This article is written by Akanksha Bharadwaj, pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.

Introduction

Do you buy anything off the store without checking it to your satisfaction? Caveat emptor, remember? If we intend to invest our money into something real, it is our responsibility to do a ‘due diligence’ check so that our investment bears shiny fruits! Now, when it comes to two corporate entities willing to make a deal, or to be specific, intending to merge or acquire the other, it is wiser than wise to do a due diligence audit. What is, then, an audit due diligence? Well, it’s a mix of words like careful, investigation, review, confirmation, etc. It’s easy to know what a due diligence audit is. However, to put it together, it’s a careful investigation, audit, review or evaluate a business opportunity. Here’s more.

An audit due diligence or a due diligence audit in an M&A or a Mergers and Acquisitions transaction is a process of investigation and evaluation performed on the basis of a long list of points with respect to the performance of the company. Ideally, the buyer company here performs an evaluation wherein the financial state, tax-paying state, regulatory compliance, labour compliance, general and accounting state of the seller company before closing the deal. The purpose of the due diligence audit is to verify and confirm what the seller company offers and puts forth the buyer company for a deal to be made between them. The information brought up during the deal must be verified and confirmed so as to erase any possibilities of conflict and breach after the deal has been closed and operations have started. If there are any potential defects in the investment opportunity, that must be taken care of to ward off a bad transaction. 

Let’s now try to understand why, briefly, is a due diligence audit needed in an M&A transaction when parties always have the option to approach the Court of Justice. Why is it needed if the companies can declare the material facts and get going? Well, it’s needed: because doing the general homework cannot be ignored. It also gets translated into the common sense factor that a due diligence check is extremely important to perform the 3 ‘W’s check viz. what, why and when. Now, if a buyer seeks an important, material information about the seller company, but the seller slackens from its responsibility to disclose, then the latter is liable to prosecution. Again, the ‘caveat emptor’ comes into play. If an investor exercises due diligence on the seller company to its best potential, anything not sought by the investor from the seller company, does not make the latter responsible for prosecution. Thus, it works both ways.

Due diligence is performed by companies merging into another company or acquiring another on a number of factors and pointers. Here are some for the purpose of a clearer picture:

• Financial due diligence: Understanding of all the company’s financials like financial statements for the last three years, comparison of the financial statements with those of past years, whether what the company projects is accurate, capital expenditure plan, liabilities, etc.
• Tax due diligence: Understanding of the company’s statement of taxes viz. whether the company duly pays its taxes, whether there is any under-reporting of the taxes, the tax return documents, information as to the tax audit of the company, etc.
• Administration due diligence: Understanding of the investee company’s administration role like the facilities owned, future business plans of the company, number of offices and workstations, etc.
• Assets due diligence: Understanding whether the investee company has declared its assets fully, details of the assets, sales and purchases of the assets, agreements of the assets, and the like.
• Legal due diligence: This is the most important due diligence to be performed and it has to be done by a very active and solicitous legal team. Some of the elements of legal due diligence can be verifying the memorandums and articles of the company, minutes of the meeting of the shareholders’ meetings or BODs, all the agreements the company has entered into, etc.
• IP or Intellectual Property due diligence: Understanding of the company’s use of intellectual property most often used as assets of the company that it can use to monetize. 
• Human Resources due diligence:  Understanding of the company’s relations with its employees and staff and other factors like analysis of employees, who they are, how much do they earn, current vacancies, recruitments, human resources policies, etc.
• Strategy due diligence: Understanding of the company’s strategies: present and future, its technology, market policies, etc.

Such and other elements of due diligence play a very important role in knowing the company through and through and to prevent any bad transaction, as stated earlier too.

Now that we’ve understood what is an audit due diligence in an M&A transaction, it’s imperative that we also understand the procedure of it because since no understanding of due diligence audit is complete unless we know the ‘how’ behind it:

• Evaluation of the goals of the project: Clearly defined and structured goals are key to investment success. The goal of the investment project should be well defined and delineated so as to avoid any confusion and hassle. It should align with the strategies planned. In other words, pertinent questions around the goals and outcome must be brought to the table to find alignment with the investment.
• Analysis: No process must start without analysing whatever it is that can conclude in a deal. In other words, analysing the status makes it easier to get a clearer picture of the status quo. So, in an M&A transaction, the investor company must make a careful analysis of the investee company. The capital of the company, the current position of it, the ownership of the company, the financial status, the size of the company. The size of the market target of the company and other factors should be taken into consideration while analysing the investee company.
• Gathering of the documents: Now when the goals have been set and put forth, certain elements have been analysed, it is now time to gather all the relevant documents pertaining to the audits, the investee company’s financial performance, the compliances met by them-legal, environmental, labour, etc.

This process may also involve the investor company conducting interviews, surveys, visiting the site of the company and getting physical first-hand information about the company.

• Examination of the financials and competitors of the company: Now that the documents have been gathered, analysis of all the elements of the company is to be done through examination of the company’s revenue, profit, it’s trend in the market, the competitors of the company. In addition to these, other questions must also be considered like whether the investee company is a leader in the industry, whether the targets of the company are achievable and chased, calculating the company’s ratios viz. Price to Sales ratio, Price-to-earnings ratio to measure the valuation of the company (to draw out a comparison with the company’s competitors in the market).
• Analysis of the business Plan and model: The business plans and strategies for growth, is yet another indicator of the health of a company. Analysing the same in an M&A transaction is again of paramount importance so that the investor company gets a clear understanding of what the investee company aims to do and how it aims to fulfil the targets. To assess the viability of the target/investee company’s alignment and integration with the buyer/investor company is a part of the due diligence process.

In order to do the same, some elements like management, share ownership, stock price history, play a decisive part of the due diligence process.

• Final offering and expectations: After having done the analyses carefully, certain changes, omissions, or alterations may become necessary to achieve alignment for the deal to be closed. 

For the deal to be successful, both the companies should reach a consensus with the help of discussions and collaborations for long-term trends affecting the industry and the like. The teams should sit together to evaluate the findings and negotiate thereby to meet success. The information collected is used for valuation measurement and it thereby substantiates the final amount of the deal to be cracked, all by negotiation.

• Risk Analysis and Management: Here we come to the almost final step of the due diligence audit process where risk assessment is done keeping in mind the potential risks that may be involved in the transaction. For the same, both long-term as well as short-term risks must be examined. Not just the risks specific to the company, but also the industry-wide risk must be brought into assessment. In addition to this, the worst-case scenarios and the possible outcomes of the same must not be ignored.

Conclusion 

These are the steps that can outline the picture of the company’s performance and also give a better understanding of the company’s health in future. While in theory, it may look like a fairly easy process, in practice, it takes months for the process to be complete, and sometimes, also leads to the abandonment of the deal. As smooth as it looks, it’s also a complicated and tedious process. Nevertheless, it’s as important a part of the M&A deal as the deal itself. It can make or break a deal. An audit due diligence is a reflection of the buyer company’s carefulness. It is also a translation of how well-equipped the legal team of the buyer company is, since a due diligence check lies with the legal team of the company. An M&A transaction is thus incomplete without a due diligence audit. So, get the checklist updated, comprehensive and of course ready, to do the ‘Due Diligence Audit’ perfectly to not welcome any bad-transaction in the future!

Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.

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