This article is written by Prince Pathak who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
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Due diligence is a process that helps investigate a potential investment of product purchase. And when a company is evaluating or reviewing the odds for acquiring an entity, then due diligence is an unavoidable process that addresses all potential risks and concerns. The concept of due diligence mainly originates from the US, and it plays an important role in both private and commercial law. In other words, the due diligence process gives or reveals possible risks or odds hidden with the company.
Due diligence can increase transaction value; it highlights the opportunities in a transaction and mitigates the risks in the transaction. This knowledge may either confirm an acquisition’s asking price or open one or more avenues for negotiating a better price on the buy-side of a transaction. This method ensures that the company’s accounting processes and reports are correct, well-organized, and viewed in the best possible light on the sale side. An inadequate due diligence effort can increase the risks or diminish any transaction value.
This article has tried to decipher the importance of due diligence in an M&A transaction, risks factors while conducting the due diligence and attempted to define the procedures to eliminate those risk factors.
Due-diligence: Areas of Application
When making an investment in a company, reasonable due diligence is needed to make the most informed decision possible. Risk management and due diligence are serious matters that should start with a policy and a strategy. Companies more or less try to prevent financial losses and negative legal consequences using a due diligence process. During the due diligence process, the target company/entity is screened on various parameters. More importantly, owners pay more attention to certain aspects like commercial or corporate, financial, tax, and legal, due diligence. And if the company fails to prevent the risks factors while conducting the due diligence, then it would create financial loss and negative legal consequences on both the companies.
Commercial and corporate due diligence
Commercial due diligence (DD) is valuable for prospective buyers to obtain a detailed understanding of a target’s actual situation and long-term viability. Commercial due diligence is used to identify the company’s corporate structure and capitalization. Further, one should review the Corporate identification numbers (CIN), organizational documents and public, corporate records carefully to mitigate the risk factors. The corporate due diligence will cover:
- Business strategy.
- Strength and weakness of business.
- Stockholder and voting agreements.
- Minutes of all board, shareholder and executive meetings.
Failure to review any of these factors would lead to serious consequences. Further to this, if a target company is associated with corruption or other criminal activity, this will affect the reputation of the company.
Financial due diligence
Under the Financial Due Diligence (FDD), the buyers try to identify or weigh up the target company’s financial strengths and weaknesses. Financial due diligence to identify the issues facing by the target company’s business. In this process, the balance sheets and profit & loss accounts of the target company should be analyzed carefully. A buyer needs to be assured and understand the risks that exist with the target company’s business. Financial due diligence has certain objectives which must be fulfilled, and they are following:
- Provide a better understanding of the historic financial situation of the target company.
- It helps to understand the target company’s profit and loss. It asses the target company’s earning and helps to understand whether the target company is sustainable in the future?
- It helps to understand the assets and liabilities of the target company (Balance Sheet).
Due to the costly nature of financial due diligence, it is crucial to determine when the process should commence further analyzing of the financial statement is one common method to commence the financial due diligence process. After the proposed transaction (Acquisition or merger), all financial risks of the target company are going to the acquirer company, so it is pertinent to do the adequate due diligence process because inadequacy can lower the value of the proposed transaction result in financial ruin of the acquirer.
For a company’s acquisitions or mergers, a reasonable purchase price must be decided. Financial risks may also occur if a potential partner avoids legal requirements under sector-based laws, foreign investment laws, companies’ laws, competition laws, SEBI regulations, RBI guidelines, or any other applicable law, and this is only discovered later.
Tax Due diligence
Tax due diligence explores all the different types of taxes that may be imposed upon a particular business, as well as the various taxing jurisdictions in which it may have sufficient connection to be subject to such taxes. It also analyzes the future tax developments to save the parties from unexpected tax issues. Further, tax warranties and indemnities can be included in the agreement to mitigate the chances of tax risks.
Legal Due diligence
Legal due diligence examines all the possible legal circumstances in a target company. It generally covers the investigation of corporate or legal structure, commercial contracts, employment contracts, intellectual property, and litigation related to anything that can cause a company the loss of its wealth and reputation. Legal due diligence has some advantages, like it helps to understand the target company, determines the fair price, and identifies future legal risks.
Apart from the risks associated with closing deals, there may be risks inherent in the target company that becomes issues after the merger. Pending lawsuits, clearance on pending intellectual property (patents, trademarks, and so on), tax and other government liability, and so on are all examples of those risks. These threats may trigger significant issues in the future, resulting in a loss of valuation after the M&A transaction. Legal due diligence results in the early prediction of potential threats, and this danger can be avoided with a proper due diligence process.
Risks associated with the M&A transactions
Following are the risks associated with the M&A transactions and ways to mitigate those risks:
- Paying too much or overpaying for a target company– One of the main risks associated in the M&A transaction is overpaying. It has been seen in many cases that overpaying for a business reduces its worth to the shareholders. Now the question looms how to avoid overpaying?
Buyers must have an internal or external “go to” resource that has proven skills in corporate valuation or buyers can completes its own valuation. The next step should be to collect all the key financial and tax information, each synergy should be identified & evaluated so that buyers can get the actual price and mitigate the chances of overpaying.
- Inadequate due diligence procedures- The next risks that could be associated with the transaction is inadequate due diligence process that can simply affect the deals. In reality, inadequate due diligence planning and execution can lead to undervaluation and higher risk. The key to adequate diligence is to start early with the professional team. It is also important assemble a team with specific knowledge and experience because it could help in growing popularity of expert networks in due diligence for larger deals.
- Data Privacy issues– Of course, data is important when going in a transaction, because the information you collect is useful not only to you but also to hackers and criminals. Threats to protection damage both the buy-side and the sell-side, lowering the deal’s net value. What is the solution for this?
While exchanging and updating classified documents, one must put attention towards the data issues and way to avoid security risks is to use virtual data rooms. Furthermore, you’ll need a virtual data room that has strong encryption methods and two-step verification.
- Lack of accountability and coordination- Lack of communication lead to serious consequences. There has never been a contract that failed due to excessive contact. Communication is the glue that keeps most mergers going smoothly, both before and after the deal. And when there is no communication it obviously create question on accountability and transparency. Hence, technology could one of the most powerful mechanisms for ensuring effective coordination and transparency across transactions. The implementation and adoption of the virtual data room for M&A transactions has made encrypted information exchange simpler and more effective.
- Employee layoff– People are the most valuable tool for the most effective acquirers because they help businesses achieve targets, market goods, capture synergies, and accelerate growth. But in the process of merger organization may lose many employees during a merger. Inability to assess the value of its employees leads to companies firing the wrong people. Hence, one should prepare a plan early to assess the value of its employees before merger commence.
- Unforeseen situation and Act of God- No doubt we have recently witnessed an unforeseen situation in the form of COVID-19 and there are certain risks that cannot be predicted – these “acts of God” are in reality virtually uncontrollable and inevitable.
In these situations,it is better to postpone the transaction for some time nevertheless; continuous M&A research, professional learning, and consultations with other professionals will help you handle unintended industry disruptions.
Mergers and acquisitions open up a lot of opportunities for businesses to expand and diversify. Prudent preparation and enforcement management can help the business reduce the costs associated with it and one must focus to mitigate the risks associated with the M&A transaction.
Disadvantages/risks and advantages
Due diligence process is an exhausting and expensive process. Sometimes, general checklist usually does not cover all the necessary risk factors or questionnaires which can make the process comprehensible. In many cases sellers were found to be reluctant to reveal the weaknesses and they have also tried to conceal certain risks areas.
Before finalizing a transaction, an acquirer can identify and assess risks, liabilities, and business problems in the target company with help of adequate due diligence. Adequate due diligence checklists and proper questionnaires can make the due diligence process more comprehensible. Further, due diligence should be handled by specialized consultants so they can identify risks quickly and thoroughly. Nevertheless, due diligence can be a time-consuming, expensive, stressful, and exhausting process for both parties — all for an uncertain outcome. Even then, the only worse thing is entering into a blind deal and living to regret it.
Managing risks with proper due diligence
Conducting proper due diligence is a secret for successful transaction. Following are the steps which can be helpful while conducting the due diligence:
- The first move, as with any project, is to define corporate objectives. This helps to identify the resources as well as the information required, and ensures that you’re on track with the company’s overall strategy. This entails asking yourself introspective questions about what you want to get out of this investigation.
- Due diligence starts when both parties have agreed and have signed a LOI (Letter of Intent). An LOI outlines the intent of both parties. And even it is not legally binding it is better to sign an LOI because it shows that the buyer is serious about a potential purchase. Due diligence is a tedious and expensive process. It’s best get started early and one of the first steps is to research publicly accessible sources. Here, anyone can find the initial but important information relating to the target or acquiring company.
- Due diligence process requires an expert professionals such as investment bankers and consultants which can make the due diligence process more efficient. And if these experts recognize any risks during diligence, they should address them promptly.
- Setting up a data room for handling the transaction is next time for affective due diligence. A data room is a secure place that is used to store privileged data, there are basically two types of data room: physical data room and virtual data room. These data rooms usually set up at in the seller’s business premises or office, where the buyers, sellers, and the attorneys handling the transactions can meet to access documents.
- After gathering and uncovering all the information one should evaluate the risk and address the potential risks and benefits with the proposed transaction.
It is clear that managing risks and performing adequate due diligence is a serious business that should begin with a proper policy and plan. Due diligence works as a risk assessment, and it weighs the advantage and risks associated with the purchase apparent to the buyer. Companies and their advisors need to carefully scrutinize every aspect of the due diligence process because well-conducted due diligence is an integral part of a successful M&A transaction. A well-equipped and competent team should be formed to detect that the risks associated with the transaction.
Suppose, the due diligence process is not handled correctly. In that case, there is a risk for all parties, i.e, for the buyer, a key risk or potential opportunity is not fully explored prior to the deal’s completion, and for the seller, poor process management results in a loss of credibility, mistakes, or delays, impacting deal completion or price. Hence, due diligence should be done with due care, otherwise, it could lead to serious consequences.
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