What is due diligence, why is it required?
Making an investment in a business or buying a business is quite risky. Suppose a person wants to buy a company and later he comes across that the representations made by the seller were untrue and that there are a lot of hidden risks which are associated in the business like, suits against the company or that the Company was formed without complying to the provisions under Companies Act, 2013 and now the company has to compensate heavy penalties. Hence the buyer would be overburdened such liabilities, fines, compensations and penalties and buyer would end up in a helpless position.
In order to avoid falling into such a trapped situation of unforeseen risks, liabilities and penalties, it is advisable for the buyer to conduct due diligence (“DD”) on the seller’s entity in order to acknowledge all the upcoming liabilities associated with the company.
A person or business entity before entering into a legal contract has to take some reasonable steps to investigate and exercise his power, this reasonable care and caution refer to due diligence.
Due Diligence refers to conduct thorough investigation and examination of all critical aspects of a business such as finance, operational tax, commercial duties, all sorts of taxation, IT, integrity, social diligence, environment, health and safety etc.
Due diligence in basic terms refers to the background check before entering into a legal contract with the seller to invest or buy into his company.
Purpose of Due Diligence
The main purpose of due diligence is to provide assurance to the buyer/investor that the proposed transaction is safe and that he can go ahead with it. The team who conduct such background investigation review all sorts of documents both relevant and important, and all the information pertaining to the target company is examined. The discoveries which are made if associated with risks then it is indicated by raising red flags wherever necessary. Once the risks involved are identified it is again compensated by the taking specific representation, warranty and indemnity from the seller to the buyer or acquirer.
- Due Diligence helps the acquirer to be notified with all the material facts in relation to the business, including associated risks and opportunities. Such an investigation reduces the risk of unpleasant contract or post-transaction surprises, by assuring the acquirer about the business in detail.
- Due diligence helps to build a trustful relationship between the acquirer and the target company.
- Representation and warranties for indemnification can be identified through such investigation.
- It helps in discovering and evaluating all possible financial risks which are very important for the acquirer to know before buying or investing in the business.
- It also notifies the acquirer whether all necessary regulations have been followed and the laws with Companies Act 2013 has been complied with.
Types of Due Diligence:
· Business due diligence
Under the business category, the business model of a particular company is examined and analyzed whether the business of this particular company has growth potential. The profit growth of the company is also measured by analyzing its revenue and cash flow structure.
· Legal due diligence
Legal due diligence ensures whether all the necessary rules and regulations for a company have complied with respect to the Companies Act, 2013 and all other statutes. All the secretarial standards, rules and regulations by which business is governed, contracts that the present company has entered into and if any litigation process that is ongoing is also examined.
· Accounting due diligence
All the information in relation to the finance of the company is scrutinized under this category. This sort of investigation is usually conducted by an accountant who ensures whether or not all the financial information that have been provided by the target company is accurate and correct as reflecting on their accounting records.
· Environmental due diligence
The team conducting environmental due diligence ensures on if any environmental risks or liabilities are involved with the target company and its business.
Concluding remark
There is also various other diligence that can be looked upon varying from company to company. There may be matters relating to privacy, confidentiality, intellectual property issues, and other potential issues. It requires meticulous research before investing or buying into a particular company in order to be on safe side. In spite of having all necessary conditions if due diligence is not conducted in a proper manner then the acquirer will undergo a great loss. Due diligence is a provision which helps to manage all the risks and hence it shall be followed before hurrying into making a legal contract of purchase or investment.
