For a layman, the term ‘Due Diligence’ means the reasonable verifications and precautions taken to identify or prevent foreseeable risks. It is the process of evaluating a business situation diligently from various aspects before arriving at a decision.
In the context of an M&A transaction, Due Diligence provides the buyer with reliable and complete background information on proposed deal and also helps in uncovering potential liabilities and discrepancies and thus enables the buyer to take an informed decision. There are various forms of Due Diligence depending upon the area/scope of coverage like Financial Due Diligence, Legal Due Diligence, Commercial Due Diligence and Tax Due Diligence. Other diligences may be performed in areas such as IT and human resources. It should be noted that there are no clear boundaries between these categories.
One or more of the above areas may not be relevant to all Due Diligence engagements and a bespoke scope will be required to focus on the issues of each unique transaction.
Why Due Diligence is important in M&As:
• To investigate into the affairs of a business as a prudent business-person
• To confirm all material facts related to the business
• To access the risks and opportunities of a proposed transaction
• To reduce the risk of post-transaction unpleasant surprises
• To confirm that the business is what it appears
• To identify areas that influence valuation of the deal
• To identify potential deal breakers in the Target company and avoid a bad business transaction
Planning effective Due Diligence:
The first step of any Due Diligence assignment should be to discuss the scope of the engagement with the client to do the following:
• Understand the proposed transaction and the degree of access expected
• Understand what benefits are expected to arise from the Due Diligence process
• Identify client concerns and implement strategy to counter these
• Determine the overall timelines for the process and delivery of the Due Diligence report.
Once agreed, the scope of the engagement will allow advisors to deliver a report containing information pertinent to the acquirer, which will act as a meaningful decision-making tool throughout the transaction.
Types of Due Diligence:
I. Business Due Diligence: This mainly includes the following types
a. Operational Due Diligence: Aims at the assessment of the functional operation of the Target company. Consideration of non-financial matters of a Target business, which may include assessment of systems and processes, review of the incumbent management team, staffing levels and other HR activities, or insurance arrangements and risk assessment.
b. Technical Due Diligence: Involves review & diligence of intangible assets like Patents, Copyrights, Designs, Trademarks and Brands. It also includes assessing the Target company’s performance on current level of technology and further scope of improvement in this regard.
Some of the primary reasons for conducting Business Due Diligence include:
• Assess the opportunities available to the Target company for margin expansion.
• Validate the vendor assumed operational improvements in projections.
• To evaluate the competitive landscape and the technological trends along the industry’s value chain which are key parameters to understand the business of the Target company.
Key Focus Areas of Business Due Diligence :
♦ Technology/Intellectual Property: The buyer will be interested in the extent and quality of the Target company’s technology and intellectual property. Key questions will revolve around the following:
• What domestic and foreign patents does the Target company have?
• Has the Target company taken appropriate steps to protect its intellectual property?
• What registered and common law trademarks and service marks does the Target company have?
• What copyrighted products and materials are used, controlled, or owned by the Target company?
• Is the Target company infringing on (or has the Target company infringed on) the intellectual property rights of any third party, and are any third parties infringing on (or have third parties infringed on) the Target company’s intellectual property rights?
• Is the Target company involved in any intellectual property litigation or other disputes?
• What technology in-licenses does the Target company have and how critical are they to the Target company’s business?
• Has the Target company granted any exclusive technology licenses to third parties?
• Are there any other liens or encumbrances on the Target company’s intellectual property?
♦ Sales & Marketing: The buyer will want to fully understand the Target company’s marketing strategies, customer base including the level of concentration of the largest customers as well as the sales pipeline. Topics of inquiry or concern will include the following :
• Who are the top customers and what is the share of revenues from each of them?
• What customer concentration issues/risks are there?
• Will there be any issues in retaining customers after the transaction?
• How & what seasonality in revenue and working capital requirements does the Target company typically experience?
• Does the Target company provide products, services, or technology the buyer doesn’t have?
• What is the extent of sales returns and realization of sales?
• What revenue enhancements will occur after the transaction?
Basic checklist for conducting Business Due Diligence:
• Market Review including market mapping, market size, key players, industry value chain, value drivers, market potential, etc.
• With respect to each product line, understand the Target company’s existing marketing strategy and any contemplated changes.
• Obtain a summary of significant new products, technologies or processes currently under development.
• Agreements related to the marketing of the Target company’s products, franchise agreements, Target company sales forms or literature, including price lists, catalogs, purchase orders, etc
• Technology agreements, documents pertaining to proprietary technology developed / owned by the Target company including copyrights, patents filings, copy of all permits and licenses necessary to conduct Target company’s business.
• Understand the status of the relationships with major suppliers and vendors, including a description of any supplier quality issues.
II. Legal Due Diligence: Legal Due Diligence is the process of collecting, understanding and assessing all the legal risks associated during an M&A process.
Some of the primary reasons for conducting Legal Due Diligence include:
• To better understand the Target ’s legal arrangements and regulatory compliances
• Help in drafting the relevant M&A agreement
• Identify Impediments to closing the deal
Key Focus Areas include:
♦ Material Contracts: One of the most time-consuming (but critical) components of a Due Diligence inquiry is the review of all material contracts and commitments of the Target company. Some of the categories of contracts that are important to review and understand include the following:
• Real estate leases/purchase agreements
• Review copies of all agreements affecting real property
• Review of all the insurance agreements
• Review of all guarantees and indemnities provided by the Target company
♦ Financing Agreements: Review copies of all agreements evidencing borrowings by the Target company, whether secured or unsecured, documented or undocumented, including loan and credit agreements, mortgages, deeds of trust, letters of credit, indentures, promissory notes and other evidences of indebtedness, and any amendments, renewals, notices or waivers.
♦ Litigation and Regulatory Matters: Review a documentation relating to and description of all pending, threatened or completed litigation, claims, suits and proceedings in which the Target company is, was or could be a defendant for the past five years, including the nature of the litigation, the amount involved and any opinion of counsel as to the probable outcome.
Basic checklist for conducting Legal Due Diligence :
• Memorandum and Articles of Associations and bye laws.
• Corporate regulations including special industry policies, practices and procedures
• Employment agreements
• Prospectus filed at the time of raising funds from public
• Copies of any lawsuits involving the Target company or the subsidiaries or any such decrees, orders or judgements of courts or governmental agencies
• Documents filed with ROC for registration of Charges or Immovable properties.
• Any settlements made in any of the litigations and if so documents relating thereto.
• Mortgages, financial or performance guaranties, indemnifications, equipment leases or other agreements evidencing outstanding loans which the Target company is a party or was a party within past three years.
III. Financial & Tax Due Diligence: In an M&A transaction on the financial front, the buyer will be concerned with all of the Target company’s historical financial statements as well as the reasonableness of the Target ’s projections of its future performance. Financial Due Diligence will involve a review of historic data for the entire entity or possibly on specific projects, review of forecast performance and funding requirements.
Some of the primary reasons for conducting Financial Due Diligence are outlined below.:
• Financial Due Diligence is conducted to support deal decision making, negotiating, and eventually, post-announcement planning and execution
• Gain understanding of Financial position of Target company
• Arrive at the valuation of the Target company and to negotiate the purchase price
Key Focus Areas in Financial Due Diligence include:
♦ Quality of Earnings: Key questions will revolve around the following:
• Do the Target ’s earnings closely approximate cash flows and if not, why?
• What do the Target company’s annual and quarterly financial statements for the last five years reveal about its financial performance and condition?
• Do the financial statements and related notes set forth all liabilities of the Target company, both current and contingent?
• What accounting treatment does the Target utilize in relation to its peers and what is the reasonable estimates?
• Are the Target company’s projections for the future and underlying assumptions reasonable and believable?
• What normalized reinvestments (including working capital and net capex) will be necessary to every year to stimulate growth in operating income? How do the historical reinvestments look like?
♦ Financials & Operating Trends: A focus on identifying and analyzing key operating and financial trends that are important to gauge the likely future earnings power of the Target .
General queries revolve around the following :
• What are the key factors which are driving the margin expansion or compression, rate of cash conversion and return on invested capital
• How does the Target company’s operating cycle looks like over the last 5 years? What are the reasons for its improvement / decline. How does the Target company foresee them going forward?
• What is the condition of assets and liens thereon? Are the assets used productively?
• What is the impact of regulatory changes on the Target ’s earnings potential.
• What is the Target ’s performance with respect to KPI’s and what is the quality and reasonableness of the benchmarks established?
• Are there any unusual revenue recognition issues for the Target company or the industry in which it operates?
• How is the business being impacted by related party transactions?
Basic checklist for conducting Financial Due Diligence:
• Audited financial statements for the historical period – linked to schedules, groupings and the trial balance along with the auditors’ report and notes to the account.
• Analyzing Shareholding pattern of the Target company over the last 3 years
• Latest copy of CIBIL report and credit rating obtained by the Target company
• Details of changes made in accounting policies in the historical period and quantify the impact of the same on historical results.
• Management letters or special reports by auditors and any responses thereto for the last three financial years.
IV. Tax Due Diligence: Tax Due Diligence typically involves reviewing the tax position adopted by the Target, adequacy of tax provisions made, status of tax holidays/ incentives availed of by the Target and unabsorbed tax losses and depreciation. Thus, a tax Due Diligence helps in understanding tax impact post the transaction and enables the stakeholders to make informed decisions.
Some of the primary reasons for conducting Tax Due Diligence are outlined below:
• Identification of inconsistencies in historical tax filings/ compliances, if any, and quantification of tax exposure thereof
• Analysis of tax positions taken by the Target and assessing their impact going forward
• Ascertain ongoing tax liabilities / litigations of the Target and what is the impact on deal’s internal rate of return?
• Assessment of availability of tax attributes (tax holiday, unabsorbed losses, etc.) of the Target to the buyer
• Identifying underreported tax liabilities and ascertaining whether all tax liabilities are adequately provided for in the books
• Identifying if an alternate transaction structure is required where potential tax exposure in doing a transaction as per a given structure is significantly higher.
Key Focus Areas for conducting Tax Due Diligence include:
Some of the typical tax issues that come across in a Tax Due Diligence and have significant bearing on the transaction are as under:
♦ Recapture past losses upon change in shareholding: Under the Indian tax regime, change in shareholding of a closely held Target company by more than 49% hampers its ability to carry forward unabsorbed tax losses (excluding depreciation) which were otherwise eligible to be carried forward for eight years. While conducting the Due Diligence, it needs to assess whether there has been any change in the shareholding of the Target in the past which has impaired its ability to carry forward the unabsorbed losses. Due Diligence also enables the buyer in ascertaining the balance/ unexpired period for which the tax losses can be carried forward by the buyer and in factoring the same in the valuation.
♦ Claim of tax holiday/incentives (Section 10AA, 80IA, etc.): Under the Indian tax regime, tax holidays/incentives can be availed of for a specified period subject to the fulfilment of specified conditions. It is necessary to assess whether or not the conditions prescribed for availing of a tax holiday have been complied with by the Target company, the correctness of such a tax holiday claim and the unexpired period for which the tax holiday can be claimed by the buyer so that the buyer can factor the same in valuation.
♦ Recoverability of tax refunds/credits: Tax Due Diligence helps the buyer in ascertaining the quality and recoverability of tax refunds/tax credits like MAT credit being claimed as eligible to be carried forward by the Target company.
♦ Transfer pricing (TP) documentation: It needs to be assessed whether the TP documentation has been duly prepared and maintained by the Target company
Basic checklist for conducting Tax Due Diligence :
• Assessment status for the past three years with income tax returns and annexures
• Historical tax filings & tax computations
• Copies of all notices, intimations, etc., received in the last three years
• For the current financial year (pending return of income),analyze details of all advance taxes paid (if any) including MAT
• Analyze indirect taxes such as Service Tax/ Value Added Tax/ Excise Duty/ Customs Duty
• Sample checks of withholding tax compliance
Due Diligence Documentation:
The final output of Due Diligence is presented in the form of a Due Diligence report. A good Due Diligence report should not only list the material issues identified in Due Diligence but also provide recommendations on how each issue could be dealt with. Potential recommendations include requesting further information, conducting further Due Diligence, capturing the information into buyer’s valuation of the Target, restructuring the transaction or purchase price payment, including in the transaction documents the completion of remedial action as a condition precedent to completion, a pre or post completion undertaking or covering off relevant risks with an indemnity.
Based on the findings of a Due Diligence exercise, the parties may negotiate the commercials of the M&A transaction, which could range from debt-like adjustment to the agreed consideration or taking appropriate indemnities from the seller or creating an escrow mechanism. At times, this may also necessitate structuring a deal to ensure that the interest of the buyer is protected. The acquirer will also seek legal protection. Use of escrow accounts, indemnities and warranties are all common outcomes of the Due Diligence process. Typically, these will be included in any Share Purchase Agreement, with the vendor providing representations at the point of purchase. Should such provisions be refused by the vendor, then an acquirer may have to be prepared to walk away from the deal.
Some issues such as deficiencies in basic reporting cannot always be addressed pre-deal, despite the risk they may present to the acquirer. These can be dealt with using a post-deal plan whereby vendor and acquirer work together post acquisition to validate pre-deal assumptions, develop integration strategies and commence the delivery of short-term goals.
Due Diligence should be regarded as an integral element of an M&A transaction. The Due Diligence process must be structured and co-ordinated in such a way that the information gathered enables the buyer to make an informed decision on whether to go through with the acquisition and whether to manage any post-acquisition issues that have been identified. In addition, the Acquiring company’s management and Due Diligence team, supported by external advisors if necessary, have to structure and focus their Due Diligence efforts on the buyer’s objectives in order to verify that a purchase transaction can bring the desired benefits.
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