Due Diligence in Mergers and Acquisitions is the process of evaluating and investigating a prospective business decision by getting information about the financial, legal, intellectual and other material information from the other party. The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business transaction under consideration. By performing due diligence, a perfect strategy can be evolved to carry out the merger or acquisition.
Failure to exercise due diligence prior to entering into a transaction of enormous proportions such as a merger or acquisition may lead to a precarious situation where the asset acquired, may be marred by encumbrances, charges and other liabilities which get automatically transferred to the acquirer as a result of such acquisition. While the cost involved in performing a due diligence is on the higher side, as it usually involves the services of a CA and an attorney, the importance of conducting a thorough due diligence before undertaking a transaction cannot be undermined under any circumstances. To any company involved in merger or acquisition, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target company/unit/business.
The purpose of due diligence is to confirm that the business actually is what it appears to be. While gaining information about the business, the company conducting the due diligence can definitely identify deal killers and eradicate them. Further, information for valuing assets, defining representations and warranties, and/or negotiating price concessions can also be obtained vide due diligence. The information learned while conducting due diligence will further help in drafting and negotiating the transaction agreement and related ancillary agreements. This information will also be helpful in allocating risks in regards to representations and warranties, pre-closing assurances and post-closing indemnification rights of the acquirer, organizational documents to determine the stockholder and other approvals required to complete the transaction, contracts, including assignment clauses, and permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required, regulatory requirements, to determine if any governmental approvals are required, and debt instruments and capital infusions, to determine repayment requirements.
Mergers and Acquisitions revolve around certain specific steps and due diligence is the first step to make the end business successful. Due diligence helps in understanding the following about the company:
Capital structure including shareholding pattern.
Composition of board of directors.
Shareholders agreement or restrictions on the shares, for example, on voting rights or the right to transfer the shares.
Level of indebtedness.
Whether any of its assets have been offered as security for raising any debt.
Any significant contracts executed by it.
The status of any statutory approvals, consents or filings with statutory authorities.
Significant litigation, show cause notices and so on relating to the target and/or its areas of business.
Intellectual Property of the Company
Any other liability, existing or potential.
By conducting due diligence before finalizing any merger or acquisition helps in evaluating and structuring the transaction and identify legal or contractual impediments that might impact the end result. It also helps to validate the business plan and mitigate any risks that seem imminent and formulate solutions to deal with various issues.
The first step in conducting due diligence is to plan the due diligence so that the business transaction can undergo smoothly. Liaisons with Regional Legal Advisor/General Counsel, Contracting Officer/OAA, Program Office, or other office to plan an efficient approach toward conducting the due diligence should be conducted to determine and plan the due diligence memo.
Secondly, information should be gathered about the company from public domains such as news articles, company reports and subscription-only resources, such as Dun & Bradstreet, Lexus-Nexus, Factiva, etc. Constitutional documents of the Company, annual reports and annual returns filed with statutory authorities, giving information on shareholdings, directors should also be analyzed including quarterly and half-yearly reports, in the case of listed companies (in accordance with the standard listing agreement prescribed by the SEBI).
Government resources should be checked to see if there are particular issues concerning the business, relationship with a particular country, government, or client, or other policy concern. The top managers or board members of the company can also be scrutinized by conducting a search involving sensitive information to determine if the company individual is eligible for a visa to the US, which is one way to identify risks to the agency. By conducting web searches about the company untapped information about the company may also become evident which would be helpful in furthering the business transaction. Local searches should also be conducted to gather information about the company current customers, suppliers, and/or private sector or government partners, relevant local associations and to assess the overall reputation of the company.
Thirdly, after all the information about the company has been obtained, the same must be analyzed to understand the business operation and the key strengths and weakness of entering into any scheme of merger or acquisition with such company.
Fourthly, the stock exchanges where merging and merged companies are listed should be informed about the merger proposal. From time to time, copies of all notices, resolutions, and orders should be mailed to the concerned stock exchanges.
Fifthly, the due diligence memo must be prepared and discussions held with the company to bring out the true nature of the transaction process and finalize the transaction. The Memorandum of Understanding (MOU) must be drafted thereafter and reviewed by the Agency deciding official well before serious alliance discussions begin with the potential partner. The Board of Directors of each company must approve the draft merger proposal and pass a resolution authorizing its directors/executives to pursue the matter further.
Although it might seem that due diligence has come to an end after the draft merger proposal has been approved by both the companies, however, due diligence is an ongoing process and may continue right throughout the existence of the amalgamated or merged company to evaluate any risk that may crop up at any point of time during the alliance.
Mergers and acquisitions typically involve a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying and what obligations it is assuming, the nature and extent of the target companys contingent liabilities, problematic contracts, litigation risks and intellectual property issues, and much more. This is particularly true in private company acquisitions, where the target company has not been subject to the scrutiny of the public markets, and where the buyer has little (if any) ability to obtain the information it requires from public sources.
The following is a summary of the most significant legal and business due diligence activities that are connected with a typical M&A transaction. By planning these activities carefully and properly anticipating the related issues that may arise, the target company will be better prepared to successfully consummate a sale of the company.
Of course, in certain M&A transactions such as mergers of equals and transactions in which the transaction consideration includes a significant amount of the stock of the buyer, or such stock comprises a significant portion of the overall consideration, the target company may want to engage in reverse diligence that in certain cases can be as broad in scope as the primary diligence conducted by the buyer. Many or all of the activities and issues described below will, in such circumstances, apply to both sides of the transaction.
Financial Matters. The buyer will be concerned with all of the target companys historical financial statements and related financial metrics, as well as the reasonableness of the targets projections of its future performance. Topics of inquiry or concern will include the following:
What do the company annual, quarterly, and (if available) monthly financial statements for the last three years reveal about its financial performance and condition?
Are the company financial statements audited, and if so for how long?
Do the financial statements and related notes set forth all liabilities of the company, both current and contingent?
Are the margins for the business growing or deteriorating?
Are the company projections for the future and underlying assumptions reasonable and believable?
How do the company projections for the current year compare to the board-approved budget for the same period?
What normalized working capital will be necessary to continue running the business?
How is working capital determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance of the currency number.)
What capital expenditures and other investments will need to be made to continue growing the business, and what are the company current capital commitments?
What is the condition of assets and liens thereon?
What indebtedness is outstanding or guaranteed by the company, what are its terms, and when does it have to be repaid?
Are there any unusual revenue recognition issues for the company or the industry in which it operates?
What is the aging of accounts receivable, and are there any other accounts receivable issues?
Should a quality of earnings report be commissioned?
Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
Has EBITDA and any adjustments to EBITDA been appropriately calculated? (This is particularly important if the buyer is obtaining debt financing.)
Does the company have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?
Technology/Intellectual Property. The buyer will be very interested in the extent and quality of the target companys technology and intellectual property. This due diligence will often focus on the following areas of inquiry:
What domestic and foreign patents (and patents pending) does the company have?
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 (rights preserved by employees and consultants)?
What registered and common law trademarks and service marks does the company have?
What copyrighted products and materials are used, controlled, or owned by the company?
Does the company business depend on the maintenance of any trade secrets, and if so what steps has the company taken to preserve their secrecy?
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 intellectual property rights?
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?
What technology in-licenses does the company have and how critical are they to the company business?
Has the company granted any exclusive technology licenses to third parties?
Has the company historically incorporated open source software into its products, and if so does the company have any open source software issues?
What software is critical to the company operations, and does the company have appropriate licenses for that software (and does the company usage of that software comply with use limitations or other restrictions)?
Is the company a party to any source or object code escrow arrangements?
What indemnities has the company provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
Are there any other liens or encumbrances on the company intellectual property?
Customers/Sales. The buyer will want to fully understand the target companys customer base including the level of concentration of the largest customers as well as the sales pipeline. Topics of inquiry or concern will include the following:
Who are the top 20 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?
Strategic Fit with Buyer. The buyer is concerned not only with the likely future performance of the target company as a stand-alone business; it will also want to understand the extent to which the company will fit strategically within the larger buyer organization. Related questions and areas of inquiry will include the following:
Will there be a strategic fit between the company and the buyer, and is the perception of that fit based on a historical business relationship or merely on unproven future expectations?
Does the company provide products, services, or technology the buyer doesnt have?
Will the company provide key people (is this an acqui-hire?) and if so what is the likelihood of their retention following the closing?
What integration will be necessary, how long will the process take, and how much will it cost?
What cost savings and other synergies will be obtainable after the acquisition?
What marginal costs (e.g., costs of obtaining third party consents) might be generated by the acquisition?
What revenue enhancements will occur after the acquisition?
Material Contracts. One of the most time-consuming (but critical) components of a due diligence inquiry is the review of all material contracts and commitments of the target company. The categories of contracts that are important to review and understand include the following:
Guaranties, loans, and credit agreements
Customer and supplier contracts
Agreements of partnership or joint venture; limited liability company or operating agreements
Contracts involving payments over a material dollar threshold
Past acquisition agreements
Agreements imposing any restriction on the right or ability of the company (or a buyer) to compete in any line of business or in any geographic region with any other person
Real estate leases/purchase agreements
Powers of attorney
Equity finance agreements
Distribution, dealer, sales agency, or advertising agreements
Union contracts and collective bargaining agreements
Contracts the termination of which would result in a material adverse effect on the company
Any approvals required of other parties to material contracts due to a change in control or assignment
Employee/Management Issues. The buyer will want to review a number of matters in order to understand the quality of the target company management and employee base, including:
Management organization chart and biographical information
Summary of any labour disputes
Information concerning any previous, pending, or threatened labor stoppage
Employment and consulting agreements, loan agreements, and documents relating to other transactions with officers, directors, key employees, and related parties
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.)
Summary of employee benefits and copies of any pension, profit sharing, deferred compensation, and retirement plans
Evidence of compliance with IRS Section 409A in connection with stock option issuances
Summary of management incentive or bonus plans not included in above as well as other forms of non-cash compensation
Likelihood of need for compliance with IRS Section 280G (golden parachute) rules in connection with any potential acquisition
Employment manuals and policies
Involvement of key employees and officers in criminal proceedings or significant civil litigation
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
Appropriateness of the company treatment of personnel as independent contractors vs. employees
Actuarial reports for past three years
What agreements/incentive arrangements are in place with key employees to be retained by the buyer? Will these be sufficient to retain key employees?
What layoffs and resultant severance costs will be likely in connection with the acquisition?
Litigation. An overview of any litigation (pending, threatened, or settled), arbitration, or regulatory proceedings involving the target company is typically undertaken. This review will include the following:
Filed or pending litigation, together with all complaints and other pleadings
Litigation settled and the terms of settlement
Claims threatened against the company
Consent decrees, injunctions, judgments, or orders against the company
Attorneys letters to auditors
Insurance covering any claims, together with notices to insurance carriers
Matters in arbitration
Pending or threatened governmental proceedings against the company
Potentially speaking directly to the company outside counsel
Tax Matters. Tax due diligence may or may not be critical, depending on the historical operations of the target company, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carry forwards and their potential benefit to the buyer may be important. Tax due diligence will often incorporate a review of the following:
Sales and other tax returns filed in the last five years
Copies of any correspondence or notice from any foreign, federal, state, or local taxing authority regarding any filed tax return (or any failure to file)
Tax sharing and transfer pricing agreements
Net operating losses or credit carry forwards (including how a change in control might affect the availability thereof)
Agreements waiving or extending the tax statute of limitations
Allocation of acquisition purchase price issues
Correspondence with taxing authorities regarding key tax items
Settlement documents with taxing and other authorities
Antitrust and Regulatory Issues. Antitrust and regulatory scrutiny of acquisitions has been increasing in recent years. The buyer will want to undertake the following activities in order to assess the antitrust or regulatory implications of a potential deal:
If the buyer is a competitor of the target company, understanding and working around any limitations imposed by the company on the scope or timing of diligence disclosures
Analyzing scope of any antitrust issues
If the company is in a regulated industry that requires approval of an acquisition from a regulator, understanding the issues involved in pursuing and obtaining approval
Confirming if the company has been involved in prior antitrust or regulatory inquiries or investigations
Addressing issues that may be involved in preparing a Hart-Scott-Rodino filing (if thresholds are met) and effectively responding to any second request from the Department of Justice or Federal Trade Commission
Considering Exon-Florio issues if the transaction involves national security or foreign investment issues
Other Department of Commerce filings if the buyer is a foreign entity
Understanding how consolidation trends in the company industry might impact the likelihood and speed of antitrust or regulatory approval
Insurance. In any acquisition, the buyer will want to undertake a review of key insurance policies of the target companys business, including:
If applicable, the extent of self-insurance arrangements
General liability insurance
Intellectual property insurance
Key man insurance
Employee liability insurance
Workers compensation insurance