Due diligence is used to investigate and evaluate a business opportunity. It implies a general duty to exercise care in any transaction.
What is due diligence?
Most legal definition of due diligence describe it as measure of prudence activity, or assiduity , as it properly to be expected from, and ordinarily exercised by , a reasonable and prudent person under the particular circumstances , not measure by any absolute standard but depends on the relatives facts of the special cases.
Further, It is a process of investigation, performed by investors, into details of a potential investment. Such as an examination of operations and management and the verification of material facts.
It entails conducting inquiries for the purpose of timely, sufficient and accurate disclosure of all material statements/information or documents. Which may influence the outcome of the transaction. Moreover, It involves a careful study of the financial as well as non- financial possibilities for successful implementation of of restructuring plan.
Due diligence involves an analysis carried out before acquiring a controlling interest in a company to determine that the conditions of the business conform with what has been presented about the target business. Also, It can apply to recommendation for an investment or advancing loan /credit.
This may also require to be performed in cases of corporate restructuring , venture capital financing ,lending, leveraged buyouts, public offerings, disinvestments, corporatization etc. Sometimes, in a restructuring exercise , while the unit may remain within a group . It may pass from under the charge of one management team to that of another team. This situation also gives rise to the need for a due diligence review.
Importance of due diligence
When a business opportunity first arises, it continues throughout the talks, initial data collection and evaluation commence. Thorough detailed due diligence is typically conducted after the parties involved in a proposed transaction have agreed in principle that a deal should be pursued. And after a preliminary understanding has been reached, but prior to the signing of a binding contract.
The purpose of due diligence is to assist the purchaser or the investor in finding out all the care that a reasonable person can about the business he is acquiring or investing in prior to completion of the transaction. Including its critical success factors as well as its strength and weaknesses.
In addition , it may expose problems or potential problems that can be addressed in the price negotiations or by dealing suitable clauses in the contractual documentation, in particular, warranty and or indemnity provisions.
Following are the reasons for carrying out due diligence
- To confirm that the business is what it appears to be;
- To identify potential ‘deal killer’ defects in the target company and avoid a bad business transactions;
- To gain information that will be useful for valuing assets , defining representations and warranties, and/or negotiation price concessions ; and
- To verify that the transaction complies with investment or acquisition criteria.
What are the classification of due-diligence?
Following are the classification of due-diligence:
1 Commercial or operational :
It is generally performed by the concerned acquire enterprise involving an evaluation from commercial, strategic and operational perspectives. For example, whether proposed merger would create operational synergies.
2 Personnel :
It is carried out to ascertain that the entity’s personnel policies are in line or can be changed to suit the requirements of the restructuring.
3 Environmental :
It is carried out in order to study the entity’s environment, its flexibility and adaptiveness to the acquirer entity.
4 Legal :
This may be required where legal aspects of functioning of the entity are reviewed.
5 Information Systems :
It pertains to all computer systems and related matter of the entity.
6 Tax :
It is a separate due diligence exercise but since it is an integral component of the financial status of a company, it is generally included in the financial due diligence. The accountant has to look at the tax effect of the merger or acquisition.
7 Financial :
It involves analysis of the books of accounts and other information pertaining to financial matters of the entity. It should be performed after completion commercial due diligence.