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What is due diligence?

Due diligence is an investigative process generally used to audit a potential investment process or a business transaction and the entities involved in.  An investment transaction can lead to acquisition of a company's shares (in which case control over the business is acquired through majority shareholding or other rights) or acquisition of the business, in which case the company's assets which constitute the entire business are acquired together (without acquiring the shares). Target Company and Target Business are terms used to distinguish between these scenarios.
There can be certain differences when due diligence is undertaken for both kinds of transactions. For example, in a share acquisition, an inquiry will be made into whether the sellers (the target) are actually owners of the shares, and any economic burdens attached to the shares. This inquiry will be irrelevant when a business is being directly acquired - in which case the obligations (e.g. encumbrances and charges) on assets which constitute the business will be more relevant. Hence, the difference in the checklist.
The video tackles both kinds of acquisitions at a general level, and hence both terms are being referred to.  In this video Ketan Mukhija explains what due diligence is.

What is the purpose of due diligence?

Due diligence studies the impact and strategic synergies of the transaction. Lets understand why we should conduct business diligence in details and what are the different component of business due diligence.


Time and purpose of due diligence

Due diligence for a transaction is commenced after the term sheet is offered by the investor (or the acquirer or purchaser) to the seller or investee, and the two agree to proceed forward with the transaction. While there are various types of due diligence such as business due diligence, financial due diligence, environmental due diligence and legal diligence, we will refer to legal due diligence and discuss it in detail in this chapter.

The purpose of the due diligence exercise is to determine the legal risks inherent in the business model of the investee / seller. Since the investor or acquirer will be purchasing or investing in the business, any risks which can have adverse financial or regulatory implications will have to be appropriately mitigated, or their consequences will need to be factored into the investment documentation so that the investor is not harmed, or so that he is compensated in case the risks materialize.

Outcome of due diligence

Post the due diligence exercise, an investor / acquirer is expected to have a snapshot of contracts, licenses and approvals which require to be freshly undertaken or modified before undertaking the transaction, any renewals that may be required and the current state of legal compliance of the business.
Depending on the findings of the due diligence, the investee company or the seller may have to undertake certain steps to mitigate the risks uncovered by the diligence exercise. These are factored into the investment documentation as conditions precedent. As per any shareholders agreement, the investment will only occur subject to a ‘completion of the due diligence exercise, which must be to the satisfaction of the acquirer’, which is itself a condition precedent to the transaction. Typical steps that are taken post the due diligence exercise, to mitigate risks are:
  • Modification of existing contracts of the investee / seller with other entities
  • Securing necessary approvals and permissions from regulators, or renewing any approvals that have expired
  • Obtaining no-objection certificates or consent of lenders and key suppliers, vendors or other key parties that the investee/ seller has relations with,
  • Providing representations, warranties and indemnities to the acquirer
  • Taking appropriate insurance to minimize risks
Due diligence can have varying implications on the transaction – apart from impacting conditions precedent, it could even impact the transaction valuation or the deal structure, or in extremely rare cases, a deal-breaker may be identified.

For example, when an acquirer wants to acquire an IP-heavy business (its most valuable assets are patents and other intellectual property) and realizes that its key patents are subject to very serious litigation, or that there have already been adverse court orders against the business, it could be a deal breaker.

Brief process of undertaking a due diligence

A due diligence exercise is commenced by preparing a ‘legal due diligence checklist’ (DD checklist) which is sent to the investee / seller. Relevant documents are shared by the seller (under strict condition of confidentiality) based on the checklist – these documents are reviewed by legal advisors, and their findings and action points are captured in a ‘due diligence report’ (DD Report).

The videos below and in subsequent chapters explain how to proceed with a due diligence exercise in detail.

A sample DD Checklist and DD Report are uploaded as separate chapters.

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