Due diligence on a company involves researching the firm or organisation before investing in it. This includes investigating the firm’s financial soundness, management, products and services, competitive landscape and other aspects. So, it becomes essential for potential investors to conduct due diligence on a company before investing.
Due diligence is an important element of investing properly. You may avoid costly mistakes and guarantee that you know exactly what you are investing in by doing your homework ahead of time. Therefore, due diligence on a company serves as one of those basic checks for any investor to guide not only the present course of action with respect to the company but also influences all future actions in this context.
When to Conduct Due Diligence on a Company?
The conduct of due diligence on a company holds significance for prospective buyers considering acquiring a private company or forming a partnership.
Due diligence presents potential buyers with the chance to look into the records, assets and operations of the target company. This exploration aids in evaluating the company’s suitability as an investment opportunity. The overarching objective of due diligence is to gather sufficient information enabling the buyer to make an informed judgment regarding the viability of proceeding with the proposed business transactions.
Though the due diligence process may entail complexity and consume time, its vitalness lies in facilitating a well-grounded investment decision. Those who conduct due diligence on a company before investing are better positioned to realise both the inherent risks and prospects associated with the intended purchase or partnership.
Types of Due Diligence on a Company
There are a number of types of due diligence that can be conducted on a company, which include:
Financial Due Diligence
Financial Due Diligence involves a meticulous investigation into a company’s financial and accounting aspects by financial professionals and chartered accountants. This process provides the buyer with a comprehensive grasp of the company’s financial standing and revenue position. This examination delves into the balance sheet, profit and loss account and past transactions to unveil the genuine financial status.
Legal Due Diligence
Legal Due Diligence centres on exploring legal complications affecting the seller or the asset on sale. It entails scrutinising ongoing litigations and compliance issues. In mergers and acquisitions, legal due diligence is paramount, focusing on disputes, compliance and debts within the seller’s subsidiary or affiliated entities, typically managed by transaction lawyers.
Environmental Due Diligence
Environmental Due Diligence ensures a company’s adherence to environmental regulations. This assessment verifies compliance with emissions and carbon standards. Industrial units’ adherence to environmental standards, particularly in waste management and emissions control, is examined to guarantee compliance.
Asset Due Diligence
In the M&A process, Asset Due Diligence involves assessing specific assets being purchased. Share Sales involve acquiring a company’s share capital, while Asset Sales pertain to the acquisition of particular assets, movable or immovable. The investigation is narrowed to the asset in question.
Administrative Due Diligence
Administrative Due Diligence examines an organisation’s administrative system, including its hierarchy and procedures. This review investigates the operational processes and procedures while excluding strategic agreements.
Management Due Diligence
Management Due Diligence evaluates the organisation’s leadership, encompassing executives such as CEOs, directors, CFOs and more. This includes criminal background checks and scrutinises the management team’s history.
Commercial Due Diligence
Commercial Due Diligence investigates the company’s strategic approach, analysing objectives, partnerships and agreements. It examines short and long-term goals, often conducted by third-party consultants to align the business’s strategic vision with the buyer’s objectives.
Documents Required to Conduct Due Diligence on a Company
When conducting due diligence for a company, the following information and documents are necessary:
- Memorandum of Association
This document outlines the company’s objectives, scope and purpose as per its formation.
- Articles of Association
The articles lay down the company’s internal regulations and governing structure.
- Certificate of Incorporation
Proof of company’s legal existence, indicating its registration with the authorities.
- Shareholding Pattern
Details of the company’s ownership structure, showing the distribution of shares among shareholders.
- Financial Statements
Including balance sheets, profit and loss statements, cash flow statements and notes to financials.
- Income Tax Returns
Records of the company’s income, expenses and taxes filed with the tax authorities.
- Bank Statements
Reflecting the company’s financial transactions and cash flow over a period.
- Tax Registration Certificates
Documentation of various tax registrations, such as GST, VAT, etc.
- Tax Payment Receipts
Proof of tax payments made by the company.
- Statutory Registers
Records of various statutory meetings, resolutions and other legal compliance documents.
- Property Documents
Details of properties owned or leased by the company.
- Intellectual Property Registration or Application Documents
Patents, trademarks, copyrights or pending applications to protect the company’s intellectual property.
- Utility Bills
Proof of utility bill payments for company premises.
- Employee Records
Documents related to employees, including employment contracts, payroll records, benefits and any ongoing disputes.
- Operational Records
Contracts, agreements, licences and permits relevant to the company’s operations.
Procedure Involved in the Due Diligence Process
The due diligence process involves the following three key stages:
Pre-Diligence Process
The pre-diligence phase marks the initial step, encompassing the organisation of documentation and personnel management:
- Initiating Agreements: The investor signs the Letter of Intent and Non-Disclosure Agreement with the target company.
- Document Review: The investor receives documents from the company and cross-checks them against the pre-submitted checklist.
- Issue Identification: Detecting potential concerns or issues in the reviewed documents.
- Document Compilation: Gathering the necessary documents required for thorough diligence.
- Data Room Creation: Establishing a data repository to manage and access the collated information.
Diligence Process
Following the diligence phase, the appointed professional compiles and presents the Due Diligence Report. This report can assume various forms, each conveying distinct outcomes:
- Summary or Detailed Report: The Due Diligence Report can be summarised or detailed, based on the depth of analysis.
- Outcome Types:
- Deal Breakers: Highlighting severe issues, such as criminal proceedings or substantial liabilities.
- Deal Diluters: Pointing out violations that could result in penalties and diminish the company’s value.
- Deal Cautioner: Identifying fixable but confirmed non-compliances, requiring informed decision.
- Deal Makers: Rare reports indicating no violations, portraying a clean status.
The Due Diligence Report is vital for informed decision-making, casting light on the company’s future earnings generation plans and overall state of affairs.
Post Diligence
The post-diligence phase deals with the rectification of non-compliances revealed during the due diligence process. This phase involves application submission, compounding of offenses petition and shareholder agreement negotiations. Post-diligence activities empower investors to finalise the deal-making process effectively.
Detailed Analysis of How to Conduct Due Diligence on a Company?
The detailed process of how to conduct due diligence on the company is as follows:
Reviewing MCA Documents
Initiating a comprehensive company due diligence often commences with Ministry of Corporate Affairs (MCA) records. The MCA website grants public access to a company’s master data. By paying a nominal fee, all Registrar of Companies filed documents are accessible. This MCA data stands as the primary point of verification. The acquired documents and information encompass:
- Company particulars
- Incorporation date
- Authorised and paid-up capital
- Last Annual General Meeting date
- Last Balance Sheet date
- Company status
- Director specifics
- Directors’ names
- Director appointment dates
- Recorded Charges
- Details of secured lenders
- Secured loan amounts
- Relevant documents
- Certificate of Incorporation
- Memorandum of Association
- Articles of Association
Furthermore, financial data and various company-related filings downloadable from MCA supplement the understanding. This step of MCA document review lays a solid foundation for the due diligence process.
Articles of Association Scrutiny
An essential phase involves examining a company’s Articles of Association. This evaluation establishes classes of equity shares and corresponding voting rights. Transfer restrictions on shares, if any, are often outlined in the Articles. Careful review uncovers procedures for share transfers.
Reviewing Company’s Statutory Registers
The Companies Act, 2013 mandates private limited companies to maintain statutory registers encompassing share allocation, transfers, board meetings and directors’ details. Scrutinising these registers provides insights into directorships and shareholdings.
Examination of Book of Accounts and Financial Statements
Complying with the Companies Act, 2013, maintaining comprehensive accounts with transaction details is obligatory. Thorough auditing of these financial transactions ensures alignment with the prepared financial statements. Key areas within business financial due diligence include:
- Bank statement verification
- Assets and liabilities assessment
- Cash flow verification
- Cross-referencing financial statements with transaction data
Taxation Aspects Review
Careful assessment of taxation aspects is vital to prevent unforeseen future tax liabilities. This encompasses:
- Filed income tax returns
- Income tax payments
- Calculated income tax liability
- ESI/PF returns filed
- ESI/PF payments and calculations
- Service Tax/VAT returns filed
- Service Tax/VAT payments and basis calculations
- TDS returns, payments and calculations
Legal Aspects Scrutiny
A legal practitioner’s comprehensive audit is necessary to uncover potential legal actions, both against and by the company. Important legal aspects include:
- Real estate property legal due diligence
- Secured Creditor no-objection for transfer
- Verification of court documents and filings
Operational Aspects Review
Gaining an in-depth comprehension of the business model, operations and related information is vital. This includes:
- Business model understanding
- Customer and employee counts
- Production and vendor particulars
- Machinery and utilities information
Final Thoughts
The conduct of due diligence on a company holds significant importance for individuals and organisations aiming to invest in a company or collaborate with it. It involves thoroughly examining the company’s financial state, management methods, product offerings, competition and other aspects. This thorough investigation aids in preventing major errors and offers investors a solid grasp of their investment’s nature.
Though the process of conduct of due diligence on a company might consume considerable time and entail some complexity, it remains highly essential. Those who dedicate time to detailed research on due diligence, position themselves advantageously to understand the potential risks and benefits associated with the investment or partnership under consideration.
For more information on how to conduct due diligence on a company, connect with our experts at StartupFino.
