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Guide on Due Diligence- Types and Need of Due Diligence for Business

What is Due Diligence?

Due Diligence can be described as an act of investigation, audit, inquiry, or review that is performed to confirm such facts, reality, or details of a matter that is under consideration for the conformity and accuracy of the potential seller and buyer.   
Generally, in the world of finance, it requires an examination of financial statements and records before entering into a joint venture with another business. This type of investigation is done by investors and companies that are considering M&A deals. The scope, extent, and breadth of investigation varies from client to client and situation to situation. 

What is the need for due diligence?

Due Diligence is generally undertaken in case of deals under mergers and acquisitions.The process of due diligence is a time-consuming, and complex process.The failure of most M&A transactions is primarily due to incomplete or improper conduct of due diligence. Thus, it is vital for firms to thoroughly investigate, inquire and understand the real value of the target entity. The need for a thorough due diligence arises when the following activities are carried out:

  • Investigation of financial records of the target company
  • Analysis of the Auditor and Board Report  
  • Understanding the business model, product line and the customer base of the target company
  • Evaluating the performance metrics of the target company
  • Determine the valuation of the target company
  • Drafting a negotiation deal


Types of Due Diligence

There are majorly three categories in which due diligence can be classified:

  1. Financial Due Diligence
  2. Legal Due Diligence
  3. Technical Due DIligence

Financial Due Diligence:

Financial Due Diligence can be expressed as a thorough research and analysis of another company’s financial records. It is generally done by a business before entering into any legal agreement with another business.  
The exercise aims to assess the calculated risks and return associated with the target company. The following documents and information are considered material while carrying out financial due diligence:

  • Balance Sheet
  • Statement of Income (Profit and Loss Account)
  • Cash Flow Statements
  • Statement of Change in Equity
  • Trends related to revenue, growth, and profit. 
  • Short-Long Term debts and other significant liabilities.
  • Financial Ratios vs. Competitors and Industry Benchmarks

Legal Due Diligence:

Legal Due Diligence is an investigation of a business by analysing contracts, agreements, legal papers, material information and interviewing employees and officers.The three main sub-categories of legal Due Diligence are as follows:

  • Accounting Due Diligence
  • Business Due Diligence
  • Intellectual Property Due Diligence

Through legal due diligence, it seeks to understand the target company’s future obligations and risks associated with long term contracts, lease agreements, workmen compensation liabilities, financial debts, warranties and claims.

Technical Due Diligence:

Technical due diligence is a key risk management tool which helps to identify limitations and investment opportunities in transactions associated with mergers and acquisitions. It includes the process of analyzing and evaluating the technologies, product, structures, and processes of the target company prior to effecting a mergers and acquisitions deal. The reasons for technical due diligence may vary. The need to carry out technical due diligence generally arises out of requirements proposed by a venture capitalist company, an investment bank, or an OEM (original equipment manufacturer).

 

What are the core areas that are investigated while preparing a due diligence report?

The core areas that must be investigated while preparing the due diligence report is dependent on the type of due diligence that is being carried out. However, some of the core areas that form part of every due diligence report have been highlighted below:
Target company business vitals including composition of the key managerial personnel, major stakeholders.

  • Applicable statutory compliances
  • Licenses and certificates including those associated with intellectual property rights (IPR). 
  • Financial Statements including Board Report and Audit Report
  • Legal liabilities including pending court cases and penalties.
  • Probability of materialisation of contingent assets and contingent liabilities including contractual commitments.

Challenges faced during Due Diligence:

Due diligence is a closer form of investigation into the target company’s financial and operational effectiveness. However, while carrying out due diligence, the following challenges are generally faced by the due diligence team:

  • Unavailability of sufficient data
  • Incompetency of the in-house staff of target company in providing data
  • Improper planning and execution of the due diligence strategy
  • Inefficient and ineffective due diligence team leading to manpower constraint
  • Lack of technical knowledge and competency while handling complex due diligence projects

Key things to keep in mind while preparing a due diligence report:

The following things must be kept in mind while formulating a due diligence strategy:

  • Define the objectives of the due diligence clearly and concisely.
  • Prepare a well defined plan and strategy to ensure achievement of the predefined objectives.
  • Ensure that the due diligence team is competent and is well versed with technical knowledge.
  • Set standard operating procedures (SOP) and define the roles and responsibilities of each team member.
  • The due diligence team must obtain a certificate of completion from the target company, to ensure the target company certifies the credibility and completeness of financial information and documents shared with the team. The team must ensure that the target company does not withhold any crucial information which may negatively impact the course of the due diligence process.
  • Prefer physical verification to ensure proper insight into the business. At most times, the internal team of the target company, window dresses facts and figures. It is very important to ensure that the internal controls are very stringent and there is minimal scope of fraudulent representation of facts and figures.
  • The due diligence team must ensure to closely assess transactions associated with contingent liabilities, legal proceedings against the company and expected legal costs. The team must closely analyze if the target company is facing corporate distress and if there is a possibility of revival or not.
     

 

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