The importance of due diligence in an M&A transaction can never be overemphasized. It is an essential step in effectuating a deal successfully.
Let us discuss the utility of this step-in risk mitigation during the transaction. the due diligence involves screening the company on various parameters and identifying potential risks and strategizing to prevent them. It gives the firms actionable data to rely upon in international transactions. External consultants can be appointed by the firms to carry out due diligence. This would give the added advantage of in-depth industry risks and a more nuanced approach to mitigate them. In transactions that are likely to be less risky, a simplified analysis of all relevant areas is enough.
Start-up companies employing few people and having minimum government contact tend to have a low-risk potential. Similarly, if the potential party to the transaction only operates at a domestic level, then compliances to international measures and provisions is not an area of analysis. A narrow financial analysis and tax audit with a sweep on the internet about the public data present about the party would be sufficient in such cases. On the other hand, if the party operates at both regional and international levels, then more than financial audits and public data might not suffice. The acquirer will have to look at the cultural aspects of the company as well. If the deal comes through, more than financial aspects help realize the expected synergies.
These areas must be focused on to assess risks during the due diligence process:
(i) Financial due diligence: Under this, the buyers try to assess the strengths and weaknesses of the target firm’s finances. During this, the financial statements of the company such as the balance sheet, the profit and loss account, and the cash flow statements are scrutinized. This is very important in nature, as the financial risks faced by the target firm shift to the buyer after the transaction is effectuated. Putting inadequate efforts in conducting financial due diligence can result in great financial losses to the acquirer’s firm.
(ii) Market and commercial due diligence: Market and commercial due diligence are correlated. In commercial due diligence, the marketability of the company is assessed, i.e., the aspects of the company which is unique to itself. The kinds of contracts that the company has negotiated, the research and development took up the company and the management of the material by the company are covered under this. It helps to assess the future potential of the company. This helps to correctly calculate the synergies of the transaction so as to avoid risks arising due to the overestimation of synergies and failure to capture them. The market due diligence involves assessing the market in which the target company operates. It entails studying its competitors and analyzing the products that brought the company the most success. This can help in understanding the market trends that can affect the post-merger entity and helps in avoiding unexpected reputational and market risks.
(iii) Tax due diligence: Under tax due diligence, both the current and future tax developments must be analyzed. Since the transaction of M&A itself would have some tax consequences, it would be unwise to leave this area of scrutiny. If the target company is going through some court proceedings of department instituted tax audits, then further tax liabilities might arise in the future. Moreover, tax regimes may vary in different jurisdictions in the case of cross-border mergers. The agreements can include a clause of tax indemnity and warranties to mitigate the risks of bearing tax of the opposite party.
(iv) Operational due diligence: This kind of due diligence is especially relevant to transactions where industrial companies are involved. It helps in understanding a company’s work process, its supply chain, and workflow. This is necessary to determine if the proposed business plan is feasible for the parties given the operational possibilities and risks. This helps to bring down the overestimated synergies and create a realistic picture. Financial institutions generally take up this kind of due diligence to calculate the risks linked with the over calculation of daily expenses.
(v) Technical due diligence: This is one of the most significant due diligences in cases of real estate acquisitions. The buyers are generally interested to know the capacity of the plants they are acquiring if they are used to their capacities and the quality of products they can produce. Depending on the industry it relates to, the buyer also needs to assess the risks of explosion, loss due to accidental fire, possible chemical contamination and radioactive reactions of the materials utilized, etc. This is an important risk mitigation step to minimize losses from causes whose occurrence cannot be foreseen. It helps to keep the acquired estate in its best condition, modernize it to adapt to the contemporary technology and needs, and remedy its known defects,
(vi) Environmental due diligence: Under this, the buyer checks the target company’s compliance with the national and international environmental regulations. The target company must have the necessary approval for the operations that it is undertaking. With growing environmental awareness and degrading health of the ecological system, it has become all the more important to manage environmental risks posed by the business operations of a company. Ignoring this aspect can have both monetary and reputational costs to the firm.
(vii) IT due diligence: IT Due Diligence is not just important in transactions where an IT company is involved. The sale of goods and provision of services over the internet is more prevalent now than ever and would be more so tomorrow. It is important to check the security of the online presence of the company and the communication channels that it utilizes in its operation. Some companies employ their own IT systems while others use licensed software by specialized companies. In the due diligence process, it is important to check the validity and authenticity of these licenses to avoid future ado. In the case of personalized IT systems, the compatibility of the two IT systems of the two potentially merged companies must be matched. This would save a sizable time and cost factor. This could also uncover security gaps in the system.
(viii) Human resource due diligence: This engages in the human aspect of the companies. This poses the biggest risk in the transaction. Human capital, in comparison to financial capital, is irreplaceable and often more valuable. In any kind of M&A transaction, the personnel structure of the companies involved tends to go through changes. This can affect the work processes of the company for the long term and might also project its influence on the planned synergies. The employment contracts must be reviewed in the human resource due diligence and conspicuous features in the contract must be paid sufficient attention as they can impact the purchase price. This will be discussed in more detail in the next section.
(ix) Legal due diligence: There is no need to separately mention this due diligence, as the legal aspects in all the application areas must be reviewed in their respective due diligence. However, this cannot be ignored, as an application area itself. Compliance with all the laws that apply to the target company must be reviewed. All the contracts that the company has entered into must be examined. The ownership structure of the company and its associates and subsidiary companies must be assessed. This will ensure that in the event of a takeover, the buyer doesn’t have to pay for shares that don’t have influence voting influence in the decision making. The purchase contract itself must be carefully scrutinized as it would be the basis for future risk-sharing between the parties.
(x) IP due diligence: This involves examining the intellectual property rights of the company. Registered patents, legally protected trademarks, the licenses granted to the company, and other industrial property rights that the company enjoys and deals with must be checked and changes in their ownership must be discussed before a transaction is entered into.
(xi) Cultural due diligence: This term is broader than it seems. It is not external as it may seem, but the internal form of the company. The corporate culture of the parties involved tends to differ, even if they belong to the same geographical location. Furthermore, if the parties involved are from different geographical locations, there is more than the corporate culture that needs to be reconciled. If the cultures of the companies are not compatible, then disputes can arise in an early stage and might result in communication gaps and failed mergers. The best way to analyze the culture of a company is to analyze its internal documents like newsletters, protocols, etc. This helps in understanding how employees and management interact with each other. The employee turnover rates of the company can be studied to understand the corporate culture as well.
(xii) Strategic due diligence: Experts must be employed for this purpose. They examine the aptness of the abovesaid areas in the context of the purpose of the merger. Aspects like value chain, competition analysis, market trends and driving forces, entry barriers to the market, risk analysis and dependencies. The experts take into account these factors and develop a future image of the merger. This helps in making profit-maximizing decisions and reducing non-value-adding costs.
(xiii) Secretarial Due diligence: There are some laws that apply to companies specifically. Compliance with such laws before and during taking any action is necessary to avoid any penalties. Company law, labor laws, and industrial law codes are a few of the application areas of Secretarial Due diligence. It also involves ensuring compliance with the company’s charter documents. It includes checking all the regulatory filings of the company and understanding the terms of Shareholders agreements to avoid any conflict of interest in the future. It is a focused version of legal Due diligence, where past compliances and regulatory submissions are ensured before entering into the transaction.
(xiv) Forensic Due Diligence: Even though most acquirers conduct legal and financial due diligence, forensic due diligence is often left out. Forensic due diligence investigates on a transaction level to find irregularities and inherent risks that are not likely to be detected by an outsider. It is very essential to conduct this due diligence, failing which the acquirer can be exposed to strict regulatory action coupled with huge financial loss. It involves checking the authenticity of financial statements, scrutinizing undisclosed related party transactions and liabilities within the target company, activities towards bribery or corruption and any issues surrounding the key managerial personnel or promoters of the company.
