This article is written by Priyanshi Soni, a student of Symbiosis Law School, Noida. This article seeks to highlight the meaning, importance, and types of due diligence including its drawbacks in the business world. It also discusses the need for a legal team for entrepreneurs in due diligence.
Table of Contents
Today’s business and corporate world is becoming more and more complex with the coming of new rules and investment strategies and many companies, including the big ones, struggle with diligently making decisions and even compromise on the integrity aspect with an intent to evade scrutiny and gain money through illegal means. Therefore, it is increasingly important for investors and buyers to insist on thorough due diligence before making the final move. It is very crucial for them to investigate the financial and overall health of the enterprise before making agreements so as to avoid future losses or complications. And, due diligence facilitates this aim. It helps in such scrutiny beforehand so that they come to know if such an investment will be worthwhile or not.
Due diligence means an investigation or inspection or a risk assessment of an upcoming business transaction done i.e., before purchasing another property or company. This is kind of a background check done to ensure that all the facts are in place and the parties to the business transaction have the required information and in the business world. It specifically is a “strict legal investigation” done to ensure that investment will be beneficial and all the required facts are known to the parties. It empowers the maxim “caveat emptor” i.e. let the buyer beware while purchasing.
Due diligence is the process by which confidential, legal, or financial information, as well as other relevant information, is exchanged, examined, and appraised by the interested parties in a business transaction.
With due diligence, we can identify specific dangers and avoid costly mistakes. Depending on the circumstances, it could be a lengthy process that takes weeks or even months to accomplish.
There are certain areas of focus during ‘due diligence’ in the business ecosphere such as-
- The effect of synergy: Synergy between the two companies makes decision-making easier.
- Environment: The target company’s macroenvironment and its impact.
- Existing and potential liabilities: If there are any pending lawsuits or regulatory difficulties.
- Monetary aspect: looking at the financial data available to understand the whole thing better.
- Technology: assessing the profitability of technology available in the targeted company.
Objectives of due diligence
The main objective remains the finding of problems and issues which might crop up in the business to give unexpected liabilities.
- Collect material information from the target company;
- To take a correct and judicious decision about an investment;
- Conduct a swot analysis to identify strengths and weaknesses and further improve the bargaining position on the basis of the swot analysis;
- To identify areas where representation and warranties are required;
- To attain the desired comfort level in a transaction and bridge the gap between existing and the expected.
When is due diligence required
- Mergers and acquisitions: In this, due diligence is done from the viewpoint of both seller and buyer. It has to be taken into concentration on what both of them focus on, i.e., their prime importance. Like, the seller focuses on the financial ability of the buyer, the experience of the buyer, etc and the buyer focuses on budget, litigation, patents, etc.
- Partnership: For business alliances and connections, due diligence holds importance.
- In joint enterprise and collaborations also.
Due diligence is conducted by the enterprises analyzing the risks in two ways or both together:
- Hard due diligence – This deals with legalities, mathematics, and strategies mainly. Analyzing the assets, benefits, costs come under this.
- Soft due diligence – Basically, this deals with the overall internal functioning and health of the organization including its human elements.
There are 3 types of due diligence applicable to different purposes and enterprises but the object of due diligence remains the same.
- Business due diligence – This type helps the companies and enterprises in assessing the business risks and investment possibilities, etc., which even assists the buyers in understanding the potential risks and gives clarity in planning for the integration.
- Legal due diligence – Legal difficulties are assessed in depth. Legal risks associated with mergers and acquisitions are taken into consideration so as to avoid any future legal complications. This sort of due diligence covers both inter-corporate and intra-corporate transactions. This due diligence also results in several regulatory checklists, in addition to the pre-existing documents.
- Financial due diligence – This evaluates the accounts, financial conditions, budgets, and decisions related to the same. Also, tax compliance and audits are also covered under this.
What do investors look for
What investors look for in the targeted company is its key areas of investment such as current and future financial details, budget, what are the growth prospects of the enterprise in the coming years, will it be beneficial to investors, the actual market size of the company, it’s potential to compete in the market, team structure with its level of competence, etc.
All interactions with investors, agreements with customers and suppliers, credit and loan/debt liabilities, partnership and joint venture agreements, and lawsuits, if applicable, must be supplemented.
It is of utmost importance that all the documents and data are ready and compiled if at all required during due diligence. If there is an existing claim or problem, be it legal or business-related, it can cause hurdles in dealings. And thus, even when the target company has some hidden facts and unresolved issues which it has not disclosed, then it can cause issues in the future. It is better if all the documents are presented and nothing is hidden. It is observed that investors tend to favor companies that are easy to communicate with. Keeping lines of communication open and being responsive to clarification requests with factual explanations will provide major benefits to the potential company.
It is also advisable that the company should have a detailed presentation of various departments and information related to finance etc. ready with it to show the investors. The information, as we discussed, should not be having any hidden or false information.
Furthermore, the company should maintain open channels of communication with its investors and act quickly on any issues that arise.
Significance of a legal team
Now we can clearly see that there is ample work required to be done to achieve this. Due diligence requires the rigorous collection of data, then its analysis, and a lot more. It is very important to have a proper legal team for maintaining due diligence, securities, and drafting before the investors which not only gives correct and crucial legal advice but also makes an impression before them regarding the systematic and punctual working of the company. Investors may also insist on document revisions, adjusting the bidding price, fine-tuning the shareholding structure, or changing investor rights and duties. This will be done quickly and without complications, if a systematic legal team exists.
After the basic information sharing and assimilation of facts, the investors can rectify the problems. But there will be few issues that will be beyond their control and a piece of legal advice will be required to rectify them. When all the issues are settled, only then the process of due diligence is said to be completed. Though there is no one way for this, firms who grasp the importance of this process and its components will undoubtedly have an advantage when it comes to recruiting investments.
There are few provisions under the Securities and Exchange Board of India (Regulations) 1996 (SEBI), Securities Contracts (Regulation) Act, 1956 (SCRA), Income-tax Act 1961, etc., which show that a competent legal team is very important from the start of signing till the end, wrapping it up. Section 24 of the SCRA of 1956, Section 27 of the SEBI 1992, Section 278(B) of the Income-tax Act of 1961 – all these provisions list the offenses which will make companies stand guilty.
The way to manage this in a judicious manner is that there should be an existence of a strong legal team and the entrepreneurs should keep on communicating with their legal team from the very start as such interactions will ensure that the data is clean and updated and no loophole remains.
Disadvantages of due diligence
The major disadvantages of the process of due diligence are that it can be lengthy, difficult, and tiring. While conducting the investigation, the buyer will, more so depending upon the transaction, ask questions and try to gather facts from different people and departments, such as lawyers, accountants, etc., and this will consume a lot of time and can also lead to incomplete records. This will become very tough for the buyer to understand the facts in less time.
Further, the seller will also be affected negatively as he will now have to focus more on solving the queries and assessing the same. This will consume his time and divert him from running the business.
For the company investors to manage and conduct due diligence, it is very crucial to maintain all the records with discipline and honesty. If they work hard towards this, then it would be a cakewalk in the future. We already saw how due diligence works and benefits if conducted properly. A legal team further adds more to the whole process. It is always suggested to divide the work among partners to keep a timely check on records. This will give positive outcomes and ensure that they have daily data at their fingertips.
To summarise, the following are the top ten key tasks that every entrepreneur should undertake rigorously, regardless of the stage of the company –
- Make an index of all signed documents and official records.
- Keep all records in one secure location.
- Use colour coding and time stamping to label your files.
- Hold regular and frequent board meetings.
- Check each item on the pre-planned agenda one by one and ensure that the necessary paperwork is in place.
- Entrepreneurs should be aware of their finances and keep track of them.
- As discussed above, interaction with your legal advisor is equally important.
- Even if you think that your data is not worth sharing, they also do not hide or fudge it from the investors. Also, be honest with your records, if not perfect, as you may be an early entrepreneur with less experience, but honesty plays a major role.
Due diligence is a valuable tool for risk management.
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