DUE DILIGENCE A PRACTICAL APPROACH By K.K.Chhaparia FCA, ACS, DISA(ICAI)

Transcription

1 DUE DILIGENCE A PRACTICAL APPROACH By K.K.Chhaparia FCA, ACS, DISA(ICAI) kkc@chhapariaassociates.com Introduction The expression due diligence, in commercial transactions, means an investigation into the matters of the company and an assessment of the risks in the commercial context. It as a verification process, in which detailed internal analysis and review of the financial position and performance of the company is conducted to check and confirm the factual representations made by the investee company with the understanding that any unacceptable variations therein could kill the deal. An investment transaction contingent upon a satisfactory outcome of a due diligence helps to ensure that investment deals do not go away and that the buyers is delivered, just that what was promised to him. Due diligence is certainly not performed by number crunchers or by building complex financial models. The essence of a due diligence often involves simply asking specific questions and seeking answers. A due diligence is required to limit reliance placed on vendor s warranties it is better to discover the hidden liabilities before the business is bought afterwards. The cost of buying a business with unexpected difficulties can be disastrous. Purpose of Due Diligence Due diligence is necessary to allow the investigation party to find out everything that he needs to know about the subject of the due diligence. The investor would then have the following options open: To withdraw from the deal: if the due diligence unearths information that makes the investment, loan or participation risky or undesirable and which cannot be adequately resolved then the investor may withdraw from the deal. To adjust the valuation of the deal: the investor may revise his valuation of the company or reassess the price at which it will make the investment. More often, information will be adverse and thereafter the price of the deal may go down or price may go up, as positive information will have been made more publicly available by the target from the start. To have the problem remedied: it may be possible for a problem uncovered by the due diligence to be remedied before the deal goes ahead.

2 Types of Due Diligence Different types of due diligences are conducted depending on the requirement, some of them are: Management due diligence to assess the quality and potential of the management team. Legal due diligence to unearth hidden legal problems that could impact the enterprise and the investor. Financial due diligence an early stage financial analysis for valuing the company. Information to be gathered There are various information to be reviewed in a due diligence some of them which are easily identified are mentioned below: Historical Financial Data Current Financial Data Forecasted Financial Information Business Plans Minutes of Director s Meetings and Management Meetings Contracts with suppliers, customers and staff Confirmations/representations from financiers, debtors, etc However, due diligence review should not be limited to reviewing the above mention documents. Much can be learnt about the target from discussion with the staff, be it formally or informally. It is for the very reason that it is recommended that the review be conducted by high-level experienced staff. Stages in Due Diligence There are various steps which need to be taken care of in a due diligence. It can be broadly be divided into 3 stages 1. Pre Due Diligence stage 2. During Due Diligence stage 3. Post Due Diligence stage The above mentioned stages are now discussed in detail: 1. Pre Due Diligence Stage: This stage generally referns to management and gathering of papers, files, etc. Few documents which are required are:

3 a. Signing the Letter of Intent (LOI)/Term Sheet and the Non Disclosure Agreement (NDA). b. Receipt of documents from the company and review of the same with the checklist of documents already supplied to the company. c. Identifying the issues. d. Organising the papers required for a diligence. The foremost thing in a deal for the management of the target company, is that the investor is to sign a Letter of Intent/Term Sheet which highlights the various terms on which the proposed deal is to be concluded. Immediately on receipt of the LOI/Term Sheet the investor signs a NDA with the various companies who are responsible for conducting the due diligence. The company, generally receive a checklist from the companies conducting the due diligence. The checklist is exhaustive in nature, and therefore the company may either collate and compile the documents in-house, or outsource this to an external agency. While the data is being collated care should be taken to ensure that there is no negligence while compilation of the data. Some of the important things that one should take cognizance of from the corporate view point are the following: a. There should not be a delay in the deadlines. b. Mark each module of the checklist provided for separately. c. In case some points of the checklist are not applicable it can be marked as Not Applicable. d. In case some issues cannot be resolved immediately, it should be put to notice. e. Put a single point contact to oversee the process of due diligence. f. Keep a register, to track people coming in and going out. g. An overview on the placement of each file. h. Introduction of the point person. As regard the process of due diligence, as a professional care should be taken to scrutinise every document that is made available and ask for details and clarifications, though, generally the time provided to conduct the due diligence may not be too long and through things have to be

4 wrapped up at the earliest. The company may be provided an opportunity to clear the various issues that may arise out of the due diligence. After the due diligence is conducted, the professionals submit a report, which is usually called the Due Diligence Report. These reports can be of various kinds, a summary report, a detailed report, and the findings mentioned in the report may be very significant, in as much as the deal is concerned. There are certain terms used to be define the outcome of these reports: a. Deal Breaker: in this report the findings can be very glaring and may expose various non-compliance that may arise i.e. any criminal proceeding or known liabilities. b. Deal Diluter: the findings arising out a due diligence may contain violations which may have an impact in the form of quantifiable penalties and in turn may result in diminishing the value of the company. c. Deal Cautioners: it covers those findings in a due diligence which may not impact the financials, but there exists certain non compliances which though rectification, require the investor to tread a cautious path. d. Deal Makers: which are every hard to come by and may not be a reality in the strict sense, are those reports wherein the due diligence team have not been able to come across and violations, leading them to submit a clean report. Interestingly only after the reporting formalities are over and various rectifications are carried out, the shareholders agreement is executed. This agreement contains certain standard clauses like the tag along and drag along rights; representations and warranties; condition precedents, and other clauses that have an impact on the deal. 2. Post Diligence stage: there can be interesting assignments arising out of the due diligence made by the team of professionals. It can range from making applications/filing of petition for compounding of various offences or negotiating the shareholders agreement, since the investor will be on a strong wicket and may negotiate the price very hard. Hence, arising out of this diligence, there are various opportunities for a professional in practice, which may include inter-alia, compounding application to the statuary bodies, amending the various shortcomings and

5 so on. In fact, filing of these applications becomes a pre condition to close the transaction, and therefore, the expertise of professionals is always in demand. Due diligence is one tool which can add excellence in compliance levels, and is a business value additions as far as a professional is concerned, whether employed or in practice. Thus, one can sum up to say that a due diligence exercise proves the level of compliance in a corporate and acts as a healthy check to ensure that the standards are maintained. A due diligence therefore, can go as far as the law itself. Though to an extent, it may be a post-mortem exercise, it is still forward looking, futuristic and brings out the essence of a professional, in the truest sense. Thus the due diligence helps in reducing uncertainties, confirm assumptions and define scope and prioritize issues. CHECKLIST FOR DUE DILIGENCE REVIEW (This list is illustrative only. Modification may be required keeping in view the facts and circumstances of each case) History of target Company no. Permanent A/C no. Date of incorporation Date of commencement f business Brief history of business Current operations and principal products Approval for sales: Board FI/Banks Changes in director/auditors/ceo etc. in recent past and reasons. No. of employees (management, staff ad labour) JV partner. Capital Structure Capital structure: authorised, issued, subscribed, paid up capital-type wise agree with member s register and confirmation from registrar. Bonus, rights issue history issue of ADR, GDR etc. Group Company details (including associates, subsidiaries).

6 Restriction on share transfers, lien on shares, lock in period, etc. Software Software/ERP used. Computer controls and licenses Financial management Financial and internal controls. Budgetary control Delegated powers. MIS Forex management Break even point. Accounting records Accounting policies/practices- check changes if any in last five years. Balance sheet List of assets, location etc. (area, floor space etc.) Immovable property documents scrutiny- free and leasehold- cross check with Govt. taxes etc. check for surplus land etc. for future expansion. Major capital additions of last five years. Pre-operative expenditure capitalized and if in accordance with ICAI guidance note. Analysis of investments especially group investments. Assets with impairment in values. If any asset immediately to be subjected to any major repairs etc. Any asset acquired purely for tax planning? List of inventories and policies. Slow/non moving/unsuable inventories; inventories not in present manufacturing program. Whether cut-off proper? Confirmation for third party stocks. Valuation of inventories proper? Aged analysis of receivables, advances etc. assessment of bad and doubtful debts/advances Dues from Govt./Govt. bodies. Confirmation.

7 List of deposits and recoverability. Creditors, liabilities. Provision for warranties, sales returns etc. Wealth tax, property Tax etc. liability. Confirmation. Reconciliation and confirmation of bank/ loan accounts. Cash confirmation. Compliance with S 58 A. Deferred revenue expenditure. Review of muster rolls, salary registers, PF, ESI etc. Deferred taxes. Physical verification Physical verification of: Investments Stocks Fixed assets Profit and loss account P&L analysis and comparison with previous period and budget. Income recognition policy. Extra ordinary and non-recurring expenditure and income. Analysis of other income. Depreciation and amortization policies. Consumption of key raw materials etc. actuals v norms. Inter company transactions within group/inter division transactions. Transactions immediately before decision to sell. Ratio analysis. Benchmarking/inter firm comparison. Marketing and Selling Market segments and market shares. Competitor data; prices; market shares; volumes; R&D etc. Export pricing. Sales analysis by region, product, sales channels, types of products, customers etc. Brand value, position. Reliance on few customers. Product lists, catalogues etc.

8 Manufacturing /Operations Manufacturing process. Technology absorption and foreign tech know how. Capacity and utilization (any dispute with Govt.?) Factory lay out. Power back up. Patterns, moulds, dies. Is technology latest? Pollution and environment. Spares/ support availability. R&D (what is in pipeline?). Quality (ISO etc.) Awards. Purchasing Availability of key raw materials. Purchase efficiency. Imports and time required. Import duties; MODVAT/CENVAT available. Govt. controls. Reliance on one supplier for key raw materials. Inter company purchases within the group. General Lease for premises etc are current? Any expected changes in legislation effecting the industry/unit? Is the price asked too good to be true? IPR related issues. Long range outlook for industry.

9 CONTENTS OF A DUE DILIGENCE REPORT The contents of due diligence report will always vary with individual circumstances. Following headings are illustrative. Executive Summary. Introduction Background of target. Objectives of due diligence Terms of reference and scope of verification. Brief history of the company. Share holding pattern. Observation on the review. Assessment of management structure. Assessment of financial liabilities. Assessment of valuation of assets. Comments on properties, term of leases, lien and encumbrance. Assessment of operative results. Assessment of taxation and statutory liabilities Assessment of possible liabilities on account of litigation and legal proceedings against the company. Assessment of net wealth. Interlocking investments and financial obligations with group/ associates companies, amounts receivables subject to litigation, any other likely liability which is not provided for in the books of account. Status of charges, liens, mortgages, assets and properties of the company. Suggestions on ways and means including affidavits, indemnities, to be executed to cover unforeseen and undetected contingent liabilities. Suggestions on various aspects to be taken care of before and after proposed merger/ acquisitions.