CA. Rajkumar S Adukia
B.Com(Hons.) FCA, ACS,MBA, AICWA,
LLB ,Dip In IFRS(UK) rajkumarfca@gmail.com
www.carajkumarradukia.com
9820061049/9323061049
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It’s a proactive management tool.
Taking every reasonable precaution.
It is essentially an investigation to manage risks.
Systematic, structured research effort to ascertain and accumulate facts necessary to make an informed investment “decision”.
In common parlance, a care that a reasonable person or organization exercises under specific circumstances to avoid harm to themselves or others.
A measure of prudence, activity, or assiduity, as is properly expected from, and ordinarily exercised by, a reasonable and prudent man under the particular circumstances.”
Black’s Law Dictionary with Pronunciations, sixth edition 1994, p. 457
Due Diligence is a process of investigation undertaken by various lenders including banks and financial institutions for assessing the performance of business.
The process of investigation performed by investors into the details of a potential investment such as examination of operations and management and the verification of material facts.
The term Due Diligence was first used under US
Securities Act, 1933 as Due Diligence Defence.
Due diligence defense is generally used by brokersdealers for inadequate disclosure to investors.
Initially, Due Diligence was restricted to Initial Public
Offer (IPO) only but overtime Mergers and
Acquisitions etc. also found the place.
Due Diligence helps to get the realistic picture of business today and tomorrow.
To spot out the evils, which may invite some unanticipated liabilities in future.
To forecast the future performance of an organization by analyzing the potential risks and threats.
To help in identifying liabilities, negotiate a lower price, avoid lawsuits and costly mistakes and top of all to make good business and financial decisions.
Essential to determine the hidden risks which are attached to the transaction as it may result in the transaction being aborted or affect the purchase price or terms of the agreement.
Transactions involve substantial financial obligations.
The need for Due diligence is sought to unearth the secrets which every business tend to have one.
Good Corporate Governance
DUE DILIGENCE
Validate assumptions of Information
Memorandum
Understanding Investment Return & Risk
Profitability /Performance Ratios
ROCE vis-à-vis Cost of Capital
Cash Flow analysis
Identify
Potential Adjustments
Potential Risk/Exposures
Off balance sheet exposures
Identify Information not presented
Legal Non-Compliances
Incorrect Representations/Information Memorandum
Reduce Surprise from becoming Black holes
Red Flags
Identify exclusions to be mentioned in
Final Agreement
Exclusions – Ownership encumbrances
Shareholders Agreement
Contingent liability
Indemnity/Warranties
Identify structuring issues – e.g. Lease & buy back
Identify Growth Drivers and USP
Analyze Present Key Business Drivers
Review bottlenecks
Strategy for future
Systems & Personnel - information
Due Diligence is far beyond the financial analysis. Audit is concerned with the truth and fairness of historical financial statements only.
Due Diligence can be conducted by any of the professionals whereas Audit is to be conducted mandatorily by the Chartered Accountants.
Scope
Legal
Requirement
Statutory Audit
Defined
Mandatory
Focus Historical focus
DDR
Tailor Made
Non-Mandatory
Historical and futuristic focus
Appointment
Statutory Audit
Appointed by the company
Attitude Watch-Dog
DDR
Appointed by either the buyer or the seller
Investigator
Emphasis True & Fair
Commercial Aspects
Issues concerning
Term sheet
TRADITIONAL V/S VIRTUAL DATA ROOM
Traditional Due Diligence Data
Room – Data is available in a lawyer’s office or conference room
Virtual Due Diligence Data Room –
Data is accessed through the internet.
TRADITIONAL V/S VIRTUAL DATA ROOM
Location - A traditional data room is usually located at a nearby lawyer’s office to increase security. This also increases costs. A Virtual data room is located on a secure server at a third party data center.
Effort - Traditional data room will require the printing and indexing of many electronic documents, financial spreadsheets and contracts.
While many paper documents must be scanned to create the electronic images for a virtual data room all of the electronic documents can be processed online.
Security - With a lawyer’s office the security is only as good as the paralegal who is in the room taking care of the documents. If implemented correctly a virtual data room can be more secure than a lawyer’s office. You can restrict who sees what documents and who can copy what documents.
TRADITIONAL V/S VIRTUAL DATA ROOM
Cost A Traditional data room is not as cheap as the Virtual data room after you add up the labor to copy and index all the documents plus the legal office space to manage a multi week data room effort.
Record Activity – In a Traditional data room you cannot record who sees what document, wherein in a Virtual data room, however, one can have daily reports of who viewed at which documents.
Document Reviewers – In a Virtual data room one can keep track of who reviewed which documents, on the other hand such an advantage is lacked in a traditional data room.
Lower Investor Risk – There is less investor risk involved in the case of a Virtual data room as compared to a Traditional data room.
TRADITIONAL V/S VIRTUAL DATA ROOM
Multiple Bidders A Virtual data room by its nature can allow all users to access the same documents concurrently and in private.
New Info Distribution Bidders will often submit questions and request additional data. With a Virtual data room is very easy to add new documents to the data room and notify everyone of its posting.
Restrict Access – In a Virtual data room the access to the information may be restricted to specific / authorised people.
TYPES
BUSINESS
FINANCIAL
LEGAL
SECRETARIAL
Business Due Diligence aims to ensure that the buyer gets all the material facts required to make a fully informed decision and assessment of the true condition of the business while not disrupting the seller’s business unduly.
Timing is critical. It is best to work out some type of planned schedule in advance so everyone’s expectations are met and we do not have disagreements or unnecessary delays.
It includes:
Operational due diligence
Strategic due diligence
Technical due diligence
Environmental due diligence
Human Resource due diligence
Financial due diligence analyzes, qualitatively and quantitatively, how an organization has performed financially to get a sense of earnings on a normalized basis.
It includes:
Review of accounting policies
Review of internal audit procedures
The quality and sustainability of earnings and cash flow
The condition and value of assets, liabilities and potential liabilities
Accounting systems and controls
Tax implications of deal structures
Examination of key operational processes
Examination of information systems to establish the reliability of financial information
Legal Due Diligence is about the management of risk.
The Legal Due Diligence covers two aspects – intracorporate transactions and inter-corporate transactions.
Legal Due Diligence investigations give the most complete picture of a company.
The investigation or inspection would cover:
Compliance with local laws
Securities or other regulatory violations or disciplinary actions
Extensive litigation and/or bankruptcies – assessment of feasibility of pursuing litigation
Financial statements
Unpaid tax liens and/or judgments
Past business failures and related debt
Fraudulent or exaggerated credentials
Misrepresentations or character issues
Discoveries and disclosures
Assets – real and intellectual property, brand value
Reputation and goodwill
Cross-border issues – double taxation, foreign exchange fluctuation, sovereign risk, investment climate, cultural impact on human resources.
Secretarial Due Diligence ensures that the targeted company has duly complied with the corporate laws and regulations and other applicable provisions, if any.
It refers to the secretarial audit of the company.
Clarity of object
Size of the organisation
Key Concept to be kept in Mind
Avoid "Casual" Due Diligence Consultants
Consider an End-to-End Provider
Beware of Hidden Interest
Multi -Functional Expertise
Secure Long-Term Relationships with Your Consultant
Selecting the Best Firm
DUE DILIGENCE
Client base of the Consulting Agency
Meetings should be arranged
Terms & Conditions should be discussed before hand
Consultant should be selected vigilantly
CRUCIAL FACTORS TO BE CONSIDERED WHILE
CONDUCTING DUE DILIGENCE
Be prepared with :
A detailed listing of the exact due diligence steps to follow
A checklist of everything to complete in each due diligence area
Specific due diligence tasks that need to be completed
All of the materials you need from the seller before you start
CRUCIAL FACTORS TO BE CONSIDERED WHILE CONDUCTING
DUE DILIGENCE
Allow yourself time
Information from vendors and customers
Analyse financial as well as following key factors:
The management team’s past performance, roles and talent
Organizational strategy and business plans
Risk management structure
Technological superiority
Adequacy of infrastructure
Internet Research
Planning Preparation of Due
Diligence Report
Data Collation Data Analysis
Scope and Core areas
Appointment of the team - Skills/expertise
Clear and definite mandate
Defining the time schedules- how to deal with challenges within agreed time frame with available resources
Timely communication of information requirements (Due Diligence Checklist)
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Research for data could be either qualitative or quantitative
One on one interviews with management from the target company
Data room and access to the room
Sources : Internet, Competitors, Industry associations, Regulatory organizations and databases which will include searches of public registers, Customers, Vendors etc.
Understanding everything you can about the company
It should be done keeping in mind the objectives of
Due Diligence
The analysis of due diligence findings is generally a weighing of a variety of factors in order to determine whether team should give a positive recommendation eg : business criticality, functional complexity, technical complexity, infrastructure requirements etc.
DUE DILIGENCE
A summary of the scope of the review
A list of all the information disclosed by investigations
An analysis of the documentation and information revealed
An executive summary which outlines the legal issues identified and advises on the legal implications of proceeding with the transaction
(Risks and Liabilities)
Highlight the material issues arising from the due diligence review and advice on the factors influencing the price to be paid
Professionals involved in
Due Diligence
Company Secretaries
Chartered Accountants
Cost Accountants
Advocates / Solicitors
Financial Analysts
Professionals should have
Expert knowledge
Analytical & business advisory skills
Clarity of object
Confining to time frame and deadlines
[A] MERGER, AMALGAMATION AND ACQUISITION
Due diligence is a comprehensive undertaking in cases of potential mergers and amalgamation
Track record of the past as well as future prospects of the company is required to know so as to identify the potential growth of the company.
One should incorporate an element of objective self-analysis.
To complete the Due Diligence within a reasonable period of time,
- either
outsource the Due Diligence task to a reputable research firm or
build an efficient in-house program within their legal, marketing, or corporate security sectors.
A detailed assessment of the market and target of the proposed acquisition should also be clear prior to closing a deal.
In today's fast-changing business environment, one should look into following areas:
Financial
Research and Development
Intellectual Property
Material Agreements
Assets/Liens
Employment-related matters
Corporate Issues
Licensing and Litigation
DUE DILIGENCE
[B] PARTNERSHIP
One should conduct negotiations and investigation into affairs of the entities before entering into partnership.
Different types of partnerships where due diligence investigation is required to be done:
Strategic Alliances, Strategic Partnerships
Business Partners and Alliances, Partnering Agreements,
Technology and Product Licensing, Joint Development
Agreements, Technology Sharing and Cross Licensing Agreements
Business Partners, Affiliates, Franchisees and Franchisers.
[C] INTELLECTUAL PROPERTY
A detailed assessment of Intellectual Property (IP) assets has become an increasingly integrated part.
Due diligence process involves investigation of a party’s ownership, right to use and right to stop others from using the IP rights involved in sale or merger.
Thorough internal assessment of its own assets can enhance IP planning and management.
Acquiring or investing in a business that own IP assets require the scope and depth of due diligence.
CORE AREAS OF IP:
(1) Significant patent issues
– Scope of rights
– Rights transferable
–Issues raised by license agreements, other rights transfer agreements
–Reviewing/evaluating all pending/threatened infringement claims/enforcement opportunities etc.
(2) Significant copyright issues
– Assignment and Registrations in Proper Order
– Grants Effective
– Rights Transferable
(3) Significant trademark issues
– A list of all licenses, franchises, royalty agreements, or similar arrangements related to the target company and/or products
– Third party use
– Policing/licensing
(4) Significant trade secret issues
(5) Significant domain name issues
[ D]INITIAL PUBLIC OFFER (IPO)
Due Diligence plays a key role in an IPO.
Tool to optimize potential of the company, thereby increasing its value to potential investors.
Due Diligence is required to be conducted by the
Merchant Bankers.
Helps to identify any potential shortfalls in
Corporate Governance issues or financial reporting procedures so that the company is able to take corrective action prior to listing.
Pre-IPO Due Diligence process will result in a gap analysis between the present status of the company and the company that should be floated.
It identifies the weaknesses and strengths of the company.
Provides comfort in preparing a prospectus in accordance with Securities Markets Act.
Allows the management and lead manager to assess the reasonableness of the statements made in the prospectus as required by law.
Helps the lead manager to understand the business of the corporation and the main risks associated with it.
Sensitivity by seller / issuer access of confidential data to investors, especially when the latter are existing competitors.
Confidentiality Agreements : Limited disclosure to counter-party and its advisors with an obligation to return data in case deal falls through.
DUE DILIGENCE
Psychological Issues
Information Overload
Delay in reply to important queries - “divert attention”
Information provided in bulky format – Hard copies with unimportant details
Financial & Accounting Scandals
Non financial angle to weak areas
DUE DILIGENCE
Disapproval from the company.
Outcome of the Due Diligence Process may be consciously or unconsciously tainted by owners, managers and researchers who stand to benefit personally or professionally from the proposed activity.
Due Diligence is a difficult and extensive experience.
It is complex since more negatives may be established or envisaged.
DUE DILIGENCE
A major US Company intended acquiring an independent BPO
Company in India. The BPO Company as per their claims had an excellent line up of clients and credentials. They also claimed large business activity in Singapore.
The US Company wanted the due diligence team to find out if the acquisition candidate was indeed as sound as was made to believe, before they began any discussions with them.
The team’s investigations found that the BPO Company had started performing well only in the recent past, and that they were a group of companies and not one company, one of the companies of the group which had the same set of Promoters and Directors, had been sued against in the US for Product Liability.
DUE DILIGENCE
Exhaustive list of requirements.
Look for contradictory information or replies.
Ask questions where the intentions / objectives are disguised so that the replier cannot manipulate the reply.
Look at comments of Internal Audit Reports.
In case of resistance in providing information try to figure out why the information is being withheld.
Track the time period within which the replies are provided.
Is the tone of reply defensive or attacking.
Look at transaction post Letter of Intent (LOI) and pre Due Diligence
Report (DDR).
Look for deferment or expedition of transactions.
Review transactions with related parties and Transfer Pricing Policy for group company transactions.
Scrutinize the legal and professional charges.
"Due Diligence" is simply a phrase used to describe what are generally, “business investigations”. It is commercial jargon for the detailed analysis and risk review of an impending commercial transaction.
Adequate Due Diligence helps the buyer to
ascertain the current business conditions
status on pending litigations
negotiation of purchase price
decide on the proposed investment