What is Due Diligence?
Due diligence is an investigation or audit of a potential investment or product to confirm all facts, such as reviewing all financial records, plus anything else deemed material. It refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. Due diligence can also refer to the investigation a seller does of a buyer; items that may be considered are whether the buyer has adequate resources to complete the purchase, as well as other elements that would affect the acquired entity or the seller after the sale has been completed.
Diagram 1: Mergers & acquisition process
In simple words, it is a complete medical check-up on the target company to understand the financial health conditions and full pictures in terms of all aspects.
Why do I need to do perform due diligence exercise?
Let’s assume that you are planning to buy out one of your competitors who is retiring. The business is attractive to you because it’s perfectly positioned in an area of town that is tough for your business to reach. Before you purchase the business, you (often with the help of professionals) will perform due diligence.
Does the business have healthy cash flow?
By looking at the books, can you tell where the revenue stream is coming from?
How reliable are its financial projections and what multiple is it placing on those earnings?
What are the long-term contracts signed?
Are profits going up or downwards trend?
How big is the market for the company's products or services?
Is the market growing, shrinking or stagnant?
Are there any major new competitors in or coming into the area that could negatively impact earnings?
What kind of online presence does the business have, and how does it compare to its competitors?
If the company has physical assets, are they valued correctly and fairly?
Are there any hidden liabilities?
Are the company documents complete? (Articles of incorporation, board meeting minutes, tax registration, etc.)
Is the business up to date on its taxes?
Does it lease property? If so, when does the lease end?
What insurance information is provided and what is covered?
Are there complete employee files including salary and benefits?
Of course, this is a very short list of the due diligence that would take place before purchasing another business, but maybe you are not in the market to purchase a business. Maybe you’re planning to purchase a new building, add a new vendor or product line. There are plenty of decisions you are likely to make where proper due diligence is key.
Types of due diligence
Legal Due Diligence
Legal due diligence is extremely important in this exercise and typically includes examination and review of the following documents:-
Copy of Memorandum and Articles of Association
Minutes of Board Meetings for the last three years
Minutes of all meetings or actions of shareholders for the last three years
Copy of share certificates issued to Key Management Personnel
Copy of all guarantees to which the company is a party
All material contracts, including any joint venture or partnership agreements; limited liability company or operating agreements
Licensing or franchise agreements
Copies of all loan agreements, bank financing agreements, and lines of credit to which company is a party
Financial Due Diligence
One of the most important types of due diligence is the financial due diligence, reason being the audited financial position and the future performance of the Company or cash generation of the Company determines the valuation and purchase consideration on the subject entity to be acquired. Thus, the objective if financial DD is to provide a thorough understanding of all the company’s financial performance and position of recent three years, up-to-date unaudited financial statements with comparable statements of the last year, the company’s discounted cash flow projections and its basis, capital expenditure plan as well as inventory, debtors and creditors schedules, etc.
The financial due diligence process also includes analysis of recoverability of current assets like receivables and inventories, analysis of major customer accounts, fixed and variable cost analysis (mainly for manufacturing companies), analysis of profit margins, and examination of internal control procedures.
At many cases, the acquirers require a detailed financial analysis focused on the target company’s debt situation, evaluating both short-term and long-term debt, applicable interest rates, the subject entity’s ability to repay its outstanding loans, to check if there are any breach of covenants and to secure more financing if needed, along with an overall examination and evaluation of the company’s capital structure.
Of course, you as the acquirer can determine the scope of the due diligence exercise and specific key area to be focused. The scope and process would vary from entity to entity.
Asset Due Diligence
Asset due diligence is required if the target company are heavy in fixed and current assets like property, plant and equipment, investment properties, inventories, etc. Asset DD report typically include a detailed schedule of fixed assets and their locations (physical verification should also be done, where possible), all lease agreements for equipment, a schedule of sales and purchases of major capital equipment during the last three to five years, verification of real estate deeds, mortgages, title policies, and use permits.
Tax Due Diligence
Tax DD focused on review of tax liability/ recoverable of the target company, potential of under-reporting of tax submission, potential imposed penalty, including direct and indirect taxes for the past seven (7) year of assessment. Additionally, the process also verify the status of any tax-related case pending with the tax authorities.
Documentation of tax compliance and potential issues generally includes verification and review of the following:
Copies of all tax returns – including income tax, withholding, and GST/SST tax – for the past seven years of assessment.
Information relating to any past or pending tax audits of the company
Documentation related to unused credit carry forwards of deductions or tax credits
Any important, out-of-the-ordinary correspondence with tax agencies
Transfer pricing documentation
Permanent establishment
Tax resident status
Criteria/conditions to be met for tax incentives
Customer Due Diligence
In certain industry, the customer list is exclusive and the largest key asset of the company. In that case, customer due diligence would be important to review and analyse the target company’s customer base, as follows:
The company’s top customers: customers who make the largest total purchases (volume or monetary term) from the company and also the customers who are the “largest” in terms of their total assets – customers that are important regardless of their current level of spending with the company
Service agreements and corresponding insurance coverage
Current credit policies; run and review the days sales outstanding metric (DSO) to assess the efficiency of accounts receivable
Credibility assessment of the customers in terms of repayment trend and turnover days
List, with explanations, of any major customers lost within the past three to five years
Human Resource and Administrative Due Diligence
This process may include the following:
Analysis of total employees, including current positions, vacancies, due for retirement, and serving notice period
Analysis of current salaries, bonuses paid and years of service
All employment contracts with nondisclosure, non-solicitation, and non-competition agreements between the company and its employees. In case there are a few irregularities regarding the general contracts, any questions or issues need to be clarified.
HR policies regarding annual leave, sick leave, and other forms of leave are reviewed.
Analysis of employee problems, such as alleged wrongful termination, harassment, discrimination, and any legal cases pending with current or former employees
Potential financial impact of any current labor disputes, requests for arbitration, or grievance procedures pending
A list and description of all employee health benefits and welfare insurance policies or self-funded arrangements
Physical verification of facilities, occupancy rate and number of workstations
Environmental Due Diligence
Depend on the industry the target company are involved in, diligence related to environmental regulation is very important, if applicable because if the target company violates any major rule, local authorities can exercise their right to penalize the company, up to and including shutting it down operationally. Hence, this makes environmental audits for each property owned or leased by the company one of the key types of due diligence. The following should be reviewed carefully:
List of environmental permits and licenses and validation of the same
Renewal or application of required licenses or International Organisation for Standardisation (ISO) certification
Copies of all correspondence and notices with the state or local regulatory agencies
Verification on the company’s disposal methods are in line with current regulations and guidelines
Check to see whether there are any contingent environmental liabilities or continuing indemnification obligations.
Intellectual Property Due Diligence
Almost every company has intellectual property assets that they can use to monetize their business. These intangible assets differentiates the target company’s product and/or service from their competitors, and may often comprise of the target company’s most valuable assets. Items that are frequently looked into in a due diligence review are:
Schedule of patents and patent applications
Schedule of copyrights, trademarks, and brand names
Pending patents clearance documents
Any pending claims case by or against the company regarding violation of intellectual property
Strategic Fit
Acquirers are generally are eager to know if the target company is the best fit for acquirer’s overall strategic business plan, whether to expand the supply chain and complement with existing portfolio of the company or to implement the best practice on the internal control of the companies with similar nature. group also very careful about exercising due diligence in regard to evaluating how well the target company fits in with the overall strategic business plan of the buyer. A large group corporation aims a possible M&A deal considers how easy (or how difficult) it is likely to be to successfully merge the target company into the buyer’s total corporate organization, looking into the following aspects:-
Does the target company have important technology, products, or market access that the acquirer lacks and need or can make profitable use of?
Does the target company have talents that represent a substantial gain in human resources? And if so what is the likelihood of their retention following the closing?
Assess cost vs benefits operational and financial synergies that can be expected from the target’s integration with the acquirer
Examine the time and resources required, as well as cost of implementing the merger of the target company with the acquirer
Determine the best personnel from both the acquirer and the target to manage the merger process
Where do I start?
Performing a thorough due diligence on target company is critical to any successful acquisition. Without understanding the complete picture of the target company, it is almost impossible to make the best decisions on mergers and acquisitions.
Appointment can be appointed by acquirer or seller of target company, based on mutual agreement. You appoint a consultancy firm, legal firm or an audit firm respectively or as a master firm to perform the due diligence exercise.
Ask us more about due diligence exercise and ask for quotation via email : audit@ta-partnersplt.com or call us at 03-7733 1988 (Mr. Toon)
