DUE DILIGENCE
By- Prof. Sumit Maheshwari
WHAT IS DUE DILIGENCE
• Due diligence is an investigation of a business or person prior to signing a contract, or an act with a certain
standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations.
A common example of due diligence in various industries is the process through which a potential acquirer
evaluates a target company or its assets for an acquisition. The theory behind due diligence holds that performing
this type of investigation contributes significantly to informed decision making by enhancing the amount and
quality of information available to decision makers and by ensuring that this information is systematically used to
deliberate in a reflexive manner on the decision at hand and all its costs, benefits, and risks
• In Short, Due diligence is a comprehensive assessment process undertaken by a potential buyer or merger partner
to thoroughly understand the operational, financial, legal, and strategic aspects of the target company. It's the deep
dive that aims to reveal any hidden liabilities, risks, or potential red flags that might not be evident at a surface
glance.
IMPORTANCE OF DUE DILIGENCE
• Due diligence is vital safeguard for both the buyers as well as sellers. For Buyers
perspective, it helps minimize the risk, identifies synergies opportunities among
people and products. It also provide and ensure accurate company valuation and
demonstrate a responsible approach to stakeholders.
• From the seller point of view, due diligence uncovers their company actual market
value and help the founder set realistic price expectations.Though the research is
important it can provide the valuable insights into potential buyers, their financial
standing and reputation.
IMPORTANT ASPECTS OF DUE DILIGENCE
• Due diligence isn't just a perfunctory step in the M&A process; it's the backbone that can make or break a deal. Its
importance can't be stressed enough, especially when the stakes involve millions or even billions of pounds, as well as the
futures of employees, stakeholders, and the companies themselves.
1. UNCOVERING HIDDEN LIABILITIES
• Every company has its strengths and weaknesses. Due diligence helps potential acquirers understand liabilities like
unresolved lawsuits, debts, or regulatory issues that can have significant financial and reputational implications post-
acquisition.
• Case Law- In 2011, Hewlett-Packard (HP) was involved in a due diligence scandal when it overpaid for the British software
company Autonomy. HP's inadequate due diligence led to a $5 billion fraud case and a loss of over $4 billion.
• What happened?
• HP only spent six hours reviewing Autonomy's finances before buying it for £8 billion.
• HP's former CFO admitted that she didn't read the preliminary due diligence report.
• HP shareholders sued the company for negligence.
• HP was seeking compensation from Autonomy's co-founder, Mike Lynch, who was accused of inflating the company's
value.
• 2. ASSESSING TRUE VALUE
• A company's value isn't just about its current assets and revenues. Its future growth potential, intellectual property, customer base, market position, and
other intangible factors play a significant role. Due diligence provides a holistic view of this value.
Example: When Facebook acquired Instagram in 2012, the latter had no significant revenue. However, thorough due diligence enabled Facebook to recognize
the platform's potential for growth and its alignment with the mobile photo-sharing trend, making it worth the $1 billion price tag.
• 3. REGULATORY AND COMPLIANCE ISSUES
• Entering a new market or industry means navigating a maze of regulations. Due diligence helps ensure the target company has been compliant and
identifies potential regulatory roadblocks.
• Regulatory and Compliance Issues – Walmart-Flipkart Deal (2018)
• When Walmart acquired a 77% stake in Flipkart for $16 billion, it faced key regulatory challenges:
1. FDI Regulations – Had to comply with India’s Press Note 2 (2018) restricting foreign e-commerce platforms from influencing prices.
2. CCI Approval – Required clearance from the Competition Commission of India (CCI) amid concerns of monopoly.
3. Tax & Compliance – Addressed capital gains tax for Flipkart’s investors and adhered to GST laws.
4. Data Protection – Ensured compliance with evolving data privacy regulations in India.
• Takeaway:
CHALLENGES IN CONDUCTING DUE DILIGENCE
• A professional may face many challenges while conducting due diligence. He needs to deal with
these challenges and bring the best result of due diligence. Few examples of the challenges faced are
as under:
• i) Non-availability of the information or incomplete information: For eg. Non availability of evidence
related to compliances. While dealing with difficulty, he can try to find the alternate source of
getting the information.
• ii) Lack of time: Many a times a professional cannot check all the information due to paucity of time.
A professional may confine the scope of checking in this scenario. I
• ii) Non-cooperation by the employees: It is possible that few of the employees may start non-
cooperating as this may lead to focus on their mistakes. Reporting to the concerned authority may
be a good solution in this scenario.
TYPES OF DUE DILIGENCE
CONTENTS OF THE DUE DILIGENCE REPORT
• The contents of a due diligence report should more or less include certain points which would draw the
attention of the intending buyer, viz:
• Comments on the management and organization,
• Details of key managerial/ technical personnel,
• Details of marketing efforts undertaken,
• Details of financial liabilities and commitments that the intending buyer would have to meet after takeover
and which are not disclosed in the audited accounts,
• Deviations from the generally accepted accounting policies/ practices,
• Analysis of major expenditure/costs, details of major/critical customers and suppliers,
• Compliance of taxation and other statutory laws as well as status and impact of all litigation in this respect,
• Benefits enjoyed by the intending seller which the intending buyer may lose on takeover and vice versa,
• List of adjustments to the latest financial statements compiled on the basis of all findings, which have an
impact on the "price" of the target acquisition to be considered by the intending buyer
DUE-DILIGENCE CHECK LIST
• Financial Documents: Legal Documents
Operational Documents
Category Checklist Items Category Checklist Items Category Checklist Items
Financial Statements – Balance sheets Contracts – Supplier contracts
• Business Processes
– Standard operating
– Income statements – Customer contracts
procedures (SOPs)
– Cash flow statements – Partnership agreements
– Inventory
management
– Profit and loss statements – Distributor agreements
– Production processes
– Non-disclosure
– Historical financial data agreements (NDAs) – Supply chain logistics
Licences – Business licences
Tax Records – Tax returns – Hardware and
– Permits and certificates IT Systems
software inventory
– Tax payment history
– Intellectual property
– Data backup and
– IRS or tax authority licences
recovery processes
correspondence – Regulatory licences
– Leases and rental – IT security policies
Ongoing Commitments Intellectual Property – Trademarks and patents
agreements and protocols
– Copyrights
– Loan agreements – Trade secrets
– Facilities and real
Physical Infrastructure
– Supplier contracts estate documents
Pending Litigation – Pending lawsuits
– Customer contracts – Regulatory actions – Equipment and
– Legal disputes machinery records
– Outstanding loans and
debts – Claims and settlements – Maintenance
DUE-DILIGENCE CHECK LIST
Human Resources Environment and Regulatory
Compliance
Category Checklist Items Category Checklist Items
Employee Contracts – Employment contracts
– Environmental impact
Environmental Impact
– Non-compete agreements assessments
– Non-disclosure
agreements (NDAs) – Pollution control records
Benefits – Employee benefit plans
– Retirement plans – Waste disposal
documentation
– Health and insurance
benefits
Permits and Compliance – Regulatory permits and
Organisational Structure – Organisational charts Records licences
– Reporting hierarchy
– Compliance records and
Governance – Board of directors records
reports
– Shareholder agreements – Health and safety
certifications
– Minutes of meetings
PROCESS OF DUE DILIGENCE
• The due diligence process is a multi-faceted journey that delves into various aspects of a company's operations,
finances, and potential risks. Each step is crucial to ensure that the acquisition or merger is founded on a
comprehensive understanding of the target company's present state and future potential.
• Preliminary Assessment
• Financial Analysis
• Legal Aspects
• Operational Due Diligence
• IT and Cybersecurity Assessment
• Ongoing Monitoring
PRELIMINARY ASSESSMENT
The preliminary assessment is the initial stage of due diligence, where the potential buyer or merger
partner evaluates whether the deal aligns with their strategic objectives. This involves a high-level review
of the target company's market position, product offerings, and potential growth trajectories. It serves as
a 'fit-check' to determine whether pursuing the deal further makes strategic sense.
Key Aspects:
• Market Position: Assessing the company's standing within the industry and its competitive advantages.
• Product and Service Offerings: Reviewing the target company's product portfolio and innovation
pipeline.
• Growth Potential: Identifying potential areas for expansion, diversification, and synergies.
• Initial Risk Assessment: Understanding possible red flags, such as market volatility, financial instability,
or regulatory concerns.
FINANCIAL ANALYSIS
Financial due diligence involves an in-depth examination of the target company's financial
health to ensure there are no hidden financial pitfalls or liabilities. This step is critical
for understanding profitability, sustainability, and valuation.
Key Aspects:
• Financial Statements: Reviewing balance sheets, income statements, and cash flow
reports.
• Debt and Liabilities: Assessing outstanding debts, loan agreements, and potential
financial obligations.
• Revenue Streams: Evaluating sources of income, revenue consistency, and growth
trends.
• Tax Compliance: Ensuring all tax obligations are met and identifying potential
liabilities.
LEGAL ASSESSMENT
Legal due diligence examines all legal aspects of the target company to identify potential
risks and liabilities. This includes reviewing corporate governance, contracts, regulatory
compliance, and any ongoing or pending litigation.
Key Aspects:
• Corporate Structure: Analyzing the ownership framework and governance policies.
• Contracts and Agreements: Reviewing key contracts, including vendor agreements,
partnerships, and employment contracts.
• Regulatory Compliance: Ensuring adherence to industry-specific regulations and
legal standards.
• Intellectual Property (IP) Rights: Evaluating trademarks, patents, and copyrights to
safeguard proprietary assets.
• Litigation Risks: Identifying any past, ongoing, or potential legal disputes.
OPERATIONAL DUE DILIGENCE
Operational due diligence assesses the efficiency and effectiveness of the target
company's business operations, workforce, and supply chain management.
Key Aspects:
• Management and Workforce: Evaluating the leadership team, employee
contracts, and HR policies.
• Supply Chain and Logistics: Assessing vendor relationships, supply chain
efficiency, and inventory management.
• Operational Processes: Reviewing business processes, production capacity,
and technological integration.
• Scalability and Integration: Identifying potential synergies and operational
improvements post-merger.
IT AND CYBERSECURITY ASSESSMENT
In today's digital age, IT and cybersecurity play a vital role in due diligence. This
phase evaluates the target company's technology infrastructure, software
applications, and data security protocols.
Key Aspects:
• IT Infrastructure: Assessing hardware, software, and cloud computing
capabilities.
• Data Security and Compliance: Ensuring compliance with data protection
laws (e.g., GDPR, CCPA) and identifying vulnerabilities.
• Cybersecurity Risks: Analyzing past cyber incidents, security policies, and
risk mitigation strategies.
• Technology Integration: Evaluating the compatibility of IT systems for a
seamless post-merger transition.
ONGOING MONITORING
Due diligence does not end once the acquisition or merger is completed.
Continuous monitoring is necessary to ensure that the integration process is
smooth and that any unforeseen issues are promptly addressed.
Key Aspects:
• Post-Merger Integration: Overseeing the seamless transition of operations,
workforce, and technology.
• Performance Tracking: Regularly assessing financial and operational
performance.
• Risk Management: Addressing any emerging challenges that may arise post-
acquisition.
• Regulatory Compliance: Ensuring ongoing adherence to legal and industry
standards.
