[Expert Corner Series] Due Diligence: It's Types by Megha Kamboj & Monika Saini- PART-III | Corp Comm Legal on Corporate Law

Introduction

Due diligence is an integral component of a successful commercial transaction. The due diligence process empowers a buyer in assessing the value of the target business and verify the business information to determine whether to proceed with the purchase or not.

The due diligence process also allows the buyer to determine if the transaction has any risks to it. Due Diligence is a lengthy procedure undertaken by an acquiring firm to fully evaluate the business, assets, capabilities and financial performance of the target company. There are various types of due diligence.  

 

TYPES OF DUE DILIGENCE

There are various types of due diligence enquiry. Following are the major types of due diligence-

1.    Operational Due Diligence (ODD)

Operational due diligence (ODD) is the process by which a potential buyer reviews the operational aspects of a target company during mergers and acquisitions. Operational due diligence is a detailed and comprehensive analysis of the target company's key activities and its primary purpose is to ascertain if this company's business strategy is feasible and practical or not.[1] It involves evaluating a broad range of company-wide operating risks, including regulatory enforcement, information technology, sales and marketing, processes and accounting, management, valuation, and service providers. It facilitates better target evaluation and prepares the buyer for more successful market integration by evaluating the target company's position, the potential to sustain future development, the amount of investment that might be needed and the gaps that need to be remedied. It enables management to make informed decisions, while mitigating risk.[2]

The Operating Due Diligence review will explore and analyze the target business’ operational functions and structural processes, and will also seek to determine whether there are significant operational risks that the prospective buyer may consider in approving or aborting the offer or renegotiating the price. Whether it's a merger or acquisition, the investor tries to enhance returns and take benefits of then synergies. The target organization must also strengthen its operations-unlock value, capture opportunities, minimize risks and maximize cash flow efficiency over the lifecycle of the investments. To ensure this, the buyer will examine functional and departmental processes, including manufacturing activities, supply chain, and distribution networks, performance improvement opportunities, procurement, loss of working capital, information technology, as well as back-office activities such as finance, accounting, and human resources.[3]

2.    Financial Due Diligence

Financial due diligence can be defined as a project in which a thorough investigation and review is carried out to determine the key issues faced by the financial business of the particular target company. The market factors of its past and expected profits and cash flows are clearly focussed. Additionally, the balance sheet and the full profit and loss statements will also be evaluated in depth. Often it is a proprietor or business owner who spends a couple of days independently reviewing the company's financial records. While dealing with larger transactions, a specialized external firm conducts an independent financial due diligence process on behalf of the purchaser and produces a comprehensive report about the same.[4]

Financial due diligence is a larger concept it must not be confused with an audit. Financial due diligence not only looks at the past financial performance of the company but also provides an independent and professional view on the future. Through financial due diligence review one can understand the trends observed in the operational results of the company.[5] Financial due diligence typically involves techniques such as reviewing records, holding meetings with senior management and key personnel, analyzing historical financial details and trend analysis, and eventually disclosing financial risks to the purchasing party.[6]

3.    Tax Due Diligence

Tax due diligence is a thorough analysis of the various forms of taxes that may be levied on a specific corporation. The aim of tax due diligence, which is most commonly conducted on the buy side of a deal, is to discover significant potential tax exposures.[7] Tax due diligence is necessary to ensure that all historic tax responsibilities have been complied with by the acquired company. All tax filings must be up-to-date and correctly filled out. Furthermore, it is important to see if the current tax system is effective and whether potential negative tax surprises can be expected in the future.[8]

4.    Human Resources Due Diligence

At the time of merger and acquisition, the buyer also takes on the human capital of the company. The process of understanding this human side of the target company is termed as human resource or HR due diligence[9]Due diligence in the HR field is now used more frequently as part of the due diligence process than it was in the past. Ensuring that all employee contracts are properly structured is essential, and the organization has made provisions for employee pensions. In addition, due diligence in the HR field will track how the key workers are treated to ensure that they are motivated to continue working for the new owner.[10]

5.    Legal Due Diligence

Legal due diligence is normally performed when a buyer wants to buy a company. In an acquisition, the buyer needs to have certainty about the legal status of the company and any possible legal risks it is facing. Legal due diligence can therefore be defined as a process in which a detailed investigation and analysis is carried out in order to determine the potential legal issues facing a target company. The main focus in an acquisition of a company is the clear understanding of all of the company's obligations: pending or potential legal issues, client and consumer agreements and employment contracts.[11]Legal due diligence may usually cover legal issues related to corporate, contract, real estate, environment, IP, insurance, trade, administrative, enforcement, tax, employment and litigation.[12]

6.    Commercial Due Diligence

Commercial (or industry) due diligence refers to examination of commercial variables such as market, competition and the external business environment. It allows potential buyers to understand the segments of the market where the target company operates, the marketplace and business environment for its products, main competitors and the effectiveness of its operating model.If an acquisition is in a new field for the investor, it may be crucial and should include extensive primary and secondary analysis, as well as interviews or surveys with rivals, suppliers and consumers.[13]

Commercial due diligence is the process wherein a corporation or private equity firm undertakes to measure the company's commercial attractiveness. Commercial due diligence gives a complete overview of the internal and external environment of the target company. A commercial due diligence report examines the performance of the company, the probability that the company can reach its targets, and highlights potential problems that may arise as a result of an acquisition. This report provides an in-depth knowledge of the target company and the market in which it is positioned to the potential buyer. It is designed to allow the prospective buyer to make an informed decision, and to highlight any possible risks associated with the target business.[14]

7.    Information Technology Due Diligence

IT due diligence is a method designed to provide a simple and full image of the efficiency of the target company's IT capabilities as well as the risk associated with future mergers and acquisitions. There are four stages in the process of evaluating a company's IT infrastructure: reviewing the company's standards, inventory, and systems; analyzing all of the databases and applications in use; determining the IT support services in place and delivery; and examining the IT organization structure in support of business activities.[15]

8.    Intellectual Property Due Diligence

IP due diligence is an assessment to determine the quantity and quality of intellectual property assets owned or licensed by a company, business or entity and the way the intellectual property is owned and protected by the target company.[16]

Approximately every company has intellectual property assets which it can use to monetize its business. These intangible assets are something which makes their products and services different from their competitors. This usually comprises of some of the most important valuable assets of the company. There are some important that need to be reviewed while executing Intellectual Property due diligence such as Schedule of patents and patent applications, schedule of copyrights, trademarks, and brand names, pending patents clearance documents,any pending claims case by or against the company in regard to violation of intellectual property.[17]

9.      Contingent Due Diligence

Contingent due diligence implies that the buyer has expressed and confirmed interest in a client or seller. However, the final details of the transaction and the move forward decision are based on the investigation results of the buyer. That means a company or person can withdraw if their findings do not satisfy them.[18] The contingency of due diligence is active over a given period of time. This time is negotiable and the parties can decide on any period of time. This length of time is called duration of due diligence. The due diligence period is a time in which the seller may terminate the contract for any real.[19] The purchaser may terminate the contract for any reason but mostly the reason to end any contract during due diligence is that the inspection uncovers an issue that the seller is unwilling to overcome.  If the buyer changes their mind at any point during due diligence they get their earnest money back.[20]

For example in a real estate case, the time period wherein the buyer performs site visits and property examinations, is the due diligence duration.  Things like the closing price, and whether the transaction will be completed, depend on their conclusions of the inspection.[21]

10.  Business due diligence

Business Due Diligence requires looking at the parties involved in the deal, market opportunities and investment efficiency. It analyses risk associated with the business processes and related factors, including markets, customers and even the competition. Business due diligence allows the purchasing party to consider whether the future transformation of the market poses a danger, whether current procedures can be integrated into new infrastructures and whether the nature of the company's customer base entails considerable risk[22]

11.  Customer due diligence

At the most basic level, customer due diligence requires checking the identity of a client and the company they are engaged in, to a reasonable degree of confidence.Customer Due Diligence or CDD is the method of collecting and reviewing specific customer information for any potential risk to the company or money laundering / terrorist funding activities. After that, the risk profile of the customer is assessed in either of the two ways- Enhanced Due Diligence or Simplified Due Diligence.[23]

1.      Simplified Due Diligence

Simplified due diligence is one of the types of Customer Due diligence. It is the lowest level of due diligence that can be completed on a customer.  This is appropriate where there is little opportunity or risk of your services or customer becoming involved in money laundering or terrorist financing.[24]

2.      Enhanced Due Diligence:

At times when the consumer and the product / service combination is considered at a higher risk, Enhance Due Diligence becomes necessary. To minimize the increased risk this higher degree of due diligence is required. Enhanced Due diligence is a process that provides a greater level of scrutiny of potential business partnerships and highlights risk that cannot be detected by Customer Due Diligence.[25]

Enhanced due diligence is explicitly designed to deal with consumers worth high-risk or high-net, and large transactions. Since these consumers and transactions pose higher risks to the financial sector, they are highly supervised and tracked to ensure everything is up and up.[26]

12.  Vendor due diligence

Vendor due diligence is the procedure that a private enterprise undertakes when either it is being sold or when its properties are being sold. Vendor due diligence is done at the seller's request, and typically is handled by an impartial third party. The third party performs a due diligence audit which reports on the company's financial stability under review and which is available to potential buyer.[27] Financial institutions use vendor due diligence reports to evaluate potential vendors before recruiting them or to evaluate vendors they are currently using to ensure they remain reliable, ethical and powerful. Vendor due diligence in financial institutions is necessary not only to minimize risks to business processes and financial stability but also to reduce the risk of compliance and credibility.[28]

13.  Third Party due diligence

Due diligence by a third party is the procedure that a business undertakes when it is trying to outsource work to an external firm, in order to determine the level of risk involved.[29] Employing a third party-whether it is a manufacturer, agent, dealer, lawyer, accountant or consultant-carries with it many challenges and regulatory requirements. Organizations must ensure sensitive IT information is secured by their third parties, prevent unethical activities, maintain a secure and healthy working atmosphere, reduce operating risks, and more.[30]

14.  Administrative Due Diligence

Administrative due diligence involves certifying items related to administration such as facilities, occupancy rate, number of workstations, etc.[31]The aim of administrative due diligence is to verify the various resources owned and occupied by the seller and to ascertain that all operational costs are mentioned in the balance sheet of the firm.[32]It consists of ascertaining the ownership of the company, the existence of burdens or taxes.[33]

It is beneficial for prospective buyers as they have a clear idea of the operational cost they are likely to incur if they plan to have future partnership with the company.

15.    Asset Due Diligence

Asset due diligence reports are a detailed analysis of firm’s assets.[34] It includes a detailed schedule of fixed assets& their location (physical verification should be done, if possible), list of sales and purchases of major capital equipment during last 3-5 years, all lease agreements for equipment, real estate deeds, title policies, mortgages and use permits.[35]

16.  Environmental Due Diligence

Environmental due diligence is a legal and professional review that is performed using state and federal environmental laws or guidelines to meet the liabilities imposed through such laws. It can be used to establish knowledge on environmental factors which may be used to determine responsibility and mitigate environmental risks.[36]

Environmental due diligence is a systematic procedure that tests real estate for possible risk of environmental pollution, such as soil & groundwater contamination.[37]

Environmental due diligence is very necessary because if the company violates any major law, local authorities will exercise their right to penalize the company, including, operationally closing it down.[38]Hence, this makes environmental audits one of the main forms of due diligence for each property owned or leased by the company.[39]

It is closely associated with the ‘polluter pays principle’ as set out in the Environmental Damage (Prevention and Remediation) (England) Regulations 2015.[40]The principle of polluter pays states that it is the duty of the producer of pollution to pay for its clean-up and remediation.[41]It is related to environmental due diligence as where an individual buys or inherits already contaminated land and the former occupant cannot be identified and/or there is no evidence to support the argument that contamination was caused by the former occupant, the duty of cleaning up and remedying the adverse environmental effects of the contamination is also inherited.[42]

17.  Strategic Fit

Acquirers are always very cautious in practicing due diligence in determining how well the target company fits in with the buyer's overall business strategy. For example, a private equity firm contemplating a new acquisition may ask how well the potential target complements the current enterprise portfolio. A large business that looks at a potential M&A transaction contemplates as to how easy (or how difficult) it is to integrate the target entity into the overall corporate organization of the buyer successfully.[43]

Financial and legal due diligence evaluate the potential benefit of the transaction and the concern to acquire the business "at the right price," strategic due diligence examines whether that opportunity is feasible — while tempting. It puts two broad questions to test the strategic reasoning behind a proposed transaction. Is the contract commercially appealing? And are we able to realize the targeted value? The first issue includes an external investigation; the second, an internal emphasis. Each question informs the other in part, strengthening an inquiry which thoroughly plumbs the wisdom of the deal.[44]

Ms. Megha Kamboj and Monika Saini, 3rd Year Students of  Maharastra National Law University, Mumbai are interns at Corp Comm Legal under Mr. Bhumesh Verma.


[1] Due diligence mergers and acquisitions. (accessed March 31, 2020.) https://www.corporatefinanceineurope.eu/due-diligence-mergers-acquisitions.htm.

[2] “IBA Corporate and M&A Law Committee Legal Due Diligence Guidelines” (accessed April 2, 2020.) https://delawarecounselgroup.com/wp-content/uploads/2018/09/Corporate-MA-Legal-Due-Diligence-Guidelines-September-2018.pdf.

[3] Due diligence mergers and acquisitions. (accessed March 31, 2020.) https://www.corporatefinanceineurope.eu/due-diligence-mergers-acquisitions.htm.

[4]Supra note 3.

[5].Supra note 3.

[6] “Financial Due Diligence LehmanBrown M&A Services.” LehmanBrown. (accessed April 1, 2020.) https://www.lehmanbrown.com/services/professional-services/mergers-acquisitions/financial-due-diligence/.

[7]“Tax Due Diligence: Because What You Don't Know Can Hurt You.” CohnReznick. (accessed April 1, 2020). https://www.cohnreznick.com/insights/tax-due-diligence-060415.

[8]Supra note 3.

[9] Borad, Sanjay Bulaki. “HR Due Diligence: Importance, Areas of Investigation, Benefit in Decisions.” eFinanceManagement.com, August 2, 2019. https://efinancemanagement.com/mergers-and-acquisitions/hr-due-diligence

[10]Supra note 3.

[11]Supra note 3.

[12] “IBA Corporate and M&A Law Committee Legal Due Diligence Guidelines” (accessed April 2, 2020.) https://delawarecounselgroup.com/wp-content/uploads/2018/09/Corporate-MA-Legal-Due-Diligence-Guidelines-September-2018.pdf.

[13]Ibid.

[14]Team,DueDil. “A Guide to Commercial Due Diligence.” DueDil. DueDil, March 20, 2020. https://www.duedil.com/blogs/a-guide-to-commercial-due-diligence.

[15]Elberg, Anatoly. “What Is IT Due Diligence.” What is IT Due Diligence. (accessed April 3, 2020.)

https://www.paranet.com/blog/bid/107301/what-is-it-due-diligence.

[16] The importance of IP due diligence. (accessed April 3, 2020. )

https://united-kingdom.taylorwessing.com/synapse/ip_duediligence.html

[17]“Types of Due Diligence - Know the Different Due Diligence Methods.” Corporate Finance Institute. (accessed April 3, 2020.)

 https://corporatefinanceinstitute.com/resources/knowledge/deals/types-of-due-diligence/.

[18]DealRoom. “What Is Due Diligence - Meaning, Examples, Types Checklist.” DealRoom. DealRoom, February 14, 2020. https://dealroom.net/faq/due-diligence-meaning.

[19] “What the Due Diligence Contingency Is, and Why It Is SO Important in This Market.” Real Estate Wise. (accessed April 4, 2020.)

 http://www.davidcblanton.com/real-estate-wise/what-the-due-diligence-contingency-is-and-why-it-is-so-important-in-this-market.

[20] Ibid

[21] Supra Note 18

[22] “Business Due Diligence: Everything You Need to Know about Due Diligence.” GMO Buy a Business, December 2, 2019.

https://www.buyabusiness.com.au/business-insight/business-due-diligence/.

[23] Admin. “Customer Due Diligence: the Process and It's Types.” Sumsub. SumSub, May 17, 2019. https://sumsub.com/blog/customer-due-diligence/.

 

[25]“Anti-Money Laundering.” Enhanced Due Diligence. (accessed April 3, 2020.) https://www.complianceassist.co.uk/due-diligence-info/enhanced.

[26] Nicolls, Dean. “Enhanced Due Diligence for Banks and Financial Institutions: KYC & AML Recommendations.” Jumio, August 27, 2019. https://www.jumio.com/enhanced-due-diligence-banks/.

[27]Team, DueDil. “A Guide to the Different Types of Due Diligence.” DueDil. DueDil, March 19, 2020. https://www.duedil.com/blogs/a-guide-to-the-different-types-of-due-diligence.

[28] “Vendor Due Diligence.” Ncontracts, November 13, 2018. https://ncontracts.com/quick-answers/vendor-due-diligence.

[29]Supra note 27.

[30] “5 Best Practices to Enhance Third-Party Due Diligence ...” Accessed April 6, 2020. https://www.metricstream.com/insights/best-practices-to-enhance-third-party-due-diligence.htm.

[31]Shivi, “Due Diligence Of A Company In India: Meaning And Types”, Legistify, April 1, 2020, https://www.legistify.com/blogs/view_detail/meaning-and-types-due-diligence-in-india/

[32]“Types of Due Diligence”, CFI, April 1, 2020, https://corporatefinanceinstitute.com/resources/knowledge/deals/types-of-due-diligence/

[33] Calogero Boccadutri, “Due Diligence In Real Estate: What It Is And What It Involves”, Mondaq, April 1, 2020, https://www.mondaq.com/italy/Real-Estate-and-Construction/600780/Due-Diligence-In-Real-Estate-What-It-Is-And-What-It-Involves

[34] Supra note 2.

[35] Supra note 1.

[36] “The Basics of Environmental Due Diligence”, Corporate environmental advisors, April 1, 2020, https://cea-inc.com/the-basics-of-environmental-due-diligence/

[37]“What is Environmental Due Diligence?”, Environmental Monitoring Solutions, April 1, 2020, https://www.em-solutions.co.uk/insights/environmental-due-diligence/

[38] Siskinds LLP, “What is Environmental Due Diligence?”, Siskinds, April 1, 2020, https://www.siskinds.com/environmental-due-diligence/

[39] Supra note 2.

[40]Valerie Fogleman, “The duty to prevent environmental damage in the environmental liability directive; a catalyst for halting the deterioration of water and wildlife”, Springer Link, April 1, 2020, https://link.springer.com/article/10.1007/s12027-019-00586-6

[41] “What is the polluter pays principle?”, London  school of economics and political science, April 1, 2020, http://www.lse.ac.uk/GranthamInstitute/faqs/what-is-the-polluter-pays-principle/

[42] Supra note 7.

[43] Supra note 2.

[44]Gerald Adolph, Simon Gillies, and Joerg Krings, “Strategic Due Diligence: A Foundation for M&A Success”, strategy+business, April 1, 2020, https://www.strategy-business.com/article/enews092806?gko=2e820


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