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Due Diligence in streamlining Commercial Transactions

DUE DILIGENCE IN STREAMLINING BUSINESS TRANSACTIONS - AN OVERVIEW

Due Diligence, as the words suggest is the degree of care exercised by a person in a given circumstance. It echoes the Latin axiom caveat emptor, or “let the buyer beware’’. Due Diligence applies to any business transaction and is sometimes legislatively required, as contained in various provisions of SEC Act, US and Sarbanes-Oxley Act. There are several instances in which lenders conduct Due Diligence when they perform background checks for loans, ranging from home loans to large-scale commercial finance packages. The same is applicable for an underwriter who investigates the authenticity of stocks, bonds and mutual funds, and verifies the facts presented by issuers in registration statements, prospectus and other offering materials where underwriters can be held liable for any misstatements in offering materials unless they establish that they conducted sufficient Due Diligence.

VARIOUS COMPONENTS OF DUE DILIGENCE

Due Diligence in the corporate world encompasses multiple types, starting from the Due Diligence for KYC to the Due Diligence in Mergers and Acquisitions (M&A). The most widely recognised types of Due Diligence are the Financial Due Diligence and Legal Due Diligence.

In Financial Due Diligence, the focus is on the validation of historical information and the review of management and systems. The goal is to confirm the underlying profit and provide a basis for valuation.

In Legal Due Diligence, the focus is on a review of contractual agreements and commitments where the goal is to uncover warranties and indemnities as well as validate all existing contracts, sale and purchase agreements.

Apart from the aforementioned types, the Strategic Due Diligence is presented as going far beyond Financial Due Diligence. It is considered to be an enhanced version of Financial Due Diligence and when conducted comprehensively it increases the chances of a merger to succeed. The Strategic Due Diligence is a complex exercise to analyse the probability of the deal to work and if it is worth pursuing the deal. It takes into account the deal specificities and concentrates on investigating on what is considered to be critical to making the deal work. The Sarbanes-Oxley Act has further redefined the role of due diligence.

ROLE OF DUE DILIGENCE IN BUSINESS TRANSACTIONS WITH EMPHASIS ON MERGERS AND ACQUISITIONS

In the present day scenario, Due Diligence is frequently performed during M&A. As the likelihood of litigation increases in case of M&A, acquirers tend to become more diligent and begin pursuing several categories of Due Diligence. It is an evaluation process used by an interested buyer to better understand the selling business and the risks associated with potential ownership of the business. The reason Due Diligence is important from a buyer’s perspective in the case of a M&A is to understand how the business, its owners and how management operates. It is understood that buying an established company is less risky than starting one from scratch. This is because the buyer benefits from the start-up efforts of the Founder, the benefits of which are factored into the purchase price. And in such cases, to consummate a sale, the buyer and seller need to adjust their initial elements of the worthiness of business. The buyer conducts Due Diligence to make sure that he or she fully understands all aspects of business that is for sale. For buyer, the first step is to analyse the financial statements of the targeted company, whereas for a seller, it is all about getting the best deal.

In every Due Diligence process, there is a close analysis of various documents to understand the veracity on which Due Diligence is being performed. As far as mergers and acquisitions are concerned, some of the documents which need screening are company’s financial statements, breakdown of sales by product/ service group, inventory valuation, inventory write-down history, strategic plan and a five year forecast with detailed projections, and the capital budget of a company for the next three years etc.

By doing this, it helps both the targeted company and the acquiring company to achieve valuable market share, expand its product base, increase their profits and inject more equity into their brands.

Also, it is general practice that an M&A Due Diligence further conducts an in-depth analysis of balance sheets, company records and competitors that enables decision-changing insights, such as in the case of M&A deal of Amazon. Apart from the above-mentioned processes, it is also crucial for a company to examine the targeted company holistically by getting detailed inputs on existing contracts and commitments with third parties, which include settlement agreements, intellectual property rights, revenue shares and much more.

Based on the above discussion, it can be surmised that M&A is like a sport, where a player is often reminded the fact that a game is won in the actual practice and preparation of the game. In similar fashion, a successful M&A deal is concluded when Due Diligence is performed to review all aspects during various stages comprehensively.

Krishnamurthy S

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