BY – PRANJALI PANDYA
WHAT IS DUE DILIGENCE?
According to the Securities Act of 1933 which was first used has defined the term “Due Diligence” which in turn refers to a measure of prudence, activity or assiduity, as is properly to be expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstance; not measured by any absolute standard, but depending on the relative facts of the special case.
Whereas according to the Webster dictionary it refers to investigate and evaluate a business opportunity. Investigation must be done with respect to all relevant aspects of the past, present as well as predictable future of the business of the Target Company.
Due diligence is a process whereby an individual or an organization seeks sufficient information about a business entity and also to reach an informed judgment as to its value for a specific purpose.
Hence, it refers to all kinds of precaution which an enterprise takes up to identify or prevent foreseeable risks. It is the process in which an action is arrived at before consummating it. It is the buyer company or the company which wishes to merge with another to know as to whether they will be able to get the returns for as much investment they`re making to buy the company. Hence, for this very purpose the buyer – company carries out a detailed and in – depth investigation and analysis of the obligations of another company including its debts, leases, pending and potential law suits, distribution agreements, compensation agreement and many more.
There are various questions which is required to be addressed which includes –
(i) As to what is the value of the Target Company which going for Merger and Acquisition?
(ii) Will it add value to the acquiring company?
(iii) What are the risks that need to be managed to gain value while minimizing risk?
(iv) What are off – balance – sheet liabilities of the company?
(v) What are the liabilities and costs being acquired?
Reasons Involved For Conduction Due Diligence
One of the major reason as to why this process is carried out by the Buyer – company is to confirm that the business is what it appears to be. Second reason being, to identify potential “deal killer” defects in the target and also to avoid a bad business transaction. Thirdly, to gain information that will be useful for valuing assets, defining representations and warranties or negotiating price concessions; and verification that the transaction complies with investment or acquisition criteria.
In today`s globalized world, legal due diligence is not just a task to be undertaken during Merger and Acquisition, but also, stands as a necessity as Merger and Acquisition deals have power to transfer assets as well as liabilities to the company. This means that the value of the company that is bring brought cannot be understood without keeping in mind all the relevant legal questions under consideration which makes the process of Due Diligence all the more necessary.
Complete Due Diligence Examination Diligence contributes to making informed decisions by enhancing the quality of information available to the decision makers. The researcher here has focused on the concept of “Open the Kimono”, where the participants share openly all the relevant information and keep no secrets, and transparency with respect to sensitive data and frankness is maintained. Below mentioned are the checklist which needs to be maintained while going through the process of due diligence –
(i) Corporate documentation – Before the merging with any company, it is vital to examine the legal structure of the target company. The buyer should work towards inspecting the corporate records, certificate of incorporation, all the rules and by – laws, minute books with due assiduousness for ensuring a smooth and a hassle – free transition.
(ii) Financial documentation and information – Financial data plays an essential role in determining the financial benefit which the buyer – company may gain from the merger and acquisition. The process also helps the buyer company to determine the value of the enterprise and the financial risks associated with the purchase. The same also helps in identifying the current financial situation and the profitability of the target company.
(iii) Information on Customers – Customers are the heart and soul of every enterprise. Before going for merger or acquisition with the target company, the buyer must look upon the possible effects a merger is going to have upon both the companies old as well as new customer base.
(iv) Historic or Current Legal issues – The Legal team of the buyer – company must try to extract the date related to the legal cases that are pending against the target company. The buyer
s team should make necessary efforts for inquiring about the legal liability, the claim value and necessary legal documents required for ascertaining the same.
(v) Employees and Departments - The due diligence process also involves determining the employment agreements of employers and employees for ensuring that none of the agreements should be triggered or effected with the change on control. Due diligence also helps in calculating the amount of consideration that a buyer would have to shell out for future considerations.
(vi) Assets/ Property - During the process of due diligence, the seller should provide a complete list of all the tangible as well as the intangible assets of the company to the buyer – company. Analysis of the same must be made by the buyer – company with respect to all the bills, mortgage, loans and all the relevant contracts associated with the assets of the enterprise.
(vii) Legal due diligence – The purpose of legal due diligence is to closely examine the sellers legal documents and to evaluate the legal position of the target company. During legal due diligence the buyer`s advocate has to look into the liabilities and obligations of the target form which may have an impact on the value of the firm. Legal due diligence also helps the buyer – company in determining the risks and ownership associated with the assets of the target enterprise.
Due Diligence Process
Due diligence process starts when the acquiring company and the target company have reached an initial understanding for their Merger and Acquisition deal may be in a form of a letter of Intent of memorandum of understanding. By getting this step, one can get started.
The due diligence process has been segregated into four parts –
(i) Planning – The buyer company must always hire the specialized services of a legal advisor or a consultant as this process is in itself quite complicated wherein both the enterprise and the issues needs to be understood and one would be certain that the right issues are being put – up and the probable risks are uncovered. Hence, the very first step in the process should be to hire the professional legal service so that proper planning and execution of the same can take place.
(ii) To carry out research – Before both the companies enter into legal agreements, the buyer party needs to go through the company’
s account and other relevant information. If the company is a public company, it is then quite easy for the buyer to extract the date from the government reports. Whereas, in case of private company the acquirer must ask the target company or the seller to show him with the summaries including the audits, balance – sheets, websites etc. Attention in such a case must be given if the company under consideration is a small one as they are not professionalized from a legal perspective. This is so as they do not have proper infrastructure and resources when compared to that of the larger company. Once all the relevant legal documents like that of incorporation document, shareholders warrants, any outstanding warrants, licenses and permits, the process should move on the further task of inspecting all the litigation concerned with the target company. It is a vital task as the same establishes a firm overview of the outstanding risks that the buyer company would have to deal with as well as forms a ground for a better understanding of the market. The buyer – company must have knowledge about the assets and liabilities including cash, securities, inventory, intellectual property (including copyrights, patents, domain name, trademarks, trade secrets and other proprietary right) as well as the liabilities including bank debt, licensing violations, bonuses earned and yet not paid a thorough investigation is required to be done. After this, the problem of locating and managing the hidden assets and liabilities has to be dealt with as there are certain assets and liabilities in every firm which do not appear anywhere in the annual balance – sheet. The list of customers complaints and queries must also be looked upon as it would lead to know the good and the bad of the company in a better way.
(iii) Analyzing and Evaluating – After the buyer – company has obtained all the relevant information of the legal due diligence process, the buyer – company with the assistance of its advisors must analyze and evaluate all the findings in a proper systematic way. It is advisable to chase the “red flags” or any questionable or suspicious document found in the process of investigating to its root. Preferably a due diligence questionnaire must be prepared and must be highlighted with all the key areas that are required to be examined. The process of due diligence ends when the buyer – company is satisfied and had analyzed all the issues related to the company and is able to understand the market fairly well.
(iv) Presentation and Closure – The counsel or the advisor has the duty to present the findings to the buyer as per the investigation carried out by the,. As the buyer would be unknown to the legal terminology, the report should be presented in the lay mans or a user friendly language. For small deal, the presentation should preferably be presented in the verbal form while for the big deal the same must be presented in memorandum form.
is very important that this process is carried out effectively and efficiently, An inadequate due diligence can leave an indelible impact on the buyer – company which can haunt the functioning and good will of a company for a considerable amount of time.