Due diligence


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Due diligence

  1. 1. © Oxford University Press 2011. All rights reserved.Chapter 4Due Diligence
  2. 2. © Oxford University Press 2011. All rights reserved.What is Due Diligence? Implies an activity involving either the performance ofan investigation of a business or person, or theperformance of an act with a certain standard of care Also used to mean a required legal obligation althoughthe term more commonly applies to a voluntaryinvestigation Examples: Steps carried out by venture capitalists before andduring each investment phase of a start-up company Precautionary steps taken by one company indeciding whether to acquire another i.e. evaluatingwhether the buy is good or bad.
  3. 3. © Oxford University Press 2011. All rights reserved.What is Due Diligence? Banking Industry - To act in a prudent manner inevaluating credit applications. Securities Market - Responsibility of underwriters toexplain the details of new securities to interestedpurchasers. Legal Definition - “A measure of prudence, activity, orassiduity, as is properly to be expected from, andordinarily exercised by, a reasonable and prudentperson under the particular circumstances; notmeasured by any absolute standard but depends on therelative facts of the special case."
  4. 4. © Oxford University Press 2011. All rights reserved.Activities of Due Diligence Financial Statements: Review and confirm the existence of assets, liabilities, and equityin the balance sheet to determine the financial health of thecompany based on the income statement. Management and Operations review: Determine quality and reliability of financial statements to gain asense of contingencies beyond the financial statements. Legal Compliance Review: Check the potential future legal problems stemming from thetargets past. Document and Transaction review: Ensure paperwork of the deal is in order and that the structure ofthe transaction is appropriate.
  5. 5. © Oxford University Press 2011. All rights reserved.Need for Due Diligence Strengths and weaknesses of the business Gives a fair value of the investment Helps in identifying the apparent irregularities Tool of ensuring that the prevailing system ofchecks works
  6. 6. © Oxford University Press 2011. All rights reserved.What does Due diligence involve? Historical Financial Data Current Financial Data Forecasted Financial Information Business Plans Minutes’ of Directors’ Meetings and ManagementMeetings Audit Paper Work Files Contracts with Suppliers, Customers and Staff Confirmation/ Representations from Financiers,Debtors, etc.
  7. 7. © Oxford University Press 2011. All rights reserved.Transactions requiring Due Diligence Mergers and Acquisitions: Personnel Financial Operations Marketing Property and Equipments Business Operations Strategic Alliances and partnerships Joint Ventures and Collaborations
  8. 8. © Oxford University Press 2011. All rights reserved.People Involved in Due Diligence Financial Legal Operational
  9. 9. © Oxford University Press 2011. All rights reserved.Parties interested in Due Diligence Employees Trade Unions Shareholders Creditors Vendors Customers Government Society
  10. 10. © Oxford University Press 2011. All rights reserved.Steps in Due Diligence Process
  11. 11. © Oxford University Press 2011. All rights reserved. Due Diligence Reporting Should reflect a fair and independent analysis &evaluation of financial and commercial information Should ensure collection, analysis and interpretation offinancial, commercial and tax information in detail Should provide properly reviewed and analyzedfinancial information to bidders and variousstakeholders Should also provide a feedback on auditing of thespecial purpose accounts.
  12. 12. © Oxford University Press 2011. All rights reserved.Types of Due DiligenceFinancial Due Diligence: involves evaluating a company’s historical, current,and prospective operating results as disclosed in itshistorical, current and projected financialstatements, tax returns, and other information Involves analysis of balance sheet, review from cashto marketable securities, receivables, inventory,prepaid expenses and other current assets, as wellas the value of fixed assets.
  13. 13. © Oxford University Press 2011. All rights reserved. Analysis on the liability side includes accountspayable, taxes, and debt obligations must be closelyexamined Helps in getting a sense of future revenues Evaluates the underlying assumptions used
  14. 14. © Oxford University Press 2011. All rights reserved.Legal Due Diligence: Scrutiny of all, or specific parts, of the legal affairsof the target company with a view of uncovering anylegal risks and provide the buyer with an extensiveinsight into the company’s legal matters Improves the buyer’s bargaining position andensures that necessary precautions in relation tothe transaction are taken
  15. 15. © Oxford University Press 2011. All rights reserved.Objectives of Legal Due Diligence Gathering of information from the target company, Uncovering of the target company’s strong andweak sides, relevant risks and advantages inconnection with the transaction, Minimizing the risk of unexpected situations, Improvement of the seller’s bargaining position, Identification of areas where representations andwarranties from the seller should be obtained in theacquisition agreement.
  16. 16. © Oxford University Press 2011. All rights reserved.Documents verified IT law and IT contracts Intellectual property rights Patents, copyrights, andother intellectual property-related documents Company law Financing Employment law Data protection law Consumer protection law General contract law Minutes and consents of theboard of directors andshareholders Confidentiality and inventionassignment agreements withemployees Tax and financial documents Legal disputes and otherkinds of conflicts Marketing practicesregulation National and EU-competitionlaw Public procurement law.
  17. 17. © Oxford University Press 2011. All rights reserved.Operational Due Diligence: Involves the on-site analyses of the target businessdaily processes and of how the business operates. Analysis includes an evaluation of the keyemployees, managers, independent contractors,suppliers and other factors necessary for thebusiness to conduct normal operations May also cover investigation outside of the actualbusiness.
  18. 18. © Oxford University Press 2011. All rights reserved. Includes examining work centres, material flow,scrap generation, and inventory levels to identifyimprovements required to improve productivity andprofitability Helps identify and implement changes necessary toincrease EBITDA and increasing the multiples due tolower risk. Involves gathering information on: New product or service creation Markets Competition Sales Targets People/Organizational matters
  19. 19. © Oxford University Press 2011. All rights reserved.Intellectual Property Due Diligence Through analysis needed in this area as economiesare increasingly becoming technology driven process of identifying all intellectual propertyassets, verifying ownership and ensuring that suchassets are free of encumbrances for the intendedbusiness use is fundamental to any merger,acquisition or investment
  20. 20. © Oxford University Press 2011. All rights reserved. Examples range from the ingredients andmanufacturing process for coke, a closely guardedtrade secret, to the many domestic and internationaltrademarks owned by multinational conglomeratessuch as Tata, HUL, Reliance, etc.
  21. 21. © Oxford University Press 2011. All rights reserved.IT Due Diligence; Involves scrutiny of IT systems and processes inuse and ascertaining better ways of deriving valueand leverage from IT assets Involves: Sending an IT request list to the acquired company Compiling an onsite discovery process outline Conducting a review of the requested materials Scheduling and coordinating the onsite visit
  22. 22. © Oxford University Press 2011. All rights reserved.Human Resource Due Diligence: Involves valuing the contribution of HR Helps by: Establishing a link between organizational objectives and the HR function Determining HRs influence on the skills and motivation of the workforce Determining the managers views of the HR function Ascertaining the outcomes produced by the HR deliverables Measuring the adequacy of HR measures, metrics and benchmarks Ascertaining the total cost of the HR function and industry comparisons Ascertaining the HR team structure, skills and motivation.
  23. 23. © Oxford University Press 2011. All rights reserved.Areas covered Organizational culture Executive compensation and “golden parachute”contracts Collective bargaining agreements and potentialchange of ownership liabilities Defined benefit and contribution pension plans Postretirement benefits Retention and severance plans Health and welfare insurance structure and reserves HR functional structure and service delivery HR Information System (HRIS) and Employment Litigation
  24. 24. © Oxford University Press 2011. All rights reserved.Litigation AnalysisWhen one company sells or otherwise transfers all itsassets to another company, the successor is not liablefor the debts and tort liabilities of the predecessor. Successor may be liable, however, under thefollowing circumstances: If it has expressly or implicitly agreed to assume liability If the transaction is a merger or consolidation If the successor is a “mere continuation” of the predecessor If the transaction was fraudulently designed to escape liability.
  25. 25. © Oxford University Press 2011. All rights reserved.Components of Litigation AnalysisCustomers -- as well as competitors, suppliers, andother contractors—might sue over: contract disputes cost/quality/safety of product or service debt collection, including foreclosure deceptive trade practices dishonesty/fraud extension/refusal of credit lender liability other customer/client issues restraint of trade
  26. 26. © Oxford University Press 2011. All rights reserved.Employees -- including current, past, or prospectiveemployees or unions—might sue over: breach of employment contract defamation discrimination employment conditions harassment/humiliation pension, welfare, or other employee benefits wrongful termination
  27. 27. © Oxford University Press 2011. All rights reserved.Regulators might sue over: antitrust (in suits brought by government) environmental law health and safety law
  28. 28. © Oxford University Press 2011. All rights reserved.Shareholders might sue over:Contract disputes(with shareholders)Financialtransactions (suchas derivatives)Investment or loandecisionsDivestitures or spin-offs Fraudulent conveyance M&A scenarios (target,bidder)Dividend declaration orChange duties tominority shareholdersGeneral breach offiduciary dutyProxy contentsExecutive compensation(such as goldenparachutes)Inadequate disclosure RecapitalizationFinancial performance/bankruptcyInsider trading Share repurchaseStock offerings
  29. 29. © Oxford University Press 2011. All rights reserved.Suppliers might sue over: antitrust (in suits brought by suppliers) business interference contract disputes copyright/patent infringement deceptive trade practices  
  30. 30. © Oxford University Press 2011. All rights reserved.Does Due Diligence insure againstM & A failure? Helps avoid: Able to avoid unnecessary losses and expenses The organization’s governing body is able to demonstratethat it has engaged in effective oversight and Senior officers of the company avoid job- and bonus-threatening adverse events
  31. 31. © Oxford University Press 2011. All rights reserved.Due Diligence involving Financial Issues Can lead to significant unbudgeted liabilities and thediversion of time and energy of key executives Helps identify fictitious bills and fictitious originalscreated such as the signature-authority list. Helps identify dormant bank accounts for they are abreeding ground for manipulative practices. Unexpected voiding of invoices from theorganization’s accounts receivable system shouldbe investigated, particularly if your organization isstructured so that people who have the ability tovoid an invoice also have the ability to receive orissue cheques
  32. 32. © Oxford University Press 2011. All rights reserved.Due Diligence InvolvingOrganizational Records Periodic review of the minutes of board meetingsneeds to be done. Record retention policies are often advocatedacross countries as a reliable tool of reference.
  33. 33. © Oxford University Press 2011. All rights reserved.Due Diligence involving LegalCompliance Helps ensure that the organization is in compliancewith applicable law Depending on the nature and size of anorganization’, professional advisors should beengaged to evaluate the laws and regulations asapplicable, and to help management design a duediligence plan Compliance can be achieved in an orderly, cost-effective and timely manner
  34. 34. © Oxford University Press 2011. All rights reserved.Due Diligence involving Interaction ofContracts Involves due diligence of key contracts andagreements, and summarizing and cross-referencing Critical for future reference Help in avoiding inadvertent conflicts.
  35. 35. © Oxford University Press 2011. All rights reserved.Due Diligence involving InformationSystems Helps to get tuned to the rapid shift from manualsystem infrastructure to technology driveninfrastructure. Ensures adherence to regulatory compliance thatare coming into force.
  36. 36. © Oxford University Press 2011. All rights reserved.Due Diligence involving KeyCustomers and Suppliers Strong need to initiate ongoing monitoring of theoperations and plans of key customers andsuppliers as can reveal important information on itscurrent financial and operational status and near-term future events. Also reveal a deteriorating financial condition inadvance.
  37. 37. © Oxford University Press 2011. All rights reserved.Effective Due Diligence team Have members with first hand experience in the industryto which the target belongs Have members with expertise in different areas such asHR specialists, Functional area managers, individualswith knowledge of national culture, etc. Capable ofquickly identifying both the positive and negative aspectsof the property to be acquired.   Willing to carry out a site visit to evaluate the currentcondition of the assets to be acquired; both the physicalassets as well as the personnel Have members who possess excellent negotiation skills Have people who have time to lead the project and serveas team members
  38. 38. © Oxford University Press 2011. All rights reserved. Ensure that the diligence team is co-located within asecure environment, such as a corporate headquarters orcloser to the target Be familiar with the strategic and financial rationale behindthe acquisition Train the team to identify and home in on specific issues Develop and communicate rules of engagement betweenthe diligence team and the target company Make available analytical tools and techniques so the teamcan rapidly get its arms around potential synergies andintegration challenges Healthy flow of information
  39. 39. © Oxford University Press 2011. All rights reserved.Why Due Diligence fails? Failure to Focus on Key Issues Failure to Identify New Opportunities andRisks Failure to Allocate Adequate/ RightResources
  40. 40. © Oxford University Press 2011. All rights reserved.Thank you!