|Assume that you are planning to buy a used car. What all things you will consider before making the decision?||You will check its ownership documents, accident histories, physical appearance etc.|
|However, if you are not an automobile engineer or a technical person, how will you know about its technical aspects including the performance of the engine, wear and tear, etc.?||You will engage an experienced automobile technician to inspect the vehicle to decide on buying it. Isn’t it?|
Role of Due Diligence in Business Mergers & Acquisitions or similar Transactions:-
Likewise, buying or acquiring a business also requires a series of checks and confirmations. When entering into an M&A transaction involving a significant sum of money, buyers do not want any surprises. After all, once the investment is made, any historical issues become the new owner’s headache. Because of this, it makes sense that a prospective buyer would like to uncover potential risks before deciding on investing monies.
What is due diligence?
Due diligence is the process of evaluating and analysing a business from every angle before finalising a decision to acquire or purchase a business. This process is very critical in every M&A transaction as it helps to identify the undisclosed obligations, contracts that may create future problems, statutory liabilities, risks of litigation and lawsuits, risk of assets ownership, intellectual property issues, the target entity’s contingent liabilities, and much more. It is one of the essential steps to be completed before buying a business. It is generally performed after making a purchase/investment offer, but before closing the deal.
When due diligence is required
If you are entering into an investment transaction involving a sum of money, performing due diligence is advisable. It cannot always be said that due diligence is done from the part of investor or buyer, sometimes it is being performed by the seller also to know the background of the investor or buyer, his financial capacity to provide the funds, legal eligibility to invest etc. When you are entering into a partnership business or joint venture, proper due diligence can help you in identifying the existing and potential issues that may arise by entering into such a partnership or joint venture.
Types of due diligence
We can classify the due diligence into three broad types
- Business due diligence
Business due diligence covers the risks associated with a market opportunity of the business, potential for the product of a business, competition, business sustainability, its operations and processes, the management of the target entity and its vital resources etc.
- Financial due diligence
Financial due diligence covers the risks of financial impacts by acquiring a business. It includes assessment and evaluation of existing liabilities and estimation of contingent obligations and liabilities. The financial due diligence will cover financial reports, profitability, key ratios, tax liabilities, pending tax and statutory compliances etc. This is generally performed by evaluation of audited financial statement of past years, review of books of accounts, tax and statutory filings, payment of employee benefits, tax exemptions and benefits availed, pending tax litigations, contracts entered by the entity, capital structure of the company, debt structure of the entity, debt repayment history, guarantees/securities given by the entity etc.
- Legal due diligence
This part is performed to ensure that the target entity is legally compliant in all the manner to operate its business. Legal due diligence is generally performed to uncover the risks associated with ownership of movable and immovable assets, risk of present and potential legal proceedings against the entity, legal risks associated with contracts and agreements etc. In the case of companies, it is vital to consider the impact of Companies Act in the transactions of the company, including the proposed investment transaction and foreign investment guidelines of the RBI and Governments before concluding an investment decision.
If the target entity’s business involves any technical aspects, technical feasibility has to be conducted before making a final decision. In the case of IT businesses, identifying your target’s current security risks or other IT problems is critical. For manufacturing companies, it is essential to inspect the machinery, estimation of capacity and useful life, etc. before deciding on the transaction. Depending on the industry, this may be another critical factor in evaluating the target business.
Before concluding your decision about investing your hard-earned money, it is always advisable to conduct proper due diligence with the help of experienced professionals to minimise the potential risk of losing all your time and money. Further, it will help you in negotiating with the target entity and also helps you to have a better picture of the business before involving in it. Before concluding, simply reminding you of a thoughtful old proverb “prevention is better than cure”.