Due diligence

© Oxford University Press 2011. All rights reserved.
Chapter 4
Due Diligence

What is Due Diligence?
 Implies an activity involving either the performance of
an investigation of a business or person, or the
performance of an act with a certain standard of care
 Also used to mean a required legal obligation although
the term more commonly applies to a voluntary
investigation
 Examples:
 Steps carried out by venture capitalists before and
during each investment phase of a start-up company
 Precautionary steps taken by one company in
deciding whether to acquire another i.e. evaluating
whether the buy is good or bad.

What is Due Diligence?
 Banking Industry - To act in a prudent manner in
evaluating credit applications.
 Securities Market - Responsibility of underwriters to
explain the details of new securities to interested
purchasers.
 Legal Definition - “A measure of prudence, activity, or
assiduity, as is properly to be expected from, and
ordinarily exercised by, a reasonable and prudent
person under the particular circumstances; not
measured by any absolute standard but depends on the
relative facts of the special case."

Activities of Due Diligence
 Financial Statements:
 Review and confirm the existence of assets, liabilities, and equity
in the balance sheet to determine the financial health of the
company based on the income statement.
 Management and Operations review:
 Determine quality and reliability of financial statements to gain a
sense of contingencies beyond the financial statements.
 Legal Compliance Review:
 Check the potential future legal problems stemming from the
target's past.
 Document and Transaction review:
 Ensure paperwork of the deal is in order and that the structure of
the transaction is appropriate.

Need for Due Diligence
 Strengths and weaknesses of the business
 Gives a fair value of the investment
 Helps in identifying the apparent irregularities
 Tool of ensuring that the prevailing system of
checks works

What does Due diligence involve?
 Historical Financial Data
 Current Financial Data
 Forecasted Financial Information
 Business Plans
 Minutes’ of Directors’ Meetings and Management
Meetings
 Audit Paper Work Files
 Contracts with Suppliers, Customers and Staff
 Confirmation/ Representations from Financiers,
Debtors, etc.

Transactions requiring Due Diligence
 Mergers and Acquisitions:
 Personnel
 Financial Operations
 Marketing
 Property and Equipments
 Business Operations
 Strategic Alliances and partnerships
 Joint Ventures and Collaborations

People Involved in Due Diligence
 Financial
 Legal
 Operational

Parties interested in Due Diligence
 Employees
 Trade Unions
 Shareholders
 Creditors
 Vendors
 Customers
 Government
 Society

Steps in Due Diligence Process


Due Diligence Reporting
 Should reflect a fair and independent analysis &
evaluation of financial and commercial information
 Should ensure collection, analysis and interpretation of
financial, commercial and tax information in detail
 Should provide properly reviewed and analyzed
financial information to bidders and various
stakeholders
 Should also provide a feedback on auditing of the
special purpose accounts.

Types of Due Diligence
Financial Due Diligence:
 involves evaluating a company’s historical, current,
and prospective operating results as disclosed in its
historical, current and projected financial
statements, tax returns, and other information
 Involves analysis of balance sheet, review from cash
to marketable securities, receivables, inventory,
prepaid expenses and other current assets, as well
as the value of fixed assets.

 Analysis on the liability side includes accounts
payable, taxes, and debt obligations must be closely
examined
 Helps in getting a sense of future revenues
 Evaluates the underlying assumptions used

Legal Due Diligence:
 Scrutiny of all, or specific parts, of the legal affairs
of the target company with a view of uncovering any
legal risks and provide the buyer with an extensive
insight into the company’s legal matters
 Improves the buyer’s bargaining position and
ensures that necessary precautions in relation to
the transaction are taken

Objectives of Legal Due Diligence
 Gathering of information from the target company,
 Uncovering of the target company’s strong and
weak sides, relevant risks and advantages in
connection with the transaction,
 Minimizing the risk of unexpected situations,
 Improvement of the seller’s bargaining position,
 Identification of areas where representations and
warranties from the seller should be obtained in the
acquisition agreement.

Documents verified
 IT law and IT contracts
 Intellectual property rights
 Patents, copyrights, and
other intellectual property-
related documents
 Company law
 Financing
 Employment law
 Data protection law
 Consumer protection law
 General contract law
 Minutes and consents of the
board of directors and
shareholders
 Confidentiality and invention
assignment agreements with
employees
 Tax and financial documents
 Legal disputes and other
kinds of conflicts
 Marketing practices
regulation
 National and EU-competition
law
 Public procurement law.

Operational Due Diligence:
 Involves the on-site analyses of the target business
daily processes and of how the business operates.
 Analysis includes an evaluation of the key
employees, managers, independent contractors,
suppliers and other factors necessary for the
business to conduct normal operations
 May also cover investigation outside of the actual
business.

 Includes examining work centres, material flow,
scrap generation, and inventory levels to identify
improvements required to improve productivity and
profitability
 Helps identify and implement changes necessary to
increase EBITDA and increasing the multiples due to
lower risk.
 Involves gathering information on:
 New product or service creation
 Markets
 Competition
 Sales Targets
 People/Organizational matters

Intellectual Property Due Diligence
 Through analysis needed in this area as economies
are increasingly becoming technology driven
 process of identifying all intellectual property
assets, verifying ownership and ensuring that such
assets are free of encumbrances for the intended
business use is fundamental to any merger,
acquisition or investment

 Examples range from the ingredients and
manufacturing process for coke, a closely guarded
trade secret, to the many domestic and international
trademarks owned by multinational conglomerates
such as Tata, HUL, Reliance, etc.

IT Due Diligence;
 Involves scrutiny of IT systems and processes in
use and ascertaining better ways of deriving value
and leverage from IT assets
 Involves:
 Sending an IT request list to the acquired company
 Compiling an onsite discovery process outline
 Conducting a review of the requested materials
 Scheduling and coordinating the onsite visit

Human Resource Due Diligence:
 Involves valuing the contribution of HR
 Helps by:
 Establishing a link between organizational objectives and the HR function
 Determining HR's influence on the skills and motivation of the workforce
 Determining the managers views of the HR function
 Ascertaining the outcomes produced by the HR deliverables
 Measuring the adequacy of HR measures, metrics and benchmarks
 Ascertaining the total cost of the HR function and industry comparisons
 Ascertaining the HR team structure, skills and motivation.

Areas covered
 Organizational culture
 Executive compensation and “golden parachute”
contracts
 Collective bargaining agreements and potential
change of ownership liabilities
 Defined benefit and contribution pension plans
 Postretirement benefits
 Retention and severance plans
 Health and welfare insurance structure and reserves
 HR functional structure and service delivery
 HR Information System (HRIS) and
 Employment Litigation

Litigation Analysis
When one company sells or otherwise transfers all its
assets to another company, the successor is not liable
for the debts and tort liabilities of the predecessor.
 Successor may be liable, however, under the
following circumstances:
 If it has expressly or implicitly agreed to assume liability
 If the transaction is a merger or consolidation
 If the successor is a “mere continuation” of the predecessor
 If the transaction was fraudulently designed to escape liability.

Components of Litigation Analysis
Customers -- as well as competitors, suppliers, and
other contractors—might sue over:
 contract disputes
 cost/quality/safety of product or service
 debt collection, including foreclosure
 deceptive trade practices
 dishonesty/fraud
 extension/refusal of credit
 lender liability
 other customer/client issues
 restraint of trade

Employees -- including current, past, or prospective
employees or unions—might sue over:
 breach of employment contract
 defamation
 discrimination
 employment conditions
 harassment/humiliation
 pension, welfare, or other employee benefits
 wrongful termination

Regulators might sue over:
 antitrust (in suits brought by government)
 environmental law
 health and safety law

Shareholders might sue over:
Contract disputes
(with shareholders)
Financial
transactions (such
as derivatives)
Investment or loan
decisions
Divestitures or spin-offs Fraudulent conveyance M&A scenarios (target,
bidder)
Dividend declaration or
Change duties to
minority shareholders
General breach of
fiduciary duty
Proxy contents
Executive compensation
(such as golden
parachutes)
Inadequate disclosure Recapitalization
Financial performance/
bankruptcy
Insider trading Share repurchase
Stock offerings

Suppliers might sue over:
 antitrust (in suits brought by suppliers)
 business interference
 contract disputes
 copyright/patent infringement
 deceptive trade practices

Does Due Diligence insure against
M & A failure?
 Helps avoid:
 Able to avoid unnecessary losses and expenses
 The organization’s governing body is able to demonstrate
that it has engaged in effective oversight and
 Senior officers of the company avoid job- and bonus-
threatening adverse events

Due Diligence involving Financial Issues
 Can lead to significant unbudgeted liabilities and the
diversion of time and energy of key executives
 Helps identify fictitious bills and fictitious originals
created such as the signature-authority list.
 Helps identify dormant bank accounts for they are a
breeding ground for manipulative practices.
 Unexpected voiding of invoices from the
organization’s accounts receivable system should
be investigated, particularly if your organization is
structured so that people who have the ability to
void an invoice also have the ability to receive or
issue cheques

Due Diligence Involving
Organizational Records
 Periodic review of the minutes of board meetings
needs to be done.
 Record retention policies are often advocated
across countries as a reliable tool of reference.

Due Diligence involving Legal
Compliance
 Helps ensure that the organization is in compliance
with applicable law
 Depending on the nature and size of an
organization’, professional advisors should be
engaged to evaluate the laws and regulations as
applicable, and to help management design a due
diligence plan
 Compliance can be achieved in an orderly, cost-
effective and timely manner

Due Diligence involving Interaction of
Contracts
 Involves due diligence of key contracts and
agreements, and summarizing and cross-
referencing
 Critical for future reference
 Help in avoiding inadvertent conflicts.

Due Diligence involving Information
Systems
 Helps to get tuned to the rapid shift from manual
system infrastructure to technology driven
infrastructure.
 Ensures adherence to regulatory compliance that
are coming into force.

Due Diligence involving Key
Customers and Suppliers
 Strong need to initiate ongoing monitoring of the
operations and plans of key customers and
suppliers as can reveal important information on its
current financial and operational status and near-
term future events.
 Also reveal a deteriorating financial condition in
advance.

Effective Due Diligence team
 Have members with first hand experience in the industry
to which the target belongs
 Have members with expertise in different areas such as
HR specialists, Functional area managers, individuals
with knowledge of national culture, etc. Capable of
quickly identifying both the positive and negative aspects
of the property to be acquired.
 Willing to carry out a site visit to evaluate the current
condition of the assets to be acquired; both the physical
assets as well as the personnel
 Have members who possess excellent negotiation skills
 Have people who have time to lead the project and serve
as team members

 Ensure that the diligence team is co-located within a
secure environment, such as a corporate headquarters or
closer to the target
 Be familiar with the strategic and financial rationale behind
the acquisition
 Train the team to identify and home in on specific issues
 Develop and communicate rules of engagement between
the diligence team and the target company
 Make available analytical tools and techniques so the team
can rapidly get its arms around potential synergies and
integration challenges
 Healthy flow of information

Why Due Diligence fails?
 Failure to Focus on Key Issues
 Failure to Identify New Opportunities and
Risks
 Failure to Allocate Adequate/ Right
Resources

Thank you!

Due diligence

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