Due Diligence
Due diligence literally means the care that a reasonable people would take to prevent any harm or injury to other person or property. A company or a person investing in any business venture must do due diligence before investing his money. Like we should think before we speak. And when it is matter of investment, it is said that, shall perform due diligence before investing in any business venture. Due diligence is kind of doing your homework before you invest your money. It is common sense that any person or entity investing its money would look around and observe the factors that would affect the investment. Due diligence means extensive research of those factors affecting the investment. If a person is trying to start a business venture, due diligence would mean to look into market, how the location would affect the business etc. and if a company is trying to buy a company is trying to buy another company, due diligence would be different and the factors that would be observed then are different. Some areas that would require due diligence are
• Administrative due diligence – means scrutinizing the administrative item of any company like occupancy, facilities, workstations etc. This aspect of administrative due diligence covers the idea to verify facilities occupied or owned by the seller and determine the operational costs and whether captured in the financials or not. Administrative due diligence gives a picture to the company investing of the operational cost it would incur if it goes forth to pursue expansion of the target company.
• Financial due diligence – It is the most valuable due diligence a company depends on. It is pivotal part of due diligence that seeks to confirm that the financials showcased in the CIM (Confidentiality Information Memorandum) are accurate or not. Financial due diligence is done to provide a brief understanding of the company’s financial, that include but are not restricted to, audited financial statement of the past three years, all of the companies projections and the basis of such projections, recent audited financial statement and the comparable statements of the last year, capital expenditure plans, debtors and creditors, schedule of inventory etc. Aspects of financial due diligence includes fixed and variable cost analysis, analysis of major customer accounts and profit margins and examination of internal control procedures. Financial due diligence also helps in examination of sales pipeline in order to create better/more accurate projections and company’s order book. A company doing due diligence might have a separate section of financial analysis focused on the target company’s short and long term debt, applicable interests rates, ability of a company to service its outstanding debt and its ability to secure more financing, also an overall evaluation and examination of a company’s capital structure.
• Due diligence of assets – Another due diligence that is kind of a necessity for a company to conduct is asset due diligence. Assets due diligence reports include a detailed schedule of fixed assets and their locations, a detailed list of sales and purchases of major capital equipment of the past three to five years, mortgages, real estate deeds, title policies and use permits.
• Human Resources due diligence – Due diligence of human resources ought to be an extensive one. It would include analysis of
1. Total employees – including current positions, employees serving notice period, due for retirement and vacancies.
2. Current salaries, bonuses paid by the company in the past three years and years of service.
3. HR policies regarding sick eaves, annual leaves and other leaves and other policies.
4. Employment contracts, disclosures, non-solicitation and non-competition agreements of the company with its employees.
5. Employee’s problems like harassment, discrimination, wrongful termination and pending legal cases with former and current employees.
6. Detailed description of policies of health benefits and welfare insurance policies or self-funded arrangements.
7. Financial impact of current labour disputes, pending grievance procedures or arbitration.
8. Schedule of grants and ESOPs.
• Environmental due diligence – It is important due diligence because a company not complying or violating major rules can be penalised by the local authorities, which may shut it down operationally. Hence, it is an important aspect of the due diligence. Environmental due diligence includes list of environmental permits and licenses and their validation. Copies of notices and correspondence from the state or EPA and local regulatory agencies. Verifying that the company does not violate the standard disposal methods of current regulations and guidelines. Whether or not there are any continuing indemnification obligations or contingent environmental liabilities.
• Due diligence on Taxes – Due diligence on taxes means that the company is required to pay taxes with proper calculations and no intention to under report taxes. And the status of tax-related pending cases. Documents of tax compliance and potential issues that include verification and review of the copies of all tax returns, including income tax, withholding and sales tax of the past three to five years. Also include information relating to tax audits of the company, past or pending. All the documents in relation to NOL (net operating loss) or not used credit carry forwards of tax credits or deductions. Tax due diligence includes out-of-the-ordinary correspondence, if any, with tax agencies.
• Due diligence on intellectual property assets – Every company possess intellectual property assets they use to monetize their business. These are the intangible assets and are very useful as they are something which differentiates their products and services from their competitors. They comprise some of the company’s most valuable assets. Due diligence on intellectual property assets includes schedule of patents and patent application, trademarks, brand names and copyrights, any documents of pending patents claims and all the pending claims against or by the company in regards of violation of intellectual property.
• Legal due diligence – Of course, legal due diligence is extremely important as it includes detailed review and examination of the copy of memorandum and articles of association, copy of all guarantees to which the company is a party, minutes of board meetings for the past three years, minutes of all the meetings or actions of shareholders and minutes of board meetings for the past three years, copy of share certificates issued to key management personnel, licensing of franchise agreements, copies of all loan agreements, lines of credit to which company is a party, all contracts including operating agreements, limited liability company.
• Customer due diligence – It is just as important as customers are the backbone of any business. Due diligence include examination and analysis of the company’s top customers like those who make the largest total purchases and the customers who are the largest in terms of total assets, important customers to the company regardless of their current level of spending. Analysis of service agreements and insurance coverage, current credit policies: DSO (day sales outstanding metric) to assess the efficiency of accounts receivable. Customer satisfaction score and related reports of the past three years. Detailed list of customers lost within the past three to five years.
• Due diligence on strategic fit – It is due diligence done to examine how the company fits in with the overall strategic business plan of the buyer. Any acquirer would look and evaluate whether target has important products, technology or market access that acquires does not have and whether the acquirer can make any profit or not. If the merger of the acquirer company with the target company will be profitable to the acquirer and how much time and cost acquirer will incur because of such a merger. The acquirer would determine the best personnel from the acquirer and the target company to manage the merger process.
Due diligence is a process to checklist whether the step the company is willing to take of merging or acquiring some other business, will be profitable to them or not and whether or not the company will incur loss. Due diligence is the most important aspect of the company looking to merge or acquire.