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Published by Enhelion, 2019-11-25 07:43:09





3.1 Introduction

An investigation or audit of a potential investment or product for the purpose of confirming
all facts, such as reviewing all financial records, plus anything else deemed material is termed
as due diligence. It is the care a reasonable person is expected to take before entering into an
agreement or a financial transaction with another party. It also means the investigation
a seller does of a buyer or the subject matter of acquisition. In this case, the points of
consideration are whether the buyer has adequate financial resources to complete the
transaction and other material elements that would affect the acquired entity or the seller after
the sale has been completed.

In the investmenteco-system, due diligence is performed by-

➢ Companies seeking to make acquisitions
➢ Bankers
➢ Equity research analysts
➢ Fund managers
➢ Broker-dealers- are legally obligated to conduct due diligence on a security before

selling it which prevents them from being held liable for non-disclosure of pertinent
➢ Investors- doing due diligence on a security is voluntary for this class, but

Due diligence is of vital importance in M&A transactions, and this exercise may extend over
a long duration requiring intense analysis if the target firm is a large business with a global
presence. With the use of a variety of methods and accepted principles, the due diligence
team pursues an answer to the question: “Do we buy–and if so–how do we structure the

transaction and how much do we pay?”1 To answer this question, M&A due diligence
activities focus on four areas of the target firm:

➢ Strategic Position
➢ Financial Data
➢ Operational Assets
➢ Legal Matters

Each of these four areas can be further sub-divided into business, legal, and functional areas–
including IT. The degree of analysis and attention to each area depends on the nature and
category of the deal.

The meaning of the term “due diligence” has become associated with the orderly
investigation of a variety of matters pertaining to business and has been adapted for use in
many situations. Regardless of how it is used, “due diligence” implies that the person
conducting the investigation has made a “diligent” effort to obtain all the relevant and
meaningful information pertaining to the matter under investigation and the person subjected
to the due diligence has disclosed all of that information in a dutiful and forthcoming manner.
In other words, thorough, conscientious due diligence continues to provide a defence to those
who find themselves tasked with the investigation of an important business matter.

Conducting M&A due diligence in today’s marketplace is a demanding, high-pressure
undertaking that needs skill and expertise. Hence, firms that are involved in number of M&A
transaction develop their own in-house M&A due diligence expertise, whereas firms that are
involved in occasional M&A transactions often engage outside professionals to assist them
with this activity.

Mergers and acquisitions involves a substantial amount of due diligence by the buyer. He will
want to analyse the nature and extent of the target company’s contingent liabilities,
problematic contracts, litigation risks and intellectual property issues etc. This is applicable to
private company acquisitions especially, where the target company has not been subject to
the scrutiny of the public markets, and where the buyer has little ability to obtain the
information it requires from public sources.

1 Mergers and Acquisition M&A Due Diligence,,

Due diligence can be performed in different ways like- by internal teams, external advisors,
specialists, experienced/senior industry players or, as by a combination of these methods.

Many companies take help of due diligence to search for "red flags," deal breakers or fatal
flaws. It is a comprehensive approach that includes more detailed analysis of the target’s
information, industry, and economic outlook. Beyond this, due diligence can expose
fundamental insights, risks, and exposures that can have a significant impact on valuation, the
terms of the transaction agreement, culture/people risks, technology, operations or the
regulatory environment that can materially change a buyer’s interest or valuation of the deal.
A structured due diligence process can also help to assess the likelihood of the success of the
proposed acquisition.2

In certain M&A transactions such as “mergers of equals” and transactions in which the
transaction consideration consists of a significant amount of the stock of the buyer, or such
stock comprises a significant portion of the overall consideration, the target company may
engage in “reverse diligence” that in may be as broad in scope as the primary diligence
conducted by the buyer.

3.2 Work Streams in a due diligence process

Some of the critical work streams are mentioned below that should be considered in a
thorough due diligence process.

➢ Commercial/operational diligence- helps buyers understand-
1. The market segments in which the target operates
2. The industry and business outlook for its products, key competitors
3. The effectiveness of its operating model.

Commercial due diligence can be critical when a buyer wishes to acquire a new line of
business. Thus, it should involve detailed primary and secondary research as well as
interviews or surveys of competitors, suppliers, and customers.

Operational due diligence may cover the following key functional areas of the target-

1. Sales

2 -board-effectiveness/articles/the-intersection-of-due-

2. Marketing
3. Operations
4. Technology
5. Identifying gaps,
6. The ability to support future growth
7. The level of investment that may be required

➢ Legal diligence- looks at-

1. Existing and potential legal exposures and risks
2. Review of key commercial agreements, statutory records, tax records,

approvals and authorisations, Human Resources, litigation, IP, and contracts.

Counsel’s involvement due diligence is also significant in the negotiation and drafting of
the acquisition agreement, transition services agreements, and need for indemnities,
escrows, and post-acquisition true-up mechanisms (e.g., net working capital/net debt
adjustment clauses)3.

➢ Financial and accounting diligence- generally includes-

1. Detailed analysis of audited financial statements, monthly or quarterly
historical financial information

2. Reading of the audit work papers
3. Analysis of the details supporting publicly available financial information
4. Interviews with financial management and the external auditors.

This process can yield-

a) Observations of target’s earnings (such as non-recurring or one-time activities and
reserve releases)

b) Insights into post-transaction needs for net working capital
c) Shed light on debt-like exposures and trends in operating results and capital

expenditures, among other areas.

3 Id.

➢ Tax diligence- provides a deep dive into target’s tax profile—including both potential
tax exposures and available tax attributes (net operating losses, credits, etc.)

This is done by-

1. Analysing significant tax returns, financial statements and supporting

2. Conducting interviews with tax management and advisors.

Employee benefit and human resources due diligence includes-

Detailed review of the company’s relationships with its employees, such as union
agreements, regular benefits, executive compensation

3. Post-employment obligations.

Due diligence can also help to identify cost structure changes that can occur if the
target’s employees join the buyer's benefit plans post-acquisition

➢ Foreign Corrupt Practices Act due diligence (insisted upon by US companies in their
global acquisitions) can include-

1. An assessment of policies and procedures to mitigate the risk of foreign

2. A review of payment information to assess
3. Mitigate post-acquisition exposures arising from pre-acquisition compliance

violations, if necessary.

➢ Reputational due diligence- can include-

1. Background checks on the target, its shareholders and key executives.
2. Prior instances of fraud, corruption, money laundering, trade compliance,

labour, and product safety or other adverse issues can be identified through
focused integrity due diligence research.
3. Public records can also reveal financial red flags such as bankruptcies, liens,
and excessive litigation for the company and/or its principals

➢ Integration and synergy due diligence- focuses on analysing-

1. How the businesses will likely come together post-closing
2. The potential benefits and related costs of performing an integration of the

3. Typical focuses are on the selling, general and administrative (SG&A) areas of

a company such as finance, legal, information technology, human resources,
and other enabling areas, but when appropriate should include the impacts on
revenues and cost of sales as well.

Proper diligence can result in a more robust estimate of planned synergies and related
integration costs, as well as help identify any dis-synergies in combining the businesses

➢ Insurance due diligence, environmental due diligence, and engineering due diligence-
are some other common work streams in a typical due diligence approach and focus
on exposures in these areas, as well as potential changes in costs post-acquisition.

➢ Technology/Intellectual Property- The buyer is interested in the extent and quality of
the target company’s technology and intellectual property. This due diligence shall
focus on the following areas of inquiry-

a) What domestic and foreign patents (and patents pending) does the
company have?

b) Has the company taken appropriate steps to protect its intellectual property
(including confidentiality and invention assignment agreements with current
and former employees and consultants)? Are there any material exceptions
from such assignments?

c) What registered and common law trademarks and service marks does the
company have?

d) What copyrighted products and materials are used, controlled, or owned by the

e) Does the company’s business depend on the maintenance of any trade secrets,
and if so what steps has the company taken to preserve their secrecy?

f) Is the company infringing on (or has the company infringed on) the
intellectual property rights of any third party, and are any third parties
infringing on (or have third parties infringed on) the company’s intellectual
property rights?

g) Is the company involved in any intellectual property litigation or other
disputes (patent litigation can be very expensive), or received any offers to
license or demand letters from third parties?

h) What technology in-licenses does the company have and how critical are they
to the company’s business?

i) Has the company granted any exclusive technology licenses to third parties?

j) Has the company historically incorporated open source software into its
products, and if so does the company have any open source software issues?

k) What software is critical to the company’s operations, and does the company
have appropriate licenses for that software (and does the company’s usage of
that software comply with use limitations or other restrictions)?

l) Is the company a party to any source or object code escrow arrangements?

m) What indemnities has the company provided to (or obtained from) third parties
with respect to possible intellectual property disputes or problems?

n) Are there any other liens or encumbrances on the company’s intellectual

o) Customers/Sales- The buyer will want to fully understand the target
company’s customer base including the level of concentration of the largest
customers as well as the sales pipeline. The following are the concerns that are
to be concentrated upon-

➢ Who are the top customers and what revenues are generated from
each of them?

➢ What customer concentration issues/risks are there?

➢ Will there be any issues in keeping customers after the acquisition
(including issues relating to the identity of the buyer)?

➢ How satisfied are the customers with their relationship with the
company? (Customer calls will often be appropriate.)

➢ Are there any warranty issues with current or former customers?

➢ What is the customer backlog?

➢ What are the sales terms/policies, and have there been any unusual
levels of returns/exchanges/refunds?

➢ How are sales people compensated/motivated, and what effect will
the transaction have on the financial incentives offered to employees?

➢ What seasonality in revenue and working capital requirements does
the company typically experience?

3.3 Employee/Management Issues

The buyer will want to review a number of matters in order to understand the quality of the
target company’s management and employee base, including-

1. Management organization chart and biographical information
2. Summary of any labour disputes
3. Information concerning any previous, pending, or threatened labour stoppage
4. Employment and consulting agreements, loan agreements, and documents relating

to other transactions with officers, directors, key employees, and related parties
5. Schedule of compensation paid to officers, directors, and key employees for the

three most recent fiscal years showing separately salary, bonuses, and non-cash
compensation (e.g., use of cars, property, etc.)
6. Summary of employee benefits such as pension, profit sharing, deferred
compensation, and retirement plans

7. Summary of management incentive or bonus plans not included in above as well
as other forms of non-cash compensation

8. Employment manuals and policies
9. Involvement of key employees and officers in criminal proceedings or significant

civil litigation
10. Plans relating to severance or termination pay, vacation, sick leave, loans, or other

extensions of credit, loan guarantees, relocation assistance, educational assistance,
tuition payments, employee benefits, workers’ compensation, executive
compensation, or fringe benefits
11. Appropriateness of the company’s treatment of personnel as independent
contractors vs. employees
12. What agreements/incentive arrangements are in place with key employees to be
retained by the buyer? Will these be sufficient to retain key employees?
13. What layoffs and resultant severance costs will be likely in connection with the

3.4 Production-Related Matters

Depending on the target company’s business nature, the buyer may undertake a review of the
company’s production-related matters that includes the following-

1. List of the company’s most significant subcontractors, including the dollar
volume of business and the type of services or products supplied by each

2. List of the company’s largest suppliers with the amount and type of products
purchased from each during the most recent fiscal years and year-to-date, as
well as whether or not the supplier is the only source of such products.

3. manufacturing yield summaries, by product

4. Schedule of backlog showing customers, products, and requested/scheduled
shipping dates

5. Copies of inventory reports

6. Supplies or materials used by the company to produce or develop products that
are in short supply or subject to shortages

7. Product service programs and copies of standard form of service contract and
any contracts with service providers

8. Information regarding backlogs and levels of plant operation

9. All agreements and other arrangements related to the research, development,
manufacturing, and testing of the company’s products

3.5 Online Data Room

It is critical to the success of a due diligence investigation that the target company establish,
maintain, and improve an organized online data room to enable the buyer to conduct due
diligence in a systematic manner. The following are the common attributes of an effective
data room-

1. The target company makes it available to the buyer as early in the process as
possible, at the latest immediately following the parties finalizing the letter of
intent or term sheet

2. The data room has a logical table of contents or directory and full text search
capabilities (which requires scanning of all documents with optical character
recognition software)

3. The data room permits bookmarking within the application

4. Subject to confidentiality concerns, the buyer is permitted to print documents
for offline review

5. The data room is keyed to any due diligence checklist provided by the buyer to
facilitate cross-referencing and review

6. Ideally, access to the data room is accompanied by delivery by the company to
the buyer of a draft disclosure schedule and all materials referred to in the
disclosure schedule are in the data room

7. Updates to the data room are clearly marked or trigger email notifications to
the buyer’s counsel, to help ensure that nothing is missed as supplemental
materials are added during the process

3.6. Disclosure Schedule

To ensure success of M&A transaction, the target company will be required to prepare a
comprehensive disclosure schedule referring many of the key diligence topics described
above, and identifying any exceptions to the company’s representations and warranties in the
acquisition agreement. This has to be done with careful preparation. It may require revision
and update before it is delivered to the buyer. It needs preparation of the disclosure schedule
early in the planning stages of an M&A transaction. The following items have to be
considered in the schedule-

1. Does the disclosure schedule accurately tie into the representations and
warranties set forth in the acquisition agreement?

2. Are all material contracts and amendments listed, with dates and

3. Are all contracts listed in the disclosure schedule contained in the target’s
online data room, and have those contracts been reviewed?

4. Have all patents issued and pending been summarized and listed?

5. Are any important contracts affected by a change in control? Whether consent
will be obtained from the counterparty before or after the change in control?

6. If litigation is listed, has an analysis been done of the potential exposure?

7. If there are liens on any assets, how will those liens be removed at closing?

8. Are there any unusual employment agreements or severance arrangements?

9. Are the outstanding capital stock, options, and warrants of the company
properly listed?

10. Do the company’s continuing contracts provide for any issues for the company
moving forward?

11. Are there any material matters set forth in the disclosure schedule that are
inconsistent with statements previously made on behalf of the company, or
with the valuation that the buyer has placed on the business being acquired?

12. Does the disclosure schedule include any broad disclaimers or generalized
disclosures that would prevent the buyer from raising legitimate claims
following the closing if individual representations and warranties turned out to
be untrue?

13. Are there disclosures or statements in the disclosure schedule that are
internally inconsistent with each other?

3.7 Steps to improve due diligence

Ideally, boards and managements should work together to facilitate a comprehensive due
diligence process. Due diligence process will vary according to the nature of the business, but
the following steps shall help improve the likelihood of success-

➢ Management should inform the board of the pending acquisition at an early stage
which shall include an initial assessment of anticipated risks and benefits, its approach
to valuation, the due diligence plan and the transaction timeline, etc.

➢ The board should determine its role (and that of its committees) in the due diligence
process, based upon the size of the transaction, anticipated risk areas,

➢ In case of engagement of outside advisors, the board should consider both tangible
factors—for example, the advisors’ experience and knowledge of the industry and
other areas relevant to the transaction and financial incentives- success fees or fee
haircuts that could impact the advice rendered and perceptions as to the quality of the
advice—as well as intangible factors, such as whether the board and management feel
they can trust an advisor. In some cases, it may be advisable to retain additional

advisors. The board should also consider monitoring the performance of the
company’s outside advisors, as reliance upon advisors can be called into question if
the advice rendered is later deemed to be inappropriate
➢ Management should keep the board informed of the transaction regularly. Periodic
board review and consideration of the transaction will help the board to fulfil its
fiduciary duty of "due care" in evaluating the merits and risks of the transaction,
reducing the board’s liability.
➢ The board should ask management for updates in case periodic updates are not given.
Acquisitions should not follow a "set it and forget it" approach
➢ Management should keep the board informed about the status of the transaction
during the pre-closing period and the period post-closing.

3.8. Diligence in Listed and Unlisted Companies in India

Listed companies entail more extensive review of companies, as well as greater degree of
caution with respect to sharing of information and structuring of transaction, as compared to
unlisted companies.

In case of a listed company, the provisions of the SEBI (Prohibition of Insider Trading)
Regulations, 2015, as amended are applicable. The due diligence should not include review
of unpublished price sensitive information except in certain special circumstances4. However,
publicly available information under the listing agreement signed by the listed companies
may not be always adequate to base an investment decision. Therefore, in case of a listed
company, care must be taken to ensure that the insider trading regulations are not violated in
the due diligence process. This matter has to be dealt with on a case-by-case basis.

For listed companies, analysis of potential triggers of the SEBI Takeover Code, asapplicable,
in the case of a proposed acquisition or transfer will need to be made.

3.9. M&A Negotiation Process

The negotiation process for a private acquisition can be different for every deal. This section
provides an overview of the steps to be taken in one-on-one negotiations.

4 Jayant Mudgal, Role of Due Diligence in Mergers and Acquisitions,, http://lex-

Negotiations commence when one party communicates its interest in a deal. A buyer initiates
a deal with a simple statement of interest, whereas a seller usually approaches potential
buyers with target information called teaser. Thereafter, the seller faces a trade-off between
providing information to attract or improve an offer, versus withholding sensitive details in
case the deal doesn’t go ahead. Both parties may enter into a non-disclosure agreement
(NDA), whereby they commit to keep information confidential. This is generally where
lawyers are involved in the process.

In spite of the NDA, the seller is hesitant not yet provide open access to the target’s books
and premises. The parties usually assess whether they are thinking along a similar target price
range. To encourage an initial offer from the buyer, the seller may provide additional
information about the target in an information memorandum (IM). Based on the IM, the
buyer makes an initial non-binding offer i.e. a price that the buyer offers if there are no
undisclosed facts. If this offer is acceptable to the seller, an initial agreement called a letter of
intent (LOI) is signed. It is non-binding agreement and its main purpose is to provide a
structure to the deal and set a timeline for contract negotiations. In addition, the LOI may a
binding exclusivity clause, which precludes the seller from entering into negotiations with
other bidders for a certain period of time. Thereafter, the buyer is granted access to the
relevant target data.

Contract negotiations start with a draft contract provided by one of the two parties. It is a
combination of a standard sample contract typically used by the law firm and deals with
specific details. The draft of a contract varies depending on whether it represents the buyer or
seller, and the first draft contract is usually biased towards the party whose lawyers are
drafting it. Then the counter-party indicates preferred alterations. It is followed by
extensively discussions on the same which can continue over months. If the due diligence is
on-going during the contract negotiations, its results will affect the negotiations (e.g. by
demanding warranties). The target price is not a part of contract negotiations and is
mentioned only late in the negotiation phase. However, the price can be adjusted downward if
issues are not fully mitigated in the contract (e.g. through warranties or covenants).

The contract may stipulate certain conditions precedent if the transfer of control does not
occur directly with the signing. If these conditions are satisfied, there is no renegotiation after

the signing. However, if some conditions are violated then the contract can be annulled and
parties renegotiate.5

3.10. Cross Border Mergers and Acquisitions

It occurs when a company in one country can be acquired by another company from other
countries. The local company may be private, public, or state-owned company. The merger or
acquisition by foreign investors will result in the transfer of control and authority in operating
the merged or acquired company.

A cross border merger refers to- the assets and liabilities of the two companies from two
different countries are combined into a new legal entity in terms of the merger, while in
acquisition, there is a transformation process of assets and liabilities of local company to
foreign company that leads to automatic affiliation of the local company.

The state where the origin of the companies that make an acquisition (the acquiring company)
in other countries is referred to as the Home Country, while countries where the target
company is situated is referred to as the Host Country.

3.11. Cross Border Mergers and Acquisitions in India

In the modern global marketplace, the news of Indian Companies acquiring a foreign
business is more common than the other way round.

Buoyant Indian Economy, surplus cash with Indian corporate, Government policies and
dynamism in Indian businessmen have all contributed to this new acquisition trend6.

The Indian IT and ITES companies already have a strong presence in foreign markets;
however, other sectors are also now growing rapidly. This is not only an indication of the
maturity reached by Indian Industry but also the extent of their participation in the overall
globalization process.7

6 Sunder Lal Vishal, Indian Companies,,
7Vijay Kumar Sharma & Rakesh Kumar Sharma, Cross Border Merger and Acquisition with Special Reference
to India,,

3.12. Effects of Cross Border Mergers and Acquisitions

Cross border merger and acquisitions are a restructuring of industrial assets and
production structures on a global basis as it enables the global transfer of technology,
capital, goods and services and facilitates universal networking. Cross border M&A leads
to economies of scale and benefits the economy in terms of increased productivity of the
host country, increase in economic growth and development particularly if the policies
used by the government are favourable.

➢ Capital build-up- Cross border merger and acquisitions contribute in capital
accumulation on a long term basis. It not only undertakes investment in plants,
buildings and equipment’s but also in the intangible assets such as the technical
know-how, skills to ensure expansion of the business.

➢ Employment creation- M&A’s for the purpose of restructuring may lead to
downsizing. The downsizing is essential for the continued existence of operations
and long term employment gains.

➢ Technology transfer - When companies across countries merge it boosts positive
effects of transfer of technology, sharing of best management skills and practices
and investment in intangible assets of the host country. This in turn leads to
innovations and has an influence on the operations of the company.8

3.13. Cross Border Mergers and Acquisitions- Issues and Challenges

On a close analysis, it may occur that cross border merger and acquisitions are quite
similar to that of domestic M&A’s. But because the former are wide and international in
nature they pose certain unique challenges with reference to different economic, legal and
cultural structures. There could be huge differences in terms of customer’s tastes and
preferences, business practices, the culture which could pose as a huge threat for
companies to fulfil their strategic objectives. These issues and challenges may be-

8Cross Border Merger and Acquisitions,,

1. Political concerns- Political scenario could play a key role in cross border merger and
acquisitions, particularly for industries which are politically sensitive such as defence,
security etc.
In addition to this, concerns like the governmental agencies (central, state and local),
employees, suppliers and all other interested should be addressed subsequent to the
public knowledge of the merger scheme. In fact, in certain cases prior notice and
discussion with the labour unions and other concerned parties may be required. It is
important to identify and evaluate present or probable political consequences to avoid
any future political risk.

2. Cultural challenges- This could pose a huge threat to the success of cross border
merger and acquisitions. Issues arising due to geographic scope of the deal are
common. Various factors like differing cultural backgrounds, language necessities and
dissimilar business practices have been the reason of failure of mergers. Research
proposes that intercultural disagreement is one of the major pointers of failure in
cross-border merger and acquisition. Irrespective of the objective behind the proposed
acquisition, business should be well aware of the cultural differences and prospects
that can materially affect the process and should prepare accordingly. Businesses have
to invest good amount of time and effort to be well aware of the local culture to gel
with concerned parties.
Legal considerations- Companies wanting to merge cannot overlook the challenge of
meeting the various legal and regulatory issues that they are likely to face. Various
laws related to security, corporate and competition law are bound to diverge from
each other. Hence it is important to review the employment regulations, antitrust
statute and other contractual requirements to be dealt with beforehand.
While undergoing the process of reviewing these concerns it could indicate that the
potential merger or acquisition would be totally incompatible and hence it is
recommended to not go ahead with the deal.

3. Tax and accounting considerations- Tax matters are critical particularly when it comes
to structuring the transactions. The proportion of debt and equity in the transaction
involved would influence the outlay of tax9; hence a clear understanding of the same

9 Id.

becomes significant. Another factor to decide whether to opt for an asset or a stock
purchase is the transfer taxes. Countries may follow different accounting policies. The
parties having sufficient knowledge about the financial and accounting terms in the
deal, it would aid in minimizing the confusion.
4. Due diligence- Due diligence forms a very important part of the M&A process. Due
diligence can affect the terms and conditions under which the M&A transaction would
take place, influence the deal structure, affect the price of the deal. It helps in
revealing the potential dangers and gives a detailed view of the proposed transactions.
There are several other issues as every deal varies from company to company. But it is
very important to identify and tackle those challenges to help close a deal.10


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