Due Diligence In M&A Transactions

What is due diligence?

Due Diligence is the investigation process for relevant facts and financial information
undertaken by professionals of different fields to ensure that the organization is running
smoothly and efficiently without any default. The main purpose of due diligence is to give
confidence to the acquirer company that the company is in good condition, and they will not
face any such difficulty after acquiring the company. It shows the company plans to raise
additional capital. It covers both inter- corporate as well as intra- corporate transactions along
with the regulatory checklists. The cost of the due diligence depends on the effort and scope of
the kind of diligence undertaken. Due diligence is a through and through examination of all the
critical aspects of business. Every aspect of the business must be examined through due
diligence- financial, operational, tax, commercial, tax, IT, integrity, social, environmental,
health and safety, regulatory, etc. It is seen as a comprehensive appraisal of the business by a
prospective buyer to evaluate the assets and liabilities and other factors of business.

Role of due diligence in M&As

Mergers and Acquisitions involve a reasonable amount of due diligence by the buyer as before
committing to the transaction it essential for the buyer to know what it will be buying and what
all obligations it will assume with the purchase, the nature, and extent of liabilities of the target
company, litigation issues, intellectual property issues, etc. This is particularly important in the
case of private companies where the target company has not yet been subject to the scrutiny of
the public and where the buyer has very little ability to obtain information that it could
ordinarily obtain from public sources.

Thus, it can be said that the basic function of due diligence in any merger or acquisition is to
assess the potential risks involved in the proposed transaction by inquiring into all relevant
aspects of the business to be purchased in its past, present and predictable future.

The four core areas of due diligence in a merger transaction are as follows;

Financial statements review: This is done to confirm in the balance sheet the existence of
assets, liabilities, and equity, and analyze the income statement of the company to determine
its financial health.
Management and operations review: This is done to determine reliability and quality of
financial statements, and to gain a sense of contingencies which exist beyond the financial
statements.

Legal compliance review: This is done to review and check for potential legal problems that
could arise in the future stemming from the target company’s past. legal due- diligence is to
check whether the company has complied with all the relevant laws or not. The relevant laws
applicable to companies are:-

1) Companies Act, 2013.

2) SEBI Act, 1992

3) Labour laws

4) SARFAESI Act

5) Prevention of Corruption Act

6) Prevention of Money-laundering Act

7) Real Estate Regulations Act

8) Indian Trust Act, 1882

9) Transfer of Property Act,1882

It depends on the company-to-company basis under which laws they are being regulated. The

benefits of this type of due diligence are four-fold for the acquiring company. First, it enables

the buyer to understand the target company and its operations. This then aids the buyer in not

only determining a fair purchase price but helps to prepare a strong M&A contract. And most

importantly, with a thorough understanding of the target’s potential legal risks and liabilities,

you can make an informed decision and avoid falling into hot water later down the track. After

the due – diligence is approved by the professional Entrepreneurs and start-up founders are not

the kind of people who would be extremely adept with paperwork and are often clueless about

the documentation required at the time of seeking investment for their stunning business idea.

A term sheet happens to be the preliminary document that a start-up founder has to encounter
at the beginning of any investment transaction. In simple terms, a term sheet is like a marriage

proposal where the company and the investor meet to negotiate the terms of their investment.

Basically, a term sheet is a legal document that sets out the parameters to be adhered to by

parties in a business agreement. It is a document that marks the start of an investment

transaction. Some of the important clauses which parties need to be well-versed with are as

follows:-

1) Investment Amount – The amount that is being invested in the company. This clause is

important from the company’s stand view to raise capital.

2) Pre-Money valuation – Companies are valued by investors through various modes such as

Asset based model, Market Valuable model, Discount Cash flow model and others.

3) Conversion right – This is quite a favorable option for early investors whose ultimate

objective is to gain equity control in the company.

4) Liquidation Preference – LP sets out who gets paid. Firstly how much they get in the event

of winding up or investors needs to strategically exit the Company. It is said to be downside

protection clauses and means to protect investors from adverse consequences of downside

events at a valuation lower than investors entry valuation.

5) Anti- Dilution clause – Investors have an apprehension that their own shareholding may

gets diluted in came Company go ahead with new shares. For this purpose the investor insists

on “Anti-dilution clause “.

Now, let us start answering questions that arises out of the discussion in a term sheet.

A. When does a term sheet need to be signed?

Term sheets are not time-specific but they are pre-financial documents. They are the

basis on which other financial documents are executed. Hence, as far as the signing of

the term sheets is concerned, that will occur once both parties agree to the terms of the

term sheet.
 B. Who usually prepares the term sheet?

A term sheet is usually prepared by the investors after the pitch of the entrepreneur to

such investors. That being said, there is no hard and fast rule regarding who can prepare

the term sheet first. Logically, the investors after listening to the pitch of the

entrepreneurs prepare the term sheet which then goes on for several rounds of

negotiations.

Why is due diligence important for any M&A transaction?

Though a slightly time-consuming process due diligence is essential before any M&A is
undertaken. And the companies entering into an M&A must make sure it is conducted in a
proper manner as it is essential to investigate the affairs of business as a prudent person would.

The other advantages of Due Diligence are as follows;

a. It helps assess the risks and opportunities that shall be present in the proposed
transaction and reduces the risk of unpleasant post-transaction surprises.
b. It confirms all material facts of the business and that the business is exactly as it appears
without any discrepancies.
c. Due diligence helps create a relationship of trust between two otherwise unrelated
parties.
d. It helps identify potential deal killers and defects in the target business that help avoid
bad business transactions.
e. It helps gain information which would be useful for valuation of assets, indemnification
and also negotiation processes.
f. It also helps verify that the target business has bene complying with norms of the
industry and identify potential “red flags.”
g. Lastly, due diligence also helps in analyzing the target before a controlling interest is
acquired in it.

Tools of due diligence

One of these methods involves preparing a questionnaire for the target company, which helps
us in identifying the risks involved in the business of the Company and gives an overview of
the General and Financial health of the Company.
Another way is to ask the Seller to make Representations and Warranties regarding the conduct
of business in a contractual agreement.

The third method involves reviewing the financial analysis of the targeted company’s business,
analyse and identify the legal risks associated with the same.

Procedure concerning due diligence

There are two ways of conducting due diligence:

• In the first method, the seller Company presents predetermined data to the Buyer in a
data room.
• The Second method involves analysing the data provided by the Seller in response to
the questionnaire.

In the Data Room method, the Potential bidders are supplied with large amounts of data,
which is then studied and valued. Each Buyer is presented with the same amount of data and
information and any discrimination in the supply of information or documents may end up
vitiating the whole process. Therefore, in this method, due diligence is conducted on a large
amount of data and information provided by the Seller/target company.

In the questionnaire method, negotiations are done on a one to one basis based on the answers
supplied by the Seller Company. A due diligence report is prepared by the lawyers based on
these answers and further negotiations can be done based on this report.

Initially, the buyer sets up a team of legal and financial experts. This team consists of investors,
lawyers, accountants, personal consultants, and other service providers based on the business
your company is involved in.

In the next step, the due diligence team gathers all the material information and documents.
Once the confidentiality agreement is signed between the parties, the due diligence team can
request the seller company to provide the necessary documents. The objective of this
preliminary survey conducted by the team is to identify some critical issues like statutory non-
compliance, concealment of facts and figures, pending legal proceedings, any imbalances in
internal controls of the company, and so on. As a result of this preliminary survey, the buyer is
able to identify any potential risks and deal breakers issues before money and other resources
are committed to the target company.
If there is any problem during the review process, the team will decide on abandoning the
deal altogether or modifying their offer. The team can hold meetings with the seller company
to address any grievances on time. A certificate of completeness of disclosures should also be
obtained from the target company stating the authenticity and completeness of documents
provided, and that no material information has been withheld by the seller company. If the
buyer is satisfied with the information, it can proceed with the transaction and send a
purchase agreement to the seller company for approval.

Elements of due diligence

Financial due diligence

Financial due diligence is considered to be one of the most important types of due diligence. It
aims to ensure that the financials provided by the target company in the Confidentiality
Information Memorandum are accurate. It also involves an analysis of major customer
accounts, analysis of profit margins, and inspection of internal control procedures. The
Company’s order book and sales pipeline order are also examined, to make better projections.

Intellectual property due diligence

Intellectual property assets are considered to be some of the most valuable assets in possession
of a company; these intangible assets are what differentiate a company from its competitors,
vis-à-vis the products and services they provide. Therefore, it is important that a due diligence
review is conducted over some items like a schedule of patents and patent applications,
schedule of copyrights, trademarks, pending patent clearance documents, and any pending case
against the company in regard to intellectual property.

Taxes due diligence

Due diligence concerning tax liability involves a thorough review of all the taxes the target
company is under an obligation to pay and ensuring their proper calculation. Furthermore, the
status of any pending tax-related cases also needs to be examined.

Customer due diligence

Customer Due diligence is essential to a transaction as it provides the buyer company with a
close look at the target company’s customer base. It involves an examination and review of
the following:
 • Top customers of the company, customers who are indispensable to the company
regardless of their current spending with the company.

• The current credit policies, service agreements, and insurance coverage.

• Customer Satisfaction Score and a list, with explanations of any important customers
lost by the target company in the past three years.

Legal due diligence

In any acquisition, a company wants to avoid acquiring any unwanted legal liabilities from
the target company. Legal due diligence, therefore, includes a review and examination of the
following:

• The Memorandum and Articles of association of the company.

• Minutes of Board meetings of the preceding years.

• Shareholder Certificates issued to important management personnel of the company.

• All the material contracts and agreements to which the company is a party to.

• Copies of all credit agreements, bank financing agreements, licensing, and franchise
agreements.

These are some of the key elements of due diligence that need to be kept in mind before
entering into a mergers and acquisition transaction. Additionally, diligence in antitrust and
regulatory issues, insurance, material contract and employee management issues are some
other key areas where due diligence is required.

Is due diligence mandated by Indian law?

Securities and Exchange Board of India and several provisions in the Companies Act, 2013,
cast an obligation on the director to act in the best interests of the company. He is supposed to
exercise due care and skill while doing the same.

In Nirma Industries and Anr v. Securities Exchange Board of India, the Supreme Court
opined that under Regulation 27 (d) of the SEBI, 1997, an investor Company needs to ensure
that appropriate due diligence is carried out regarding the target company before investing. The
Court stated that Nirma Industries were aware of various litigations, the plea of ignorance of
litigation and dangers of investment was thereby denied.
Challenges associated with conducting due diligence in india

• In most transactions, there are confidentiality and secrecy covenants, which prevent
the disclosure of any material data or information.

• In case of a distressed M& A transaction, the investor company is dependent on the

Insolvency Resolution Person, Committee Of Creditors , and the management for
providing basic data and information. This may lead to a discrepancy in information
being shared, leading to disputes.

• A correct assessment of the contingent and past liabilities and making

recommendations for the same, make the task of a due diligence expert difficult.

• Due diligence requires a variety of experts; therefore, the procedure can end up being
an expensive one for the acquirer.

• In many transactions, there is also insufficient basic data provided to the acquirer,
which makes the procedure challenging.

How to effectively undertake due diligence exercise

Before making the last move, it is essential to keep the following things in mind to effectively
undertake due diligence:

• Firm and clear strategies and a well-defined objective are one of the fundamentals of
an effective due diligence exercise.

• Allocate clear responsibilities and formulate procedures for the personnel involved in
data management, project management, and core due diligence team and so on.

• Have an integrated approach towards the due diligence process and seek the expertise
of technical consultants whenever necessary.

• It is also expedient to store the data in electronic form, which makes it easier to
transfer to and being accessed from remote locations.

• Use the latest technology for retrieving, analysing, and reviewing data.

• It is important to deal with the media reports, although paying too much attention
should be discouraged.
 • On-site visits should be encouraged; the on-site conditions give a firsthand view of
the prevailing scenario which can never be available on paper.

• Lastly, there needs to be a continuous dialogue between the acquirer and the target
company and there should be no hesitation in seeking clarifications.

Conclusion

A comprehensive due diligence process is essential for the success of any merger and
acquisition transaction. The fundamental purpose of due diligence is to validate assumptions
on identification and valuation of risks. It must be ensured that the scope of investigations is
tailored to the nature of the transaction. Due diligence is of utmost importance, and it cannot
be emphasized enough that most deals fail due to nothing more than inadequate due diligence
due to which the buyer ends up overpaying or experiencing major integration problems or
assuming unknown liabilities.
Document and transaction review: This is done to ensure that the paperwork of the deal is in
proper order and that the transaction structure is appropriate.