Introduction
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]
[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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