What is Due Diligence?
Due diligence is the process by which confidential, financial, legal and other material information is exchanged, reviewed and appraised by the parties to the business transaction before entering into such transaction. One must access the positive and negative aspects of the transaction to be entered into. Due diligence is basically done with following objectives in mind:
- To access the legal and potential pitfalls of the transaction
- To know the positive and negatives of the transaction
- To know the hidden liabilities of the organisation
- To stand in a better bargaining position
- To access the financial aspects of the transaction
- To know the strengths and weaknesses of the business to be acquired
- To take an informed decision for the transaction
- To ensure complete and adequate disclosures
- To enhance the confidence of the stakeholders
TRANSACTIONS FOR WHICH DUE DILIGENCE IS REQUIRED?
As discussed, the due diligence is very important task to be performed. Basically, we should perform due diligence for every transaction, but following are the major transactions for which one must perform due diligence.
- Merger and Amalgamation.
- Partnership
- Joint Venture and collaborations
- Public offer
SCOPE OF DUE DILIGENCE
The scope of due diligence depends upon transaction to transaction. Due diligence is wider in scope as compared to audit. While performing due diligence one must be aware of the objective for which he is undertaking due diligence process. Due diligence is generally understood by the legal, financial and business potentials with respect to various disclosures as to assets and liabilities, intellectual property rights, pending litigations against the target company, various tax related matters of the target company.
Thus, due diligence process has to be done according to the transactions to be entered into with the objective in mind.
TYPES OF DUE DILIGENCE
- Business Due Diligence: It looks for the quality of the transaction, parties involved and the investment made. This further includes the following:
- Operational Due Diligence : This focuses on the functional operations, technological upgradation , connectivity of operations etc. of the proposed business to be taken over.
- Strategic Due Diligence: This relates to the strategic rationale behind the proposed transaction. This includes the business opportunities, commercial viability of the proposed transaction.
- Technical Due Diligence: This relates to know the technology adopted by the target company, required changes in technologies etc. This further includes Intellectual property due diligence. Intellectual Property Due Diligence is considered to be important due diligence. Nowadays intangibles are also brought and sold in the market. So it is important to know the right of the owner on those intangible assets and to assess any infringement of rights.
- Environmental Due Diligence : Environmental due diligent helps to assess the past , present and future impacts of the operations of the target company in the surrounding areas . This also assess the environmental risks associated with the organisation.
- Human Resource Due Diligence: For the success of any venture, employees also plays an important role. One must also assess the employees and related issues before entering into any transaction. Cultural issues should also be taken into account, as there are chances that due to such differences, scarce talent may leave the organisation very soon.
- Legal Due Diligence: Legal Due Diligence helps to assess the legal aspects and the potential legal pitfalls of the target company.
- Financial Due Diligence: Financial Due Diligence helps to assess the various financial aspects of the transaction such as reviewing the accounting policies, reviewing of internal audit procedures, quality and sustainability of earnings and cash flows etc.
WHAT DOCUMENTS MUST BE REVIEWED FOR DUE DILIGENCE EXERCISE?
Due Diligence is both futuristic as well as backward looking, as it helps the acquirer to dive into the past of the target company and to assess the future of the target company. Thus, the acquirer must look for the following documents for better due diligence.
- Basic Information
- Financial Documents
- Important Business Agreements
- Litigation Aspect
- IPR details
- Marketing Information
- Internal Control System
- Taxation Aspect
- Insurance Coverage
- Human Resource Aspect
- Environmental Impact
- Cultural Aspects
STAGES/ PROCESS OF DUE DILIGENCE
Process of due diligence includes three stages i.e. Pre- Diligence, Diligence and Post Diligence.
- Pre-Diligence : Pre Diligence is primarily the activities related to the management of paper, files and people.
- Investor has to sign the letter of intent and non- disclosure agreement with the company before accessing the confidential information of the target company.
- Receive the documents from the company and check it with the checklist prepared earlier
- Identify the issues lying in the organisation
- Organise the papers required for the due diligence
- Create the data room.
- Diligence: After the diligence is complete, a report is prepared known as diligence report. With the outcome of the Report one is able to categorise the transaction in the following categories:
- Deal Breakers: This discloses the non-compliances on the part of the target company which will lead to criminal proceedings.
- Deal Diluters: The violations underlying in the organisation may attract monetary penalties which will ultimately leads to diminish the value of the organisation.
- Deal Cautioners: Though these transactions does not have the financial impact but may have the non-compliances which are rectifiable. So the due diligence team must proceed cautiously.
- Deal Makers: This situation is hard to come across, where the acquirer does not find any violations, leading him to submit a ‘clean report’.
- Post Diligence: The last step where the investor can rectify the non- compliances, file the petitions/ applications for compounding of offences or negotiating shareholders agreements etc. This means that the investor can negotiate with the target company and may negotiate the prices very hard.
DATA ROOM IN DUE DILIGENCE
Data room contains the confidential data of an organisation. Confidential data includes the business trade secrets, details of Intellectual Property Rights, financial data, technology information, litigation documents etc. which when disclosed can provide a serious threat to the organisation. The room where the above mentioned documents are stored is called Data Room. For assessing the data room one has to sign the non-disclosure agreement with the company.
Data Room can be of two types:
- Physical Data Room
- Virtual Data Room
Physical data room is the room where the documents are stored physically I.e. the hard copies of the documents. One can assess the data room by signing the non- disclosure agreement with the company. The advantage of physical data room is that one can take photocopies of the documents required. But the drawback is that it is not available 24×7 and one cannot restrict the accessibility of the data for the user. Also the cost involved is very high.
Virtual data room is the which can be assessed online. Here also, the non- disclosure agreement is to be signed by the user. The user can assess the data 24×7. The company can restrict the accessibility of the data and the cost of maintaining is also not very high as compared to physical data room.
INFORMATION WHICH CAN BE ACCESSED IN THE DATA ROOM?
The following information can be accessed in the data room :
- Charter documents i.e. Incorporation details, Memorandum of Association & Articles of Association
- Financial Documents such as financial statements, annual returns
- Intellectual Property Rights details
- Information about the sales, marketing etc
- Information of the technology used for manufacturing of products
- Human Resource Information
- Compliance related information
TRANSACTIONS FOR WHICH DATA ROOM IS REQUIRED?
Following are the transaction for which data room is created or accessed by the user
- Merger, Amalgamation and Acquisition
- Strategic Alliance
- Partnering Agreement
- Joint Venture and Collaborations
- Public Issue
- Outsourcing Agreement
Thus, we can conclude that the transaction for which the user perform the due diligence are similar transactions for which he can create or access the data room.
CONCLUSION:
This can be very well observed from the above discussion that due diligence is a must process while entering into any business transaction so as to avoid any unwanted consequences of such a transaction.