This article is written by Atif Ahmed who is pursuing Diploma in M&A, Institutional Finance and Investment Laws from Lawsikho.
Table of Contents
Introduction
Buying or investing in a business is very risky. Suppose, you acquire a company and later on find out that the representations given by the seller were untrue, or the business of the company is not as valuable as projected by the seller, or there were hidden risks involved in the business, for example, suits against the company or the company had not complied with material provisions of Companies Act, 2013, or other statutes, and now the company is liable to pay heavy penalties. As a buyer, you will find yourself overburdened with compensations, penalties and undiscovered liabilities, and there is nothing much you could do about it.
To avoid falling into the above mentioned trap of unforeseen risks, liabilities, and penalties, the buyer or an acquirer often conducts an exercise of due diligence (“DD”) on the seller entity, in order to ascertain all the possible risks that are associated with the seller entity.
In this article you will learn about the relevance of DD exercise in the context of Merger & Acquisition (“M&A”) transaction, the kinds of DD, the steps involved in the process of DD, and the role played by different members of the law firm in conducting the DD exercise.
Meaning of Due Diligence and its Purpose
What is DD and what is its relevance?
Meaning of DD
Due Diligence (“DD”) can be referred to as a thorough background check conducted on the target company to discover the risks associated with the target company’s business.
It is generally conducted by the buyer or an acquirer on the company in which the investment is being made. However, it might sometimes be possible that the company which is being acquired or invested in, might also conduct a simple DD on the acquirer company.
Purpose of DD
The purpose of DD in an M&A transaction is to ensure that the proposed transaction is safe to go ahead with. The team conducting the DD reviews all the relevant and important documents and information pertaining to the target company and discovers associated risks by raising the red flags, wherever it is necessary. Once the risks and issues are found with the target company, those are compensated for, by taking specific representation, warranty and indemnity from the target company by the acquirer.
Relevance of DD
The relevance of the due diligence can be ascertained from the fact that If the issues or risks are found to be associated with the target company, then depending upon the number and kind of risk involved, it could result in one of the following:
- substantially reduce the consideration involved in the transaction, or
- increase the number of representation and warranties taken by the acquirer, or
- entirely change the mind of the acquirer against going ahead with the proposed transaction.
Importance of DD
Following are the importance of conducting DD exercise in M&A transaction:
- To confirm all material facts related to the business.
- To assess the risks and opportunities of the proposed transaction.
- To identify potential deal killers present in the target entity and avoid a bad business transaction.
- To gain information that will be useful for valuing assets.
- To take appropriate representation & warranties for indemnification.
- To improve bargaining power.
- To determine compliance with relevant laws and disclose any regulatory restrictions on the proposed transaction.
- To determine details that may be relevant to the drafting of the acquisition or investment agreement.
- To discover undisclosed liabilities or risks that may be deal-breakers.
- To evaluate other legal and financial risks of the transaction.
Common kinds of Due Diligence
Business DD
Under business due diligence, the business model of the target company is analysed and it is checked whether the business of the target company has the potential to grow. The revenue and the cash flow of the target company are also analyzed to determine its profitability and growth.
Legal DD
Under legal due diligence, the legal aspects relating to the target company are looked into. The compliances with Companies Act, secretarial standards, rules and regulations governing the business of the target company, contracts entered into by the company, ongoing or potential litigation etc. are all analyzed in depth.
Accounting DD
Under accounting due diligence, the information related to the financials of the target company is scrutinized. The team ascertains whether or not the financial information provided by the representatives of the target company is true and if it is accurately reflected in its accounting records. Often, an accountant conducts this type of DD.
Environmental DD
Under environmental due diligence, the team conducting the DD focuses on unearthing any environmental risks or liabilities that might be associated with acquiring the target company’s business.
Depending upon the industry that the target company operates in, there might possibly be other kinds of due diligence that would be carried out.
Steps involved in the process of DD
Planning
Once the buyer has chosen the company it wants to conduct DD on, he would hire the services of the experts to conduct the due diligence on the target company.
Hiring the right person for this job is an integral step and the expert would know what questions are to be asked and what information is to be sought from the target company for effective due diligence.
Planning is the first stage of any DD transaction and it sets the basis for a successful DD transaction. The expert would plan and strategize the whole due diligence process.
Industry Research
“What information needs to be sought from the target company?” The answer to this question varies from one company to the other, depending (among other factors) upon the nature of the industry that the target company belongs to, as the rules, regulations, licences and approvals required for every industry differs. This is why the next step of the DD transaction is industry research.
How to conduct research on the industry requirements of the target company?
- For listed target company:
In case the target company is listed with one of the recognised stock exchanges, then it must have filed an offer document or red-herring prospectus with the Securities and Exchange Board of India (“SEBI”).
Browsing such offer documents would give you an idea as to what are the laws and regulations that the target company is subject to, and how many and what kind of approvals and licenses are required to be availed by the target company.
- For unlisted target company:
Ascertain the nature of the industry that the target company operates in, for e.g. automobile, FMCG, health care, insurance, foods & beverage etc, and then look into the offer document filed with SEBI by another company operating in the same industry. For example, if your target company is Hops & Grains, you might browse through the offer document filed by Barbeque Nation Hospitality Limited, as both of these companies operate within the same industry, therefore the laws, rules, regulations, disclosure requirements of both the companies will be similar to a great extent.
In this manner, you would have an idea regarding what documents and information needs to be sought from the target company.
Preparing DD Checklist/Questionnaire
Once you conduct an industry research, either on the target company or the company from the peer group of the target company, you would have an idea as to what are the laws and regulations that the target company is subject to, and what licenses and approvals are required to be availed by the target company.
Now the next step would be to prepare a list of questionnaires or checklist pertaining to all the documents and information you would require in the exercise of due diligence process.
This checklist or questionnaire would be given to the representatives of the target company so that they could provide the necessary documents and information.
Analysis of Information
Once the documents and information asked for in the checklist or questionnaire is received by the team conducting the DD, the next step is the noting of all the relevant information from the documents, in the form of separate annexures to the main DD Report.
Requisition List
It might be possible that all the information and documents as sought in the checklist or the questionnaire are not given by the representatives of the target company in the last step. Further, it might so happen that the documents provided by the representatives of the target company in the last step might include a mention of certain other documents or information.
Such pending or additional documents or information is sought from the target company the team conducting the DD, chapter wise, in form of a requisition list, so as to facilitate ease for the representatives of the target company in providing the same.
Once the documents and information requested for in the requisition list from the representatives of the target company is received by the team conducting the DD, relevant information from the same is also extracted and noted in form of the annexures to the main DD report.
Preparation of the chapters of DD Report
Once the process of reviewing the documents received from the representatives of the target company and noting of information in form of annexures is completed (as mentioned in the last step), the process of writing the chapters of the Due Diligence Report (DD Report) begins.
The various chapters that usually form part of the DD Report are mentioned below for your reference:
- Executive Summary
- Corporate Matters
- Loans & Finances
- Consents and Approvals
- Material Contracts
- Litigations
- Human Resource (HR)
- Insurance
- Intellectual Property Rights (IPR)
- Annexures
These above mentioned chapters (excluding Executive Summary and Annexures) are prepared with key findings on the basis of the information as noted in the relevant annexures.
Executive Summary
Once all the chapters of the Due Diligence Report (DD Report) have been drafted, the final step in preparing the DD Report involves preparing an executive summary.
An executive summary is usually presented in the beginning of the DD Report, and it contains the gist of the entire key findings of DD transaction, presented in a very concise manner. It also lists the impact of the risk (if any) on the proposed M&A transaction, and it’s possible way-out.
How is the task of DD divided amongst various members of the team in a law firm?
It is also worthwhile to understand the roles played by different members of a team conducting the exercise of Due Diligence.
- Role of Partner
The partner is the leader of the team conducting the DD exercise. Once the team prepares the DD Report, the partner reviews the entire DD report, before sending the same to the client.
- Role of Principal/Senior Associate
Depending upon the work culture of the law firm, it is either the principal associate or senior associate, who overlooks the entire process of the due diligence. He/she allocates the tasks and responsibilities to the associates and also supervises and reviews their work.
- Role of an Associate
The associate or junior associate works on the tasks and responsibilities assigned by the Principal/senior associate, including preparing the annexures and drafting chapters of the DD Report.
Conclusion
It needs to be kept in mind that the due diligence report prepared by the accountant, law firm, or a consultant, would be read by the client, who will be a business professional. Therefore, the DD Report should be drafted in a very simple and easy-to-understand language and shall contain only the material findings, in a concise form, for the sake of brevity. The DD Report will considerably give an upper hand to the buyer or an acquirer by improving his bargaining power if significant risks and liabilities are discovered. Therefore, it is imperative that the DD Report shall not only consist of the issues but also their possible solutions or way-outs so that the client could make an informed decision.
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