perform a due diligence
Image Source - https://betanews.com/2017/02/06/due-diligence-is-vital-when-buying-a-business/

In this article, Ramanuj Mukherjee, CEO and Co-Founder at iPleaders discusses how to perform a due diligence.

Due diligence is a necessary part of deals – M&A, private equity or venture capital investments, even term loans from banks – due diligence in the step that always comes before the deal is closed.

What happens when you don’t do due diligence? Many of you may have seen a brilliant fictional example of this in Silicon Valley Season 4, Episode 2. If you are a lawyer and never watched this, please do. Silicon Valley is full of amazing legal anecdotes and maneuvers.

This episode is named Terms of Service. Without going into juicy details, lets just put it this way: a greedy tech giant desperately looking for a new breakthrough forces a hostile takeover on a popular chat service that seems to be growing virally. In a hurry, the owner of the tech giant Huli, Gavin Belson, strikes the deal over a dinner forcing the CEO Dinesh Chughtai to sell PiperChat right there on the spot. Dinesh knows that there is a potential 21 billion USD fine for violation of an important law, about which he has been really scared since he discovered the screw up. So Dinesh appears to cave in to Gavin’s pressure and signs the papers given to him. Thus Huli acquires PiperChat and all the liabilities of future fine along with it. As a result, Gavin Belson soon gets fired by his board. This is exactly what can happen if you buy a company, or invest into it without due diligence.

Let’s say you invest into a garment factory. Later it turns out that there has been serious labour law violations in the factory, or that there was massive environmental damages caused by the factory, because of which factory licenses are revoked. Your investment can become worthless overnight. Hence, due diligence is a critical part of all deals. Even before giving big loans, banks conduct due diligence.

Who has to learn how to do due diligence?

Investment bankers, corporate lawyers, CAs, analysts working in PE and VC firms, loan officers in banks – these are the people who must learn how to conduct due diligence, or how to make sense of it. There are often also other people involved who assist in the due diligence process, such as company secretaries, HR managers, operations managers, accountants etc.

Different types of Due Diligence

Technology due diligence –  This is critical for technology companies. If you are claiming that you have created a breakthrough technology and investors are putting in money on that basis, or a competitor is buying you out to get their hands on that technology, technology due diligence is a critical part of that. This is conducted by expert technology engineers and lawyers, bankers, CAs etc have no role to play.

Tax and financial due diligence – This looks into the financial aspects of the due diligence. Do the number in the books add up? Does the company really have the profit margins that it is claiming? Are there any hidden liabilities in the books? Has all taxes been paid appropriately or some sudden tax claim may come up in the future? These things can impact the price of a company or its shares in a very big way.

Legal Due Diligence – This is the more extensive part of the due diligence. The checklist changes from one due diligence exercise to another, but following things must be checked out in any case.

  • Incorporation documents and MCA filings
  • Loan agreements and financing documents
  • Business Licenses
  • Labour & Employment Law compliances
  • Intellectual Property Portfolio
  • Business Contracts
  • Real estate – lease agreements, rent agreements and land ownership
  • Tax
  • Environmental compliances
  • Disputes and litigation

What is the difference in due diligence in different kinds of deals?

The scrutiny level in due diligence exercises changes significantly depending on what kind of deal it is and how much risk the investor/buyer is getting exposed to. For instance, in case a company is buying 5% stake in a public company, the level of scrutiny will be very less. On the other hand, an acquirer acquiring a company 100% will want to exercise very high level of scrutiny because any pending issues, or risks that may materialise in the future, will all come upon the acquirer once acquisition is completed.

Similarly, when an angel investor or VC is acquiring a 10% or 15% stake in a startup, the due diligence is not as detailed as when there is a strategic acquisition of 51% or 80% stake by a big company in a startup.

It depends on the size of the deal, and therefore how much risk the acquirer/buyer/creditor is taking and whether a part of the risk is also being borne by the promoter of the company.

As a general rule of thumb, in case of investment due diligence is usually less extensive than in M&A. Small term loans come with smaller due diligence exercise while loans of large amounts require more extensive due diligence.

Other kinds of due-diligences:

There can be many other types of due diligences, where an asset is being acquired though there is no acquisition of a company or investment being made in any entity. For example, there may be IP due diligence before a highly valued IP is acquired. Land due diligences are commonplace before land is purchased. Naturally, these due diligences are different in scope. The principle, however remains the same: determining the true value of an asset and risks associated with it before buying it/ acquiring an interest in it.

How to begin the due diligence exercise?

Due diligence is all about getting access to data from the other side. It is sometimes like an investigation. You know that the company is supposed to have certain documents. If the give you those, you may find mention of more things. You also give them a questionnaire that they have to respond to. This questionnaire containing answers also becomes a part of the document given by the other side. As you get many clues about what may have happened in the company that needs to be investigated, you ask for more documents.

It all starts with a questionnaire that you make. Apart from questions that have to be answered, the questionnaire also requests certain documents. To make the right questionnaire, you have to research about the company, about its industry. If a colleague has already done a due diligence on a company from the same industry, you can get your hands on that questionnaire if possible, that may make your job far easier.

The Data Room

Due diligence data is sensitive and confidential. This is why, due diligence is usually conducted inside a data room with very restricted access. The people who are doing the due diligence of course get access, along with a few key employees of the organization on which due diligence is being conducted. All the information and documents are brought to this room, and then inspected, and then returned.

Let’s say you want to acquire a factory. Most likely, the data room maybe located at the factory, and lawyers are brought to the location. Then inside the data room, they get access to a bunch of documents, and they ask for more as they progress with the due diligence.

On the other hand, digital data rooms are quite in vogue these days. Instead of bringing lawyers, investment bankers etc to the venue, the target company uploads all the data into a digital version of the data room. This data room prevents unauthorised copying and gives access to a select few people. It saves a lot of time and expenses.

Due Diligence Report

Finally, after all the documents are expected, a due diligence report is made. A due diligence report of a large company can run into hundreds of pages but most modern law firms prefer to submit a shorter one with 30-50 pages. The rest of the data is often sent as annexure if necessary. There is also usually an executive summary so that one can easily get the headlines without having to go through a massive document.

What do you need to know to be good at due diligence?

To be good at due diligence, you need to be really good at extracting important information. Also, you need to know what information is relevant, and have some implication on the deal and what is irrelevant. Important data can hide in the plain sight, and you can’t afford to miss it.

People skills can be very important as sometimes the source of data are the employees who can tell you things about which there are no document trails. Can you make them feel comfortable to speak about it? What if they deny information or does not cooperate? What is they take ages to give you relevant information? Can you still get the work done within the deadline assigned to you?

Before doing due diligence, you need to acquire vast knowledge regarding compliances. India has hundreds of laws that can apply to a business and missing a major one could mislead your due diligence. Preparing the due diligence checklist can be quite a cumbersome task if you have never done it earlier.

Report writing after the investigation is done is also a very important skill. Most new lawyers are quite terrible at it as they have no idea how to write a good report.

How can you learn to be better at due diligence?

This is a practical skill and you get good at it only when you actually start conducting due diligence exercises. Learning from seniors is definitely a good idea. However, if you are completely clueless you might find out that you are being a burden on the entire process. Also, being good due to prior preparation will definitely earn you respect of peers and seniors. You can sign up for a course on due diligence towards that end. You can also conduct a mock due diligence once to get familiar with different steps.

Here is an exercise you can do at home: Make a due diligence checklist for an acquisition transaction of a fertilizer factory located in Haryana.

All the best with your due diligence skills! Hope you develop some serious prowess soon.

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