Due diligence allows the buyers to ensure that they know what they are buying, obligations associated with the transaction, the nature and extent of the seller’s contingent liabilities, problematic contracts, litigation risks, intellectual property issues, and much more.
Poor due diligence often result in surprises post transaction like previously unknown litigations and liabilities. Due diligence helps in making informed decisions by enhancing the quality of information available to decision-makers.
The objective of due diligence in the M&A transactions is to confirm the vendor’s pertinent information such as financials, contracts, customers, etc. This article will discuss due diligence in mergers and acquisitions, why is due diligence important, the impact of Covid-19 on M&A due diligence, and finally, key considerations to put on your due diligence Checklist.
What is Due Diligence?
Due diligence is a process of investigation, inquiry, and verification of a potential investment to confirm to examine aspects like corporate structure, supply chains, litigation, licenses, finance, and employment through a microscopic lens. “Due diligence” resulted from the U.S. Securities Act, 1993 which shifted responsibility onto securities dealers and brokers to make sure that, full disclosure of the information is revealed to all potential investors related to the securities or instruments that they were selling.
During the due diligence process, research is conducted to make sure that all relevant facts and financial information are correct and to verify anything else that was brought up during an M&A deal or investment process before entering into a financial transaction or agreement with another party.
Why is Due Diligence important for M&A transactions?
Due diligence is important to clearly understand the current financial condition of the company along with internal control regulations and operations management. Due diligence services are essential for any merger or acquisition situation as they provide the buyer with insight into a target firm’s operations and inner workings. Due to the complex nature of mergers and acquisitions, the due diligence process can last several weeks to months.
The first step of the process involves collecting information, then quantifying the liabilities, identifying contractual impediments, and finally, verifying the accuracy of business aspects. The process is time-consuming but is crucial for any M&A transaction, which not only assists the investor in understanding the extensibility of the potential investment but also helps the seller in the true valuation of its business.
Due diligence is essentially an effective way for buyers to protect themselves from risky business deals. As the due diligence process requires a great amount of communication between the two parties, the businesses are also able to form a working relationship.
A structured due diligence process can also help management assess the likelihood of the success of, and limit surprises during, the post-transaction period. While not a comprehensive list, below are the more critical work streams that should be considered in an M&A due diligence process.
1. Financial Health Checks: Vendors or Partners with stressed liquidity carry the risk of becoming insolvent or bankrupt amid an engagement. You must ask your vendors to declare their last three-year turnover as part of your onboarding process. This helps you gauge and address possible insolvency issues. You can validate the data given by the counterparty by extracting their balance sheets from the MCA (http://mca.gov.in) using the registered name of the business. For relationships where vendor solvency is a key risk, validating vendor financials with their data available on MCA is a must.
2. Litigation Checks: Highly litigious entities are always a red flag. You must request your counterparty to declare any ongoing litigations that could have a material impact on your engagement. You can validate this data by running your query on the ecourts website of India (https://ecourts.gov.in/ecourts_home/), and separately on key tribunals. This is better done by a legal analyst, and easiest performed on SignalX. Courts and Tribunals are a lengthy list with noisy data.
Automation enables us to cut through the clutter and identify relevant litigations in no time. There have been instances where firms admitted for insolvency proceedings have bid for vendor engagements. Litigation checks surface such critical risks. Firms with dubious litigations or criminal charges against their promoters have to be dealt with caution.
3. Tax Compliance Checks: GST (https://gst.gov.in) portal makes it possible for you to check how compliant the vendor is when it comes to filing his monthly GST returns. Vendors with poor filing history could impact your ability to claim tax credits on time. You can run a query on the GST portal using the Vendor’s GST number and check the filing table. You can also identify the registered business name using the GST number from the GST portal.
Severe defaults in GST filings will inevitably land the vendor in trouble and can make him insolvent. This comes with the added headache for you of not being able to claim tax credits for the payments made to the vendor.
4. Headcount Checks: You may have to request the vendor to declare his current headcount to get an idea of his operational bandwidth. You can also validate the same using LinkedIn by looking at the number of employees on his Company page, or better, by running a query on the Labor Department’s website. For this, you will need the vendor’s Corporate Identification Number which you will get when you execute pt 1. Headcount check through the labor department (https://www.epfindia.gov.in) also gives you the surety that the counterparty has legit ongoing operations and is not a shell company.
5. Reputation Checks: A customer reference and a cursory check on any search engine help you identify any reputational risks that may be of concern. It is also important for the customer reference to be that of a non-related party. You can verify this by checking for related companies from the MCA or on SignalX.
Key Considerations to Put on Your Due Diligence Checklist
Ease of execution and speed is of the essence for the following vendor due diligence checklist. This will in no way constitute thorough diligence. That said, this is a starter and you could incorporate these in your vendor onboarding SOPs. All the below-mentioned checks can be executed on SignalX.ai in a matter of a few minutes, whereas they may take much longer when executed by a legal or financial analyst.
1. Promoter Profiles
Vendors with no public promoter profiles on their website or on LinkedIn could be dubious. Well oiled companies tend to have executive quotation or basic profile of their management on the marketing assets.
2. Director appointment dates
If the third-party is an India based entity, the govt. makes available various resources that you can use to validate vendors. One such resource is the MCA portal. A quick search on the ‘ View Company Master Data’ section under the ‘MCA Services’ tab on this website will throw up details on all the directors of the entity and their appointment dates. Firms with freshly appointed directors could mean there has been a recent management change.
3. Age of the business
The cursory search on the MCA also throws up the date of incorporation of the business. Vendors who have weathered 5 years or more in the market could potentially be less risky compared to freshly incorporated entities when it comes to internal operating procedures and client relationship management.
4. Incorporation Structure
A business that is incorporated as a Private Limited entity is much better organized from the point of view of compliance compared to one that is a Partnership or Sole Proprietorship. If you’re unable to find the company in the MCA portal, you may want to check with the vendor on their incorporation status. Accounting, Audit and Legal firms operate on a partnership model, but your enterprise software vendor must be a Private Limited firm.
5. Credit Scores
Given the size of the order that you are looking to execute with the vendor, it may call for a credit check. Various credit rating providers make credit profiles publicly available for you to check. If the company has not been rated, you can use a service like SignalX to dig into their financial health or request the vendor to get rated. The later would take its sweet time. You can check on a firm’s credit rating at Chrysl, CARE and IndiaRatings by following the marked URLs.
6. Cursory Media Checks
A general search on Google News will throw up media mentions. A quick review for anything adverse will be handy. Criminal litigations against the firm for abuse or fraud would count as adverse. Civil litigations are a normal affair for most companies as they grow.
7. LinkedIn headcount checks
Checking for headcount is important to understand the vendor’s bandwidth. LinkedIn a great source for this. Look up the vendor’s company page and it would show you the number of their employees registered on LinkedIn. A more formal way of executing this is to fetch the data from the labor department. This would take a bit of effort but is available for you by default on SignalX.
8. Glassdoor & Google reviews
Too many adverse feedback on Google and Glassdoor could a cue for concern. Reading through these to identify any adverse signals is a worthwhile initiative. Although, it is to be noted that review platforms are often filled mostly with negative reviews but adverse feedback by more than few individuals could mean a possible reputation risk.
9. Business Website
Something as simple as a website tells quite a lot about the vendor. If they an enterprise software service provider, in today’s time there is no excuse for not having a website or having a poorly maintained one. Well run firms have well maintained websites and social pages.
10. Client lists and testimonials
Client testimonials put up on a website is a good validation. However, you may also ask your vendor for client references if not mentioned. A solid client reference or testimonial goes a long way in vendor validation.
11. GST compliance
The govt. has also made available the GST portal which you can use to run a cursory check on the vendor. Check their filing table for the last filing. If this is more than 6 months ago, the vendor is already in critical default and you will not be able to claim your full tax credits. If such adverse default is present, you may want to ask your vendor to update their GST filings before onboarding.
What is due diligence in M&A transactions?
Due diligence is a process of investigation, inquiry, and verification of a potential investment to confirm to examine aspects like corporate structure, supply chains, litigation, licenses, finance, and employment through a microscopic lens. It is conducted to make sure that all relevant facts and financial information are correct and to verify anything else that was brought up during an M&A deal or investment process before entering into a financial transaction or agreement with another party.
Why is due diligence important for M&A transactions?
Due diligence is important to clearly understand the current financial condition of the company along with internal control regulations and operations management. It provides the buyer with insight into a target firm’s operations and inner workings and helps protect the buyer from risky business deals. A structured due diligence process can also help management assess the likelihood of the success of, and limit surprises during, the post-transaction period.
How has Covid-19 impacted M&A due diligence?
Covid-19 has had a significant impact on M&A due diligence. It has created challenges in conducting in-person site visits and meetings, which can make it more difficult to fully understand the operations and financials of a target company. Additionally, the economic downturn caused by the pandemic has increased the importance of thorough due diligence, as the risks associated with M&A transactions may have changed.
What are some key considerations for a due diligence checklist in M&A transactions?
Some key considerations for a due diligence checklist in M&A transactions include financial health checks, litigation checks, IP and IT checks, employment checks, and supply chain checks.
SignalX is a Due Diligence AI purpose built for compliance, risk and legal professionals. SignalX uses advanced machine learning algorithms to run comprehensive checks on any given target, starting from something as simple as a promoter background check to analytics like financial statement integrity / fraud checks etc.
Try SignalX.ai today.