic method of DD
Representation and Warranties, incorporated in the agreement, are backed by an indemnity from the seller. Thus, if a representation or warranty is breached or identified to be misleading during the later stage of the deal, the seller can invoke the indemnity clause of the agreement. Invoking indemnity for breach of agreement would not only cover the damages but also be a cause for termination of the agreement.
Scope of DD undertaken during a merger
The scope of a general DD will include aspects like –
- corporate records and filings under the Companies Act, 2013 or any other relevant law
- foreign exchange filings (if applicable) made with the RBI
- material contracts with customers, suppliers, lenders, etc., or concerning any assets of the company
- licences, registrations, and permits obtained for the conduct of operations
- pending or contingent litigations
- labour and employment-related documents
- compliance towards related party transactions
- other documents relevant to information technology and insurance policies
- any sector-specific compliance records
While DD covers almost all aspects, it is imperative to highlight the scope of information in the public domain. A buyer / professional appointed on its behalf must include an analysis of all information available publicly, for instance, details about indebtedness, financial position, ongoing litigation, and so on.
In a merger, DD allows the buyer to verify appropriate information about the seller, such as contracts, finances, and its operational details. By gathering this information, the buyer is better prepared to make an informed decision and close the agreement with a sense of certainty. The buyer can better adjust expectations by reviewing the company’s unique information.
However, if the crucial step of conducting DD is skipped and a deal is signed, there are chances that the buyer may be exposed to unforeseen risks, and it may turn out to be a damage instead of a synergy to the company. So let us do the in-depth analysis for you and help achieve the objective of the merger instead of being stuck with a hurting deal.
This is only for informational purposes. Nothing contained herein is, purports to be, or is intended as legal advice and you should seek legal advice before you act on any information or view expressed herein. Endeavoured to accurately reflect the subject matter of this alert, without any representation or warranty, express or implied, in any manner whatsoever in connection with the contents of this. This isn’t an attempt to solicit business in any manner.
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