In the financial world, due diligence refers to the process of research and in-depth investigation undertaken by an organization or a person prior to a business partnership, M&A or investment. Due diligence typically involves verifying, analyzing and assessing the financial records to ensure the information presented is corroborated by facts. The objective of due diligence is to evaluate the value of the subject of the due diligence as well as to identify underlying risks associated with the deal. Once the process is completed, the findings are then summarized on the due diligence report.
While the term ‘due diligence’ was coined more recently in 1930s, this practice has been in existence since the mid-fifteenth century. The legal term, however, originates from the US, where due diligence is defined as ‘reasonable investigation’ under the US Securities Act of 1933. According to the act, there is a law against those accused of not disclosing adequate information pertaining to the purchase of a stock.
As business models continue to evolve along with persistent changes in laws and regulations, it’s imperative that organizations follow a robust due diligence framework to make informed decisions pertaining to a business agreement and avoid any costly post-transaction surprises. Additionally, it allows businesses to learn about the target company’s supply and employee contracts, policies, financial viability (assets and liabilities) and potential problems. Due diligence is a lengthy process as interest parties can take months to review financial, legal and other material information.
Due diligence should be done before entering any business contract, which includes, but is not limited to, partnerships, mergers and acquisitions, joint venture and collaborations, and public offers. While a due diligence review is often confused with an audit, there are key differences between the two processes.
The due diligence process encompasses a broad range of areas such as legal, operational and financial aspects. Typically, due diligence can be broadly categorized in four types, i.e., financial due diligence, legal due diligence, operational due diligence and tax due diligence.
Financial due diligence: When it comes to financial due diligence, also known as accounting due diligence, the process primarily focuses on providing businesses with a 360-degree understanding of the target company’s (potential investment) revenue channels, historical background of working capital management, sales and marketing-related operating expenses, key factors used for growth forecast, and accounting information systems, among others.
Legal due diligence: As suggested by the name, legal due diligence involves the assessment of all legal aspects of the target company as well as its relationship with its stakeholders. This includes analyzing contracts, license for operating, regulatory issues and even pending legal liabilities.
Operational due diligence: This due diligence process looks into the target company’s operations, mainly evaluating the viability of the business model by recognizing the strengths and weakness in the operations. The aim is to identify and tackle operational risks associated with the target company.
Tax due diligence: Tax due diligence is carried out to gain an understanding of the target company’s tax profile and to ensure that the tax liabilities are paid. Moreover, it can help a business uncover historical tax risks and also utilize tax opportunities, if any.
Tackling due diligence can be equally daunting and overwhelming, but it is an essential step towards ensuring the successful closing of a fair and equitable business contract. A due diligence checklist allows an organization to acquire and consolidate all the relevant information pertaining to the target before progressing with a deal. While the checklist can vary depending on the type and size of the business contract, it should broadly cover the following areas –
Products and Services
The due diligence process requires submission of numerous documents, which can include government audits, financial statements, bank statements, stakeholder agreements, tax income returns, employee contracts, trademarks and license agreements. When it comes to due diligence, it is imperative to be as thorough as possible.
The first and foremost step is to create a detailed checklist that will help consolidate all the facts relevant to the contract. The checklist should look at the history and background of the target company, the year-on-year financial performance, cash flow assessment, the strength, key considerations of the deal etc. Traditionally, the main objective behind due diligence was to give an overview, and it didn’t delve into details. Cut to today, businesses must opt for a due diligence process that provides an in-depth analysis of the target in order to keep up with the constantly evolving business environment and gain an advantage over their rivals. Following are the key steps that businesses should follow to conduct the due diligence in a methodical way.
The book value or capitalization can be determined by calculating the net difference between a company’s total assets and liabilities. Market capitalization is another focus area that businesses should emphasize as it can be great indicator of how volatile the target’s stock will be. For example, large-cap companies should have less fluctuations in their stock price and earnings because they tend to serve larger market areas. This is a critical step as it allows for understanding how big the target company is through evaluating the total value of its outstanding shares.
Revenue and margin trends give an overview of the financial condition of the target company. One way to do this is going to a financial news site and researching the company’s net revenue and income trends of the past two years. These news websites typically provide insights into a company’s price fluctuation patterns, allowing businesses to understand P/S ratio and P/E ratio. Furthermore, it’s important to look into the quarterly and yearly financial statements issued by the target company for reviewing profit margins and growth per annum.
Perhaps the most important step, evaluating both industry-specific and company-specific risks is crucial to understand whether the deal will bring any further value. The risk evaluation process should weigh in whether there are any outstanding legal and regulatory issues, if the target company is adhering to all the regulatory compliances mandated by the government or if the business practices adopted by the company are sustainable for long-term growth. The devil is in the details, and it’s of utmost importance that businesses go through all the relevant documents to ensure there are no existing as well as potential risks involved in the deal.
As mentioned above, due diligence is a vast and complex process, which requires thorough investigation and utmost importance to details. Thus, when conducting due diligence, it’s crucial that businesses seek professional guidance to ensure all the checklists are in place and there are minimal risks involved.
We at ASA India, are here to help you in every step as you move into a critical business juncture. Our integrated approach to due diligence will allow you to navigate the complex world of business contracts, giving a 360-degree view of financial, legal and operational areas of the target. With a specially curated team of industry experts and deal specialists, we will help you drive exponential business growth and secure your future.
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