Due Diligence In M&A : Importance And Implications

The Companies Act is the primary legislation in India that governs the incorporation, management, and operation of companies^[2]. In Indian legislation, a merger has been defined as an amalgamation of two or more companies into one new or existing company. The Companies Act deals with the process of mergers and acquisitions from sections 232-234.

The Companies Act sets out the procedures for mergers and acquisitions, including the approval of shareholders and regulatory authorities, the valuation of shares, and the treatment of minority shareholders.^[3] Mergers are lengthy and complex processes, so a lot can go wrong when negotiating a deal. As per a recent article by Harvard Business Review, nearly 70% to 90% of mergers and acquisition deals were deemed to be a failure.^[4]

One of the major reasons associated with this failure is the lack of effective due diligence. Due Diligence refers to the process of thoroughly investigating a company's overall operations. Black's Law Dictionary defines due diligence as 'the diligence reasonably expected from, and ordinarily exercised by, a person who seeks to satisfy a legal requirement or to discharge an obligation'^[5]. This process helps determine potential risks associated with the merger to foster key investment decisions. The term overall operations refers to analyzing all aspects of a company like finance, management, legal and compliance, etc.

Due Diligence is a form of research, and analysis that is conducted by the investor to ensure minimal risk of the acquisition deal. Internal information concerning, finances, legal compliance, taxes, and other operations are exchanged between the merging parties, or in case of an acquisition, the acquirer ensures a robust due diligence by creating a due diligence team that oversees the whole diligence process.

The process of due diligence is performed in different ways by different authorities e.g., by internal teams, external advisors, specialists, experienced/senior industry players, or in most cases by a combination of the above further providing leverage to the buyer's knowledge with deep transaction experience of M&A and industry professional.

Importance of Due Diligence

Warren Buffet once said, “A sales pitch gives you the price, while due diligence gives you the value.” The process of due diligence is essential at every step of the M&A process. It helps to ensure that the buyer is equipped with all the essential information to proceed with the purchase. The procedure makes sure that both parties receive the greatest fair-value price. It gives the buyer an inside view into how the business is handled, by giving them the required knowledge about the operations of the business.

In 2015, through lawsuits, shareholders challenged 65 percent of M&A deals valued at over $100 million or more, involving Delaware-incorporated companies.^[6] One of the major reasons behind this failure was ineffective due diligence.

Due diligence helps businesses prepare for future obstacles, maximize profitability, and determine the merged operation's scalability. A successful M&A facilitates a company's market presence, fills in gaps in a company's product, and improves profitability and other performance metrics.

There exist transactions that do not perform as per expectations of the acquirers/merging entities like not making positive returns or resulting in negative growth which can cause serious damage to the company, board of directors, and management. As already mentioned, M&A is an integral process for any company's growth hence, the managers need to monitor the process from the beginning till the end. Management shall conduct a robust due diligence process to pick out potential risks and valuation considerations. An effective due diligence can mitigate potential risks so, the management shall stress upon having a well-thought due-diligence process.

The chances of a successful transaction increase if it is accompanied by a thorough due diligence process in comparison to those that do not do it. So, to minimize future legal, financial, and other risks, due diligence is essential.

Reasons cited why due diligence is not a necessity

The process of due diligence is of utmost importance still businesses fail to recognize its pivotal role during mergers and acquisitions. It is often cited as one of the major reasons for the failure of M&A deals. The reason is a lack of effective and robust due diligence. Businesses know very well the importance of due diligence they tend to avoid the whole process or try to alter the essential steps by citing reasons like:

Time Taking – Due Diligence as per definition is a form of research, any thorough research would take a specific amount of time, which often is a laborious task to do.

Huge Cost – Proper due diligence requires analyzing all the internal data of the target company from its financial statements to assessing tangible/intangible assets. Due Diligence requires on-site work, resulting costing a huge sum. This is another reason cited by management for due diligence not being a necessity.

Industry Knowledge – There are cases where the acquiring company or merging parties do not have prior knowledge of the industry they're entering into. This becomes another reason for them to avoid the process of due diligence.

No value addition – Some businesses are operating under the vague impression that due diligence does not add any value to the merger. Such perceptions are disastrous for the business entity. Due diligence is the most important process for a successful M&A.

Types of Due Diligence

1. Operational Diligence

Operational due diligence helps understand the overall operations of the company like its work process, workflow, and supply chain. For a feasible investment, it is essential to inquire about the operations of the company and determine potential risks associated with it. This helps create a true picture of the organization rather than depending upon the overestimated figures.

2. Legal Diligence

Legal due diligence is the process of collecting legal documents and information about a company. To ensure that the acquiring entity does not face any legal difficulties after the acquisition, it is essential to check all the legal documents, compliance with all the laws, and payment of shares for minimal legal risk.

3. Financial and Accounting Diligence

To determine the financial health of the company being acquired,

To determine the financial health of the company being acquired, the process of financial due diligence is of utmost importance. Both the buyer and the acquiree must indulge in financial due diligence to clarify the financial aspects of the deal. It helps determine a true picture of the financial status of the company by assessing financial instruments like balance sheets, income statements, cash flow statements, etc.

4. Tax Diligence

Tax plays a considerable role in the decision-making process. Tax diligence is performed to comprehend the target company's tax profile to quantify tax vulnerabilities. It aids in choosing and creating an appropriate acquisition structure for the given deal. By including tax guarantees and indemnities in the agreement, tax risk mitigation is most frequently achieved in practice.

5. Reputational Diligence

Reputational due diligence is often regarded as identifying the “red flags” in the new business initiative. Risks can be mitigated if reputational diligence is paid attention to. To make sure the other party in the sale doesn't offer any legal, regulatory, or societal hazards to your organization, this diligence entails doing extensive background checks. For instance, you will be held accountable for all of these crimes if your company merges with or finances a company that engages in criminal activities like worker abuse, bribery, or tax fraud.

6. Market and Commercial Due Diligence

If a corporate or a private equity house wants to acquire another company, it will have to thoroughly understand that company's current and projected performance.^[7] The process through which a buyer examines a potential company from a commercial standpoint is known as commercial due diligence. The purpose of commercial due diligence is to give the buyer a comprehensive understanding of the company, based on its position in its market or markets, and how it is likely to change going forward. Information on market demand, commercial position, revenue, and competitive dynamics is provided through commercial due diligence services.

7. Technical Due Diligence

TDD or Technical Due Diligence is a thorough examination of a company's technological state, including its products, technical infrastructure and architecture, product roadmap, services, practices, and IT staff. It provides investors with the necessary tools required for M&A decision-making.

8. IP Due Diligence

IP due diligence is diligence to evaluate the quantity and quality of intellectual property assets that a firm, business, or individual owns or has permission to use. It also provides an evaluation of how the pertinent firm or organization records and safeguards intellectual property. A potential buyer conducts IP due diligence in connection to the target company's or business's IP assets. The value of a company's IP rights may exceed the value of all of its actual assets, as IP assets are becoming increasingly crucial for enterprises. Hence, IP diligence plays a crucial role in the M&A setting.

Due Diligence: Failure and Importance

One of the problems that arises during the process of due diligence is that the acquirer depends on the target company to provide information that is not always suitable for the management.

A similar case was shown in the Daimler-Benz and Chrysler Group merger, the German auto-maker merged with Chrysler Group in 1998 for $36 Billion. Seen as a successful merger in the beginning, the value of Chrysler Group went down drastically to just $7.4 Billion. The merger proved to be unsuccessful. In the pool of the number of reasons cited for its failure, one of the major concerns was the lack of proper due diligence. Experts agreed that Dailmer never did proper due diligence before merging with Chrysler. An overestimation of the value of the merging company led to its failure.

To avoid such scenarios, businesses must indulge in a thorough due diligence process. In the case of Nirma Industries and Anr v. Securities Exchange Board of India,^[8] it was found out that the investing company Nirma Industries despite being aware of multiple legal proceedings against the target company, proceeded with the merger without taking any steps to mitigate the risks.

The court held that an investor company must conduct proper due diligence on a target company before investing, as required under Regulation 27(d) of the Securities and Exchange Board of India (SEBI) regulations of 1997.

Mergers and Acquisitions have witnessed significant growth in recent times with companies using this strategy to diversify and expand the market. It becomes essential for businesses to make a successful M&A consequently thoroughly following the process of due diligence. Often neglected, the process of due diligence plays a pivotal role in the M&A process. The in-depth analysis of the target company's operations provides valuable insights and helps mitigate potential risks to proceed with a successful transaction.

While at times reasons such as time, cost, and industry knowledge may be cited to ignore the process, its long-term benefits outweigh these concerns. Therefore, businesses should embrace due diligence as an essential step to ensure the success and sustainability of their M&A endeavors, protecting the interests of all stakeholders involved.

The author is a student at Chanakya National Law University.Views are personal.