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Due Diligence Report-Process, Importance and Types

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Due diligence is a process of research and analysis that is initiated before an acquisition, investment, business partnership or bank loan, in order to determine the value of the subject of the due diligence or whether there are any major issues involved. Such findings are then summarized in a report which is known as the due diligence report.

1. Introduction

Due diligence is a process of :

  • Analysing various aspects to estimate an entities commercial potential
  • Assessing the financial viability of the entity in terms of its assets and liabilities at a comprehensive level
  • Examining the operations and verifying the material facts related to the entity in reference to a proposed transaction

2. Transactions covered for Due Diligence

    • Mergers and Acquisitions:

Due diligence is done from the viewpoint of the seller as well as the buyer. While the buyer looks into the financials, litigation, patents and an entire range of relevant information, the seller focuses on the background of the buyer, the financial capabilities to complete the transaction and the ability to fulfil commitments taken.

    • Partnership:

Due diligence is done for strategic alliances, strategic partnerships, business coalitions and such other partnerships.

  • Joint Venture and Collaborations:

When one company joins hands with another the reputation of the company is a matter of concern. Understanding the other company’s stand and measuring the adequacy of resources at their end assumes importance.

  • Public Offer:

Aspects included during making a public offer are decisions on public issues, disclosures in a prospectus, post issue compliance and such other matters. These would usually require due diligence.

3. Need for a Due Diligence report

Finding skeletons in the closet before the deal is better than finding them later” is a relatable aspect when it comes to due diligence. The information collected during this process is crucial for decision making and hence needs to be reported. The Due Diligence report helps one understand how the company plans to generate additional earnings (monetary as well as non-monetary). It serves as a ready reckoner for understanding the state of affairs at the time of purchase/sale, etc. The ultimate purpose is to get a clear picture of how the business will perform in the future.

4. Drafting of the Due Diligence report

    • While drafting the due diligence report the 3 W’s have to be addressed.

-Who is your target audience?
-What is your objective?
-Which are the aspects that will be key to decision making?

  • Superfluous information should be avoided to make the report brief.

5. Areas of Focus in a Due Diligence Report

  • Viability: Accessing the viability of the target company can be done through a thorough study of the company’s business and financial plans.
  • Monetary Aspect: Key financial data and a ratio analysis would be necessary to understand the complete picture
  • Environment: No business operates in isolation. Hence, it is necessary to look into the macro environment and its impact on the target company.
  • Personnel: A very important factor to consider is the capability and credibility of the people who are operating the company.
  • Existing & Potential Liabilities: Any kind of pending litigations and regulatory issues should be taken into account.
  • Technology: A very important factor to consider is the assessment of the technology available with the company. Such an assessment is necessary as it helps decide future actions.
  • Effect of synergy: Creation of synergy between the target company and the existing company serves as a tool for decision making.

6. Types of Due Diligence

 

1. Business Due Diligence: It involves looking into the parties involved in the transaction, prospects of the business and the quality of investment.
2. Legal Due Diligence: It mainly focuses on the legal aspects of a transaction, legal pitfalls and other law related issues. It covers both inter-corporate transactions as well as intra-corporate transactions. Various regulatory checklists form a part of this diligence along with the already existing documentation.
3. Financial Due Diligence: Financial, operational and commercial assumptions are validated here. This provides a huge sigh of relief to the acquiring company. Review of accounting policies, audit practices, tax compliances and internal controls are done in detail here.

7. Limitations of Due Diligence

    • The due diligence gives a superficial understanding of the target company to the acquiring company. As a result of which the businesses may not always succeed.

        • The workforce, the competencies and the work culture remain a mystery to the acquiring company which are quintessential to a smooth running.
        • Due diligence is a process which is judgement driven and this can pose a risk.
        • The process is not often smooth due to one major hurdle which is the availability of information.
        • The target company is in a constant fear that the existing customers may leave due to the impending sale and these customers would not want any contact with them.
        • The confidential nature of transactions also serves as an impediment.

The due diligence report should provide the desired level of comfort about the potential investment and also the inherent risks involved. The report should be able to provide the acquiring company with information such that no onerous contracts are signed which could potentially harm the existing return on investment.