This article is written by Prachi Gupta who is pursuing a Diploma in M&A, Institution Finance & Investment Laws (PE & VC Transactions) from Lawsikho.
Table of Contents
Introduction
We come across several business deals every day. People investing millions of dollars for acquiring a whole company. If one does not have much knowledge about business deals then he would have certainly wondered as to how business people entrust companies for investing their millions of dollars?
Certainly, investing such hefty amounts is not an overnight process. Before investing even a hundred rupees, investors or companies carry out a lot of research. This research is often referred to as “Due Diligence”.
Analysing the term “Due Diligence”, one can infer that it is an act of consciously analysing something before acting on it. Now talking of it technically, it can be referred to as a conscious analysis and research done by reasonable businesses or companies before investing or carrying out any transaction. It is when this act is summarised in the form of a report, it is known as a “Due Diligence Report”.
In this article, we are going to seek answers for various questions like what is a Due Diligence Report, what is the need for a Due Diligence Report, how is a Due Diligence Report prepared, what are the elements of a Due Diligence Report, and what are some things a person must keep in mind before preparing a Due Diligence Report.
Due Diligence Report
Due Diligence Report is the summary of the data collected in the process of Due Diligence. Due Diligence is a process of estimating the commercial potential of an entity, comprehensive evaluation of the financial viability of the entity concerning its assets and liabilities, and; an examination and verification of the operations and material facts in relation to a proposed transaction.
There are essentially 3 types of Due Diligence:
- Business Due Diligence: It includes the thorough check of the parties involved in a deal, the future likelihood of the business, and the standard of the investment.
- Financial Due Diligence: It is an important part wherein the financial, operational, and commercial prospects of the business are validated. It gives a clear picture to the acquiring company as to whether the deal is worthy or not. It involves the review in detail of the following: accounting policies, audit practices, tax compliances and internal controls.
- Legal Due Diligence: It covers mainly the legal aspects of a transaction. It looks for any legal red flags or pitfalls. It usually incorporates both the intra-corporate transactions, and inter-corporate transactions.
Drafting a Due Diligence report is essentially followed by the investigation process. After collecting all the relevant information from extensive research and investigations, one must produce the results into an organized report.
There are various transactions for which Due Diligence is performed. The kind of transaction determines the scope and length of the Due Diligence Report.
The various transactions include:
- Mergers & Acquisitions: In such due diligence, the buyer checks various factors like the commercial presence of the company, financial, litigation, patents, and other relevant information of the seller. Whereas, the seller checks the background of the buyer, financial capabilities, and various factors to ensure that the party will commit to the transaction and is capable of paying the negotiated transaction amount.
- Joint Venture & Collaboration: When a company collaborates with another, the most important factor that is considered is the market reputation of the company and the acceptability of resources at its end.
- Partnership: In cases of partnership, due diligence is done for strategic partnerships, strategic alliances, or such other partnerships.
- Public Offer: The aspects such as a decision on public issues, disclosure in a prospectus, post issue compliance, etc require due diligence in Public Offer.
Elements of a due diligence report
A Due Diligence Report can have various formats depending on the targeted audience. But a Due Diligence Report typically may include the following:
- A Statement describing the subject of research.
- Documents in support of the research such as corporate reports, legal documents, transaction copies, market research, etc.
- SWOT Analysis i.e. an overview of the strengths, weaknesses, opportunities, and threats linked with the proposal.
- Information regarding any liabilities, debts, or financial obligations that might affect the terms of any business dealing.
- Statistics and other information such as surveys, valuation reports, inspections, market analysis, and sometimes public input.
The variation in the format of a due diligence report can be seen with an example. For instance, due diligence conducted by a buyer before entering into a real estate deal might create a summary of findings related to zoning and the usage of land; regulatory and compliance issues; inspection reports; and, property assessment and taxes.
Drafting a due diligence report
Drafting a Due Diligence Report requires to address three questions:
- Who is the target audience?
- What is the objective of the report?
- What are the main aspects of decision making?
The various areas focused by a due diligence report are:
- It assesses the viability of the company which can be done by a thorough study of the business and the financial aspects of the target.
- It analyses the ratio and financial data to understand the monetary aspect of the proposed deal.
- It even focuses on analyzing the macro environment of the company and its impact on the same. This is necessary as no business operates in isolation.
- An important factor that is considered is the capability and credibility of the people who are operating the company.
- A due diligence report also covers any kind of pending litigations and regulatory issues.
- An important analysis in today’s time is the kind of technology available with the company. It becomes important as technology plays a major role in deciding the future actions of any company.
- It also focuses on creating a synergy between the two companies that could help in decision making.
Sections of a due diligence report
The various sections of a due diligence report can be categorised as follows:
- Corporate Records: The legal counsel seeks to review the principal formation documents of a target company, including the articles or certificate of incorporation and bylaws if the target company is a corporation, or the articles or certificate of organization and operating agreement if the target company is a limited liability company, including all amendments.
- Financial Informations: It involves the review of the copies of financial statements for the past five years that have been audited, including all notes and management’s discussion and analysis.
- Indebtedness: It involves an analysis of the indebtedness of the seller in terms of loan agreements, mortgages, notes and security agreements; reviewing the relation with lenders and constant commercial code searches with each daughter company.
- Employment and Labour: It includes the detailed lists of officers, directors, and all the employees; documents related to pensions, any profit sharing, pensions, deferred compensation, stock plans, and other non salary compensation or benefits; and any pending litigations related to labour and employment law.
- Real estate: It includes the copies of documents like insurance policies of the real property, appraisals and all studies, site evaluations, and government filings and reports prepared by consultants.
- Agreements: All agreements of the company and its subsidiaries, real estate leases, partnership or joint venture agreements; marketing, sales, commission, distributor, franchise agreement; brokerage or investment banker agreements; client agreements; licenses and subscriptions and other material contracts.
- Supplier and Customer information: It includes the list of material customers and suppliers, correlation with the customers or suppliers related to disputes.
- Legal: It includes copies of reports filed with government agencies, details of all the litigation and legal matters, copies of government licenses and any liabilities relating to environmental laws.
Need for a due diligence report
- In a due diligence process, the main objective is to find any red flags before the deal is closed. It helps in checking for any potential risks in the future.
- The information collected through the means of this report is crucial for decision making. In case, during the process of due diligence the company comes across any flaws, this could enable negotiations.
- The report enables the company to understand how the target plans to generate additional earnings. It plays like a reckoner in understanding the state of affairs at the time of the sale or purchase, etc.
The main objective of this report is to give the dealing party a clear picture of how the business will perform in the future.
Checklist for due diligence
One could look for the following documents for performing a due diligence process:
Memorandum of Association, Articles of Association, Shareholding pattern, Certificate of Incorporation of the Company, Financial statements including Balance sheets , Profit and Loss Accounts, Income and expense statement.; Bank Statements; Income Tax Returns; Details and Information of the Directors and management of the Company; Statutory Registers; Utility Bills; Employee records; Intellectual Property Registration and other application Documents; Tax Registration Certificates; Property Documents ; Operational, Legal, other Financial Documents; etc.
The various information one should look for during due diligence:
- Information on the company’s finances. This consists of financial statements for past years, tax returns filed and documents from accounts receivable. Information related to debt and loans could also be included in this category.
- Information on the employees of the company. This category includes information on the people holding positions in the company with their work experience. It may also include the data of the retired employees and their pension details.
- Information on the company’s assets. This category houses the details about the company’s different facilities, technology, and assets like intellectual property rights and copyrights.
- Information on partners, suppliers, and customers. This incorporates data about the different parties in the company’s supply chain and their relationships with each other.
- Legal information about the company. This includes data regarding any pending litigations, contracts, licences and permits with the company.
Some of the aspects reviewed during due diligence:
- Reviewing Articles of Association & Memorandum of Association could enable in knowing the powers.
- Statutory Registers of the Company
- Financial Statements and Bank Accounts
- Taxation Aspects
- Legal Aspects
- Operational Aspects
Tips that could be considered while drafting a due diligence report
- While drafting a Due Diligence report if any issue is identified, one could consider discussing the same and its probable consequences. For instance, if it is identified that the target company is not compliant with a particular law, one could mention the possible consequences of such non-compliance and the ways to mitigate such non compliance.
- One could consider avoiding the following mistakes:
- Poor understanding of the task in question or purpose of Due Diligence.
- An incomplete list of documents required.
- Failure to analyze issues or the challenges which the client will land for missing key issues such as expired licenses, hidden dues, etc.
- To keep the report brief one must avoid superfluous information.
- One must be patient, thorough, and attentive to the details.
- One must ensure that only the relevant and the most important information are being added to the report.
- While investigating one must ask questions if something looks off. Even though one wants to trust the client, they might fluff information in the Confidentiality Information Memorandum (CIM).
- If a person does not have a legal background he must seek assistance from a lawyer or an attorney while drafting the report.
Conclusion
A Due Diligence Report is equally important as the business transaction. It should be done as diligently as possible. Every significant detail should be included in the report. The various elements of a report vary with different transactions. Thus, a report incorporates all the important findings of a due diligence process. Further, it gives a better picture to the investor of the investigated company. A complete and a well documented Due Diligence Report supplements the decision making process.
A Due Diligence Report thus becomes an important part of a transaction. Drafting a Due Diligence Report often seems an intimidating task but, following the right process and using the right checklists can help in making the task easier.
References
- https://www.standardsfacility.org/sites/default/files/PG_343_Legal_Due_Diligence_Report.pdf
- https://www2.deloitte.com/content/dam/Deloitte/us/Documents/Real%20Estate/us-engineering-construction-ma-due-diligence.pdf
- https://dealroom.net/faq/due-diligence-report
- https://www.mondaq.com/india/operational-performance-management/17241/legal-due-diligence
- https://corporatefinanceinstitute.com/resources/knowledge/valuation/due-diligence-report/
- https://www.icsi.edu/media/portals/70/241120123.pdf
- https://cleartax.in/s/due-diligence
- https://taxguru.in/company-law/checklist-due-diligence-company.html
- https://www.corporatefinanceineurope.eu/due-diligence/financial.htm
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