This article is written by Snigdha Pandey, Marketing Executive at iPleaders.

During my internship, my mentor had given me a fat bunch of documents and asked me to prepare a report on my findings. This was my brief: ‘Find what potential risks and drawbacks are there in the agreements for us, and prepare a due diligence report’. As a clueless litigation lawyer who had joined the internship to learn the nuances of corporate law, I literally did not know what to do.

Instead of asking my mentor what to do, I went and googled due diligence report. Of course the results were ambiguous and did not lay down exactly what to do. There were no associate counsels around for guidance. So eventually I started reading the agreements. It made no sense to me. By this time I had wasted considerable time, hence I swallowed my stupidity, and went to see my mentor and explained the situation.

He was patient enough to not yell at me, and rather explained to me what exactly was the purpose of this exercise. That’s when I learnt what a due diligence report was. It turns out I was only to make a part of it, the easier part and not the complex financial aspects. Phew!

So my first question was – What is a due diligence report?

In case of a merger or an acquisition, there is a transference of obligations and rights to the buyer from the seller. In order to minimize the potential risks and liabilities, investigation of material facts is conducted of the seller’s company. The report of such an investigation is called a  due diligence report.

The report includes a study of collections, review, and appraisal of business information, financial information, legal information and identification of the state of affairs, liabilities and exposures of the firm being acquired or undergoing the merger, otherwise also known as the target entity, etc. You can read more about the action points of a due diligence report here.

This report is crucial to the buyer, for they need to go into the deal on the basis of this report. Any risks or threats which are not part of the due diligence report, may affect the valuation of the company and change the outcome of the deal. Therefore, it is of utmost importance to investigate all the possible factors which may pose an issue in the future, with a fine tooth-comb.

There can be checklist prepared to reduce mistakes in the process, but there is no foolproof method to ensure the accuracy. There is always room to err and improve. But how does one avoid the mistakes? You may gain relevant experience through hands-on work or gain specialised practical knowledge through mergers and acquisitions course. The idea is to gain knowledge and experience enough to provide the best possible outcome.

What kind of due diligence mistakes can cost the buyer?

According to this article, in a deal back in the 90’s, BMW had acquired Rover to diversify in order to boost sales. But in their due diligence process, there was an oversight on the financial aspects, sales and accounts. There were also cultural clash which resulted in a 790 million pound loss.

Then there was the Quaker-Snapple deal, where Quaker wanted to replicate the success of their Gatorade deal, but instead suffered $1.4 billion loss due to an oversight in intellectual property and competitive analysis!

There may be an oversight of financial projections and expected sale, inaccurate financial statements, poor assessment of product or technologies involved, etc. There may be multiple factors which if missed can cost the buyers millions or even billions of loss.

What are the common mistakes made while preparing a due diligence report?

As mentioned earlier, there maybe a variety of mistakes or oversights of essential factors during the due diligence process which may have catastrophic results for the buyer. Some of the common mistakes are:

Poor buyer communication

During the course of the due diligence process, if there is a finding which affects the deal directly, like the lease on the manufacturing unit’s machinery expiring, then it has to be reflected in the due diligence report and timely reported to the buyer. This can possibly affect the structure of entire deal and its valuation. But delayed on inadequate communication can result in potential loss for the buyer or the entire deal falling apart. There should be clear and transparent communication processes to ensure such a situation can be avoided.

Inadequate internal coordination

The risk evaluation involves multiple departments like sales, accounts, legal, etc. Any relevant information like an unfavourable order in an ongoing litigation, or inaccuracies in the financial documents, etc. has to be communicated to the due diligence team. If the internal coordination is absent or lacking, then the due diligence report will have gaps and inaccuracies. This can be avoided by involving a coordinator who can communicate the developments from the departments to the due diligence team.

Losing sight of the goal

The due diligence report is a thorough affair, and sometimes, it may delve into aspects which are not necessary to the transaction at hand. For instance, if there is asset acquisition, then there is no point dwelling on the liabilities of the seller. It does not serve a purpose to the transaction at hand. Although it is easy to get lost with the abundant data at hand, one must not lose sight of the task at hand. If it is not pertinent, do not dwell on it.

Checklist dilemma

The due diligence report is usually dependant on a checklist of items that needs to be investigated into like financial reports, ongoing litigations, IP portfolio licenses, etc. The problem persists if only the checklist is followed or even if it is not followed. Ideally, the checklist items should be investigated first, and then other intangible factors like, the longevity of the technology in question, whether the two companies are culturally compatible and a good fit or not, etc. Many initially promising franchise mergers fall apart post-deal because of cultural integration issues      

Seller disclosing all the information

The seller however forthcoming, is not likely to be relied to disclose all the discrepancies and inadequacies of his company. It is the responsibility of the buyer to conduct the investigation of all the relevant aspects. The most common mistake is to rely on third party due diligence reports. The buyer must conduct such report independently or go with the list of verified vendors with the banks and other financial institutions. The idea is to ensure that the due diligence report must reveal the true scenario of the company being acquired.

The due diligence report is the centre of the deal. It is the basis of the valuation and the deal in itself. Therefore, it is essential for the parties conducting the due diligence report to ensure that they have necessary knowledge and experience.

How can you learn how to do it

It is very important for young transactional lawyers and law students trying to get into good law firms in transactional roles to learn about due diligence since it gives a huge advantage. We have been running a course on M&A, Investment Law and Institutional Finance where we teach the due diligence process in details, along with hands on practice of doing due diligence on fictitious companies. You even get training in preparing information requisition questionnaire, reviewing documents, retrieving MCA and other financial documents, understanding those documents, even choosing the right kind of presentation style in your DD report – we teach it all. Visit this link and try out the sample material to know what kind of advantage a course like this can give you.