DUE DILIGENCEDUE DILIGENCECA. Rajkumar S AdukiaCA. Rajkumar S Adukia

B.Com(Hons.) B.Com(Hons.) FCA, ACS,MBA, AICWA, LLBFCA, ACS,MBA, AICWA, LLB ,Dip ,Dip In IFRS(UK) In IFRS(UK)

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DUE DILIGENCEDUE DILIGENCE

CONCEPTCONCEPT 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.

DEFINITION AND MEANING OF DUE DEFINITION AND MEANING OF DUE DILIGENCEDILIGENCE

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.

HISTORICAL BACKGROUND OF DUE HISTORICAL BACKGROUND OF DUE DILIGENCEDILIGENCE

The term Due Diligence was first used under US Securities Act, 1933 as Due Diligence Defence.

Due diligence defense is generally used by brokers-dealers 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.

OBJECTIVES OF DUE OBJECTIVES OF DUE DILIGENCEDILIGENCE 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.

DUE DILIGENCE

WHY DO YOU CONDUCT A DUE WHY DO YOU CONDUCT A DUE DILIGENCE?DILIGENCE?

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

WHY - DUE DILIGENCE?WHY - DUE DILIGENCE?

Investment Risk Assessment

Validate assumptions of Information MemorandumUnderstanding Investment Return & Risk

Profitability /Performance Ratios ROCE vis-à-vis Cost of CapitalCash Flow analysis

IdentifyPotential AdjustmentsPotential Risk/ExposuresOff balance sheet exposures

Negotiation Valuation

WHY - DUE DILIGENCE?WHY - DUE DILIGENCE?

Shock Absorber

Identify Information not presentedLegal Non-CompliancesIncorrect Representations/Information MemorandumReduce Surprise from becoming Black holesRed Flags

Deal Structuring/Agreement

Identify exclusions to be mentioned in Final Agreement

Exclusions – Ownership encumbrancesShareholders AgreementContingent liability Indemnity/Warranties

Identify structuring issues – e.g. Lease & buy back

WHY - DUE DILIGENCE?WHY - DUE DILIGENCE?

Enhance Understanding

Identify Growth Drivers and USPAnalyze Present Key Business DriversReview bottlenecksStrategy for futureSystems & Personnel - information

DUE DILIGENCE vis-à-vis DUE DILIGENCE vis-à-vis AUDITAUDIT

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.

STATUTORY AUDIT & DUE DILIGENCE REPORT (DDR) –A COMPARISON

Defined Tailor Made

Statutory Audit DDR

Legal Requirement

Scope

Mandatory Non-Mandatory

Focus Historical focusHistorical and futuristic focus

STATUTORY AUDIT & DUE DILIGENCE REPORT (DDR) –A COMPARISON

Appointed by thecompany

Appointed by either the buyer or the seller

Statutory Audit DDR

Attitude

Appointment

Watch-Dog Investigator

Emphasis True & Fair Commercial AspectsIssues concerning Term sheet

TRADITIONAL V/S VIRTUAL DATA TRADITIONAL V/S VIRTUAL DATA ROOMROOM

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 TRADITIONAL V/S VIRTUAL DATA ROOMROOM 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 TRADITIONAL V/S VIRTUAL DATA ROOMROOM 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 TRADITIONAL V/S VIRTUAL DATA ROOMROOM 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.

VARIOUS TYPES OF DUE VARIOUS TYPES OF DUE DILIGENCEDILIGENCE

TYPES

BUSINESS

FINANCIAL

LEGAL

SECRETARIAL

BUSINESS DUE DILIGENCEBUSINESS DUE DILIGENCE 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 DILIGENCEFINANCIAL 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 DILIGENCELEGAL DUE DILIGENCE Legal Due Diligence is about the management

of risk.

The Legal Due Diligence covers two aspects – intra-corporate transactions and inter-corporate transactions.

Legal Due Diligence investigations give the most complete picture of a company.

LEGAL DUE DILIGENCELEGAL DUE DILIGENCE 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 DILIGENCESECRETARIAL DUE DILIGENCE

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.

DUE DILIGENCE

SELECTION OF A DUE DILIGENCE SELECTION OF A DUE DILIGENCE CONSULTANTCONSULTANT 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

SELECTION OF A DUE DILIGENCE SELECTION OF A DUE DILIGENCE CONSULTANTCONSULTANT

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 CRUCIAL FACTORS TO BE CONSIDERED WHILE CONDUCTING DUE DILIGENCECONDUCTING 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 CRUCIAL FACTORS TO BE CONSIDERED WHILE CONDUCTING DUE DILIGENCECONDUCTING 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

PROCESS OF CONDUCTING DUE PROCESS OF CONDUCTING DUE DILIGENCEDILIGENCE

Preparation of Due Diligence Report

Data Analysis

Planning

Data Collation

29

PLANNINGPLANNING

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)

DATA COLLATIONDATA COLLATION 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.

DUE DILIGENCE

DATA ANALYSIS 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.

PREPARATION OF DUE DILIGENCE REPORT 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

ROLE OF PROFESSIONALS ROLE OF PROFESSIONALS INVOLVED IN DUE DILIGENCEINVOLVED IN DUE DILIGENCE

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

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE[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.

DUE DILIGENCE

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE 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

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE

[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.

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE[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.

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCECORE 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

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE(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

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE

[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.

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE 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.

AREAS REQUIRING DUE AREAS REQUIRING DUE DILIGENCEDILIGENCE

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.

DUE DILIGENCE

CAUTIONSCAUTIONS 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

BOTTLENECKSBOTTLENECKS

Psychological Issues

Information Overload Delay in reply to important queries - “divert

attention” Information provided in bulky format – Hard copies

with unimportant details

Practical Commercial Issues

Financial & Accounting Scandals Non financial angle to weak areas

DUE DILIGENCE

BOTTLENECKSBOTTLENECKS 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

CASE STUDYCASE STUDY

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.

DD is a “Mind-Game” between Seller and DD Team!!!

TIPS FOR EFFECTIVE DUE TIPS FOR EFFECTIVE DUE DILIGENCEDILIGENCE 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.

TIPS FOR EFFECTIVE DUE TIPS FOR EFFECTIVE DUE DILIGENCEDILIGENCE 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.

CONCLUSIONCONCLUSION "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

CONCLUSIONCONCLUSION

FOREWARNED IS FOREARMED

CAVEAT EMPTOR (LET THE BUYER BEWARE)