What is due diligence?
Due diligence can mean something as simple as homework. An investor is required to do his homework before proceeding further with a transaction. Due diligence is a thorough appraisal of a business, a company or a property, as the case may be that a potential investor or buyer will undertake before the deal is finalized. A due diligence process allows a potential buyer or investor to learn all relevant details about a company, which he would reasonably require before finalizing a transaction or an investment.
It is the process that involves verifications and precautions that are necessary to identify or prevent foreseeable risks. Before choosing to act on cash reserves, an investor should make himself an expert in what he proposes to invest.
Why is due diligence necessary?
Due diligence marks the embarkation of any major transaction or investment. It is that part of the acquisition wherein the prospective buyer assesses whether he would be able to get the returns for as much investment. A prospective buyer/investor needs to be sure that he or she is making the right move. An investor needs to ensure that they are not venturing into an investment or acquisition just on good faith. The good faith needs to be backed by all relevant and strong evidence that will be provided by the process of due diligence.
Legal, due diligence is not just a task to be undertaken during an investment or an acquisition. Still, it is a necessity to have complete knowledge of the target and the liabilities associated with that target.
The investor will be able to evaluate the deal's strategic and commercial potential effectively. It not only helps in the right pricing, but the process saves a buyer or an investor from any surprise risks or dangers.
There are several types of due diligence. In the article below, we briefly discuss corporate due diligence, in the context of transactions of Mergers and Acquisition and real estate due diligence.
Corporate due diligence, in the context of Mergers and Acquisitions, helps an investor in acquiring the knowledge of the target company and also during the drafting of merger and acquisition agreement and the related ancillary agreements.
Every deal is unique. In the corporate world, there are several transactions taking place at high speed and the uncertainties involved in them are huge, which makes the conduct of due diligence, inevitable.
Conducting due diligence of a company determines the current status of the company and also the consequences of the business. It gives the buyers a comprehensive picture of what exactly is being purchased and further provides a road map for the future of its business.
A cost-benefit analysis is undertaken on the target company to help the acquirer to understand the impediments, hindrances that the acquirer would be subject to and the pros and cons of the entire transaction.
Before the interested parties execute any agreements, the acquirer should familiarise itself with the complete accounts and other relevant data of the target company. The acquirer's adviser should procure, study and educate the acquirer of all the legal documents including incorporation documents, shareholders warrants, any outstanding warrants, licenses & permits, annual returns, balance sheets etc. Upon satisfying the acquirer, the process then moves on to an investigation of all the litigations that the target is a subject. This establishes an overview of the risks involved with the target company.
After the above, the assets and liabilities are studied. Cash reserves, inventory, intellectual property, securities, bank debts, list of employees and their salaries, are all studied at this stage. An adviser also needs to search all the records and communications to ascertain the value of hidden assets and liabilities, if any.
Further, a basic review of the target company's standing on the internet should also be assessed by searching customers' review and complaints on the target company's business.
After search and accumulation of all the records and documents, the acquirer, with the help of its attorneys and advisers, analyses the findings, highlights all red flags, investigates all the red flags and warnings and satisfies itself of all relevant queries and impediments.
Key components of Corporate due diligence
A detailed search, verification and satisfaction of the following are essential in corporate due diligence:
1. Review of the structure of the organization: This would include aspects such as incorporation, capitalization, organizational details, details about securities, stock, warranties, acquisitions, minutes of meetings, etc. A complete review of the target company's financial information, statements, balance sheets, audit reports, budgets and forecasts for the next five years is carried out by the advisers and attorneys, at this stage.
2. Tax audit: A detailed analysis of tax liabilities is conducted: This includes a search of income tax, sales tax and other taxes filed in all jurisdictions concerning any federal, state, foreign regulations. The attorneys would conduct a study of all correspondences with the authorities and the filing of relevant forms.
3. Profitability and strategic fit: Along with the current status of the target company, the attorneys also conduct a study of the profitability and performance of the target company in the future. This involves the assessment of human resources, technology, marginal costs. This would help the acquirer in ascertaining the viability of the target company in fitting with the strategies of the acquirer.
4. Assets of the target: Material assets held by a target company is key to a deal. It is important to assess the total value, and this includes inventory, technology, equipment, real estate, etc.
5. Intellectual Property: A review of all intellectual property held by the target company is important to ascertain the value of the target company. It is important to establish the property's value, quality and protection.
6. Review of all contracts: It is of critical importance to review all the contracts in force at the relevant time. This includes customer contracts, supplier contracts, receivables and payables, loans, credit agreements, joint ventures, leases, employment contracts, licenses, franchises, advertising, etc.
7. Employees: Understanding the quality and structure of a company's management and employees are key.
8. Litigation: It is important to know if the target company is exposed to any potential legal threat and also if any pending litigation is of a nature that would disrupt the purpose and value of the deal and would emerge a disadvantage to the acquirer.
9. Compliances: The process of due diligence should provide a clear picture of the target company's compliances with the necessary laws and regulations.
Similar to the case of corporate due diligence, the increase and the constant fluctuation in the real estate values, has heightened the awareness of risks involved in such transactions. The process of real estate due diligence has the potential of impacting the commercials and the feasibility of the transaction itself. It is important to examine issues such as title, the legality of construction, if any, permitted use, encumbrances involved in the property, which in turn impacts the nature of the property and the transaction itself.
Due diligence primarily answers questions relating to ownership/rights of the seller/lessor; liens on the property like mortgages, charges, acquisitions, litigation, etc.; other restrictions on the property.
Depending on the nature of the transaction, the objective of parties and the property involved, due diligence/title search may be conducted for a period of preceding thirteen or thirty years. A search is usually done for thirty years for reasons such as the limitation period applicable for dispossession by government or local authorities is thirty years. Therefore, thirty years' search and derivation are essential to confirm that there is no such vested right to dispossess the present owner.
Key components of real estate due diligence
Real estate due diligence involves a detailed search and verification of the following:
1. Legal capacity of the present owner of the property: This is the verification of whether the person is legally capable of entering into a binding contract for sale or lease of the property or for mortgaging the property. And whether he is a minor or of unsound mind and if prior permissions from applicable authorities are obtained in that case.
2. Nature of current owner's right over the property, and whether such right is transferable: The nature of rights and transferability of the same are identified. The nature of the rights of a person can be freehold or absolute ownership, right of the perpetual lease, tenancy right and land allotted by State Government/ Central Government under various enactments.
3. Derivation of ownership: A person can derive rights by:
4. The legality of Construction: If the property involves construction on the land, it is necessary to examine the legality of the construction. Each territory has its own rules regarding civil constructions. The compliance of the construction as per the rules and regulations have to be verified.
5. Government approvals and authorizations: It is pertinent to inspect and verify that all the approvals and authorization concerning the property, including building & industrial approvals, taxes, environment compliances and other approvals for the transaction have been procured from the concerned government authorities.
6. Encumbrances over the property: It is critical to examine whether there are any encumbrances, charges, mortgages created on the property. The records of the Sub-Registrar should be searched, and the encumbrance certificate issued by the Sub-Registrar should also be verified. If the property belongs to a company, the records of the Registrar of Companies have to be searched and verified. The property in question should be free from encumbrances that are of the nature of causing hindrances to the title and enjoyment of the property.
7. Acquisition process: It should be verified if the property is under the process of acquisition by the government or any authority. If the government has acquired the property, then the property ceases to belong to its original owner and becomes the property of the acquiring authority. Therefore, the said property cannot be sold or alienated unless released from the acquisition process.
8. Publication: As a matter of abundant caution, it is also advisable that the proposed transaction be published on at least two local newspapers to ensure there are no claims on the property from any third party.
Upon a perusal of documents in original, necessary searches of records of concerned registrars, making required queries, the attorney issues a due diligence report or a title certificate. Due diligence is time consuming, tedious and expensive. Though having said that, it is strongly recommended that due diligence or a title search be conducted before any large transaction as it goes beyond the basic checks and uncovers the most minute details that may influence the transaction. Having gone through the complicated and tiresome process of due diligence, an individual or a company can be sure about their decision to proceed or not to proceed with the transaction.
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