What is Due Diligence? - Definition and Types

Due diligence is a process of corporate investigation by any company or corporation, which is required when the company is thinking to conduct merger or acquisition with another company or by investors that want to enter into any kind of financial agreement with the company.

As per the McKinsey Global Survey on the Merger and Acquisition practices and capabilities the company management regularly report that the companies involved, regularly examine the portfolio of the target companies that show them whether it is worth investing or not.

What is Due Diligence?

The due diligence involves an investigation or audit of any potential investment or audit of any product that you or your company might be investing in. It is a method to also confirm that whatever amount you are investing in the product or company is worth every penny.

In short, it is a research that is done by an investment company before entering into any kind of agreement or financial transaction with another party.

The process of due diligence is a very intricate and sophisticated process that require special skills so that the individual can decide upon the delicate business decisions. The process of due diligence requires a whole lot of things so that the investors can look into the affairs of the company ranging from case laws they are involved into an intellectual property that the company owns.

The laws in India cast a duty upon the person making the investment to find out the truth about the company or its assets. Section 3 of The Properties Act states that the person investing in the property is presumed to have information about the facts presented to him or her are true or not.

Indian Law and Due Diligence

Indian law has included mandatory provisions for due diligence process in India. The mandatory provisions have been introduced in the Security and Exchange Board of India(Mutual Funds) Regulations 1996 and for offshore offerings by Indian companies through American or Global Depository Receipts.                                                      

Why Perform Due Diligence?

The goal of any due diligence is to avoid a bad business or investment decision

Don C Johnson(Trace Investigation Founder)

Merger and Acquisition reacquire big changes in the running of company process and also the organisational structure of the company even if the company being taken over is a small one or if the deal involved is a small one there is a requirement of due diligence into the companies involved.

The corporate deal-making has faced a lot of changes in recent times, no more are the investors just relying upon the words of the company management they now conduct focused and in-depth investigation into companies and investments they are focused on making.

How to Perform Due diligence?

The due diligence process involves six steps that the investigators need to incorporate while conducting any kind of corporate investigations. The steps involved include the following processes.

  1. Analyse the purpose of the project
  2. Pre Analysis of financial operations of the company
  3. Full check of the documents
  4. A full analysis of the business case and plans
  5. Risk analysis
  6. Final offering Creation and ongoing monitoring

Types of Due Diligence

Any acquiring process is an extensive process that is taken up by the acquiring company so that they can assess the target companies complete financial records, assets and capabilities and financial performances

The main type of due diligence are:

1. Financial Due Diligence

When a company is involved in the process of investing in a company the most essential and important type of due diligence that is conducted by a company is checking whether the financials that are showcased in the report is accurate or not. The financial due diligence will provide a thorough understanding of all the company financials.

The financial due diligence is not restricted to the audited financials of the company also unaudited financial statements. These unaudited financial statements of the company should be compared with the financial statements of the last 3 years that are submitted by the company with MCA.

This comparison of the financial statement will help the investigator to examine the companies projections and basis of projection such as capital expenditure of the company, schedule of the inventory and list of all the debtors and creditors of the company.

2. Taxes Due Diligence

Tax due diligence involves looking into tax liability of the company; the process is sometimes overlooked by many potential investors as they keep their focus on the earning analysis of the company or other due diligence processes.

The tax due diligence involves a comprehensive examination of different types of taxes that are imposed upon the business and other taxations that the company will be levied based on its jurisdiction. The tax due diligence makes it possible for the investor to understand the significant tax exposure of the company.

The tax due diligence of the company will not only include income tax but also GST returns, employment taxes and property tax. The tax DD also includes a review of transfer pricing and any kind of foreign tax credit issues faced by the company. Analysing non-tax documents such as minutes of the board meeting, compensation plans and financial statements of the company.

To summarise the tax due diligence includes a review of the following:

  • Documents Relating to Non-Operating Loss(NOL)
  • Information regarding any of the past tax audits that may be pending
  • Copy of all the documents pertaining to any tax returns: This includes income tax receipts and GST returns filed in the past 3or 5 years by the company
  • Remember to look for any out of the ordinary correspondence that happens with the tax agencies.

3. Intellectual Property DD

Every company has some kind of Intellectual property asset whether it be trademark, patent or copyright. Each of these Intellectual property increases the value of the company in the eye of the investors.

The intangible assets of the company differentiate the product of the company from that of others and hence are considered the most valuable assets of the company and the ones that bring them to another level in comparison with their competitors

When a person or investigator is conducting due diligence they are required to look into the following:

  • Schedule of patents and any patent applications that are filed by the company
  • Scheduled trademark and brand names that are either filed or yet to be filed
  • Schedule of the trademarks or copyright that are filed with the central government.
  • Any of the pending claims or cases filed by the company or against the company in regard to violation of any intellectual property.

 

4. Legal Due Diligence

The legal, due diligence involves collecting, understanding and assessing the legal risks that are involved during the merger and acquisition process. The acquirer of the company reviews all the legal documents pertaining to the target company.

The main reason behind such an investigation is to see that the acquired company does not face any kind of future legal problems. Hence this makes Legal, due diligence an essential part of the merger and Acquisition process and provides the acquirer company with an insight in the target company as this process brings into focus the subtle things of the company which are otherwise overlooked. Such as suits that involve employee and labour arrangements and any of the cases involving infringement of intellectual property.

Key Value drivers of Due Diligence

Value drivers determine the price and structure of the transaction and define the nature and scope of due diligence. The key  value drivers are:

  • Products
  • Markets
  • Customers
  • Capabilities
  • Culture
  • Risk

Significance of Due Diligence

Due diligence is a process through which the investigators obtain information about the company function and circumstances or set conditions and uncover the circumstances that were and are influencing the business decisions.

Due diligence in some cases has saved the companies and world from big frauds that were aimed at stripping the shareholders of such companies from their money and assets that they had invested in the company.