Due diligence is essential before investing in a venture, a business, or a firm. A diligence exercise puts you in a better position to negotiate with vendors, onboard vendors quickly, and ensure that your project is successful without exposing it to avoidable risks. Vendors carry a gamut of unforeseen risks that could affect your business or derail the project that you are looking forward to.
Vendor risks could be as critical as the ability of the vendor to stay solvent during the contract period, or even as simple as a non-compliant tax situation, making it difficult for your finance team to claim tax credits on the transaction. And worse, sometimes given the way businesses are structured, you may not even know who you’re really doing business with. Long-lasting vendor relationships are key to successful business operations. A thorough vendor due diligence policy is a critical internal compliance activity that could help us avoid pitfalls.
Recently, Siemens Gamesa Renewable Energy’s India Unit fired a top executive over a lack of due diligence. The internal investigation found that the executive failed to conduct appropriate due diligence when engaging a consultancy with a political connection. While filing the court proceeding, Siemens Gamesa asserted that a significant sum of money was paid to UAP Advisors LLP without any diligence whatsoever, not even ascertaining proof of performance. The unit’s former chief operating officer and chief financial officer, R. Venkatesh (who was fired in May) disregarded the presence of corporate governance processes when dealing with UAP Advisors LLP. Siemens Gamesa claims UAP has strong links with ”politically exposed persons”.
In a statement to Reuters, Venkatesh stated that he was removed because the company owed him a large amount of money. In court filings, he has called the internal inquiry “a sham” and said thousands of pages of UAP’s findings were shared with management over time. Bad partners, vendors, and suppliers can land you in messy litigations with painful financial and reputational losses. Bad counterparties, on the other hand, cost you valuable time and money, limiting your growth and diluting your focus.
With rising cases of such issues, vendor due diligence has become the need of the hour. Apart from vendor reputation concerns, it helps ascertain if your vendor can stay afloat through the engagement and not end up insolvent. Due Diligence comes across as a complex, time-consuming activity better left to auditors. The term is frequently thrown around in situations involving investments, real estate, mergers and acquisitions (M&A), and most often in legal conversations. To offer more clarity, in this article, we detail everything that you need to know about it.
What is Due Diligence and how do you perform it?
The dictionary definition (as given by Merriam Webster) says that Due Diligence (DD) simply means ”the care that a reasonable person exercises to avoid harm to other persons or their property.” In its business sense, Due Diligence is an extensive process undertaken, usually, by an acquiring/purchasing entity with or without the assistance of experts in order to evaluate the target entity’s business, capabilities, assets as well as financial performance. Certain industries place a lot more emphasis on specific types of due diligence; of which the length, depth, and scope of the investigation usually depend on:
- The nature of the transaction
- The purchasing or investing company’s needs and interests
- The perceived level of risk
“Finding skeletons in the closet before a deal is better than finding them later’’ is a relatable perspective when speaking of Due Diligence. The information collected during this process is crucial for decision-making and is meticulously reported. The Due Diligence report helps one understand how the company plans to generate additional earnings (monetary as well as non-monetary). It serves as a ready- reckoner for understanding the state of affairs at the time of purchase/sale, etc. The ultimate purpose is to get a clear picture of how the business will perform in the future.
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 results in surprises post transactions like previously unknown litigations and liabilities. The due diligence process would include getting answers to questions such as:
- Does the business have a 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?
- 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?
Of course, this is a very short list of the due diligence that would take place before purchasing another business. A structured due diligence process can also help management assess the likelihood of the success of, and limit surprises during, the post-transaction period. There could be a possibility of as many as 20 or more types of due diligence offered. However, let’s look at the main types of due diligence.
Types of Due Diligence
Financial
Financial due diligence is one of the most critical types of due diligence that seeks to check firms the accuracy of the financial records in the Confidentiality Information Memorandum (CIM). Financial DD aims to provide a thorough understanding the company’s financials, including,audited financial statements for the last three years, recent unaudited financial statements with comparable statements of the last year, the company’s projections, and the basis of such projections, capital expenditure plan, schedule of inventory, debtors and creditors, etc. 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.
Legal
Highly litigious entities are always a red flag. Legal due diligence is, of course, extremely important and helps in determining whether the target company is legally subservient or embroiled in issues. Legal DD, typically, includes:
- Requesting counterparty to declare any ongoing litigations that could have a material impact on your engagement.
- Validating the data by running your own query on the e-courts website of India (https://ecourts.gov.in/ecourts_home/).
- Inspecting all the legal documents including the incorporation document, shareholders warrants, any outstanding warrants, licenses & permits, etc.
- A thorough investigation of all the assets and the liabilities of the target company’s assets like cash, securities, inventory, intellectual property (copyrights, trademarks, patents, domain names, and other proprietary rights) as well as the liabilities like bank loans, licensing violations, bonuses earned.
Legal DD is better done by a legal analyst, and easiest performed on SignalX. Cases under High 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.
Taxes
Due diligence in regard to tax liability includes a review of all taxes the company is required to pay and ensuring their proper calculation with no intention of under-reporting of taxes. GST portal or SignalX’s Free GST verification tool makes the whole task of checking the vendor’s GST returns easy, using the Vendor’s GST number, and checking through the filing table. Taxes DD also helps to 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. Documentation of tax compliance and potential issues typically includes verification and review of copies of all tax returns, information relating to any past or pending tax audit of the company, etc.
Operational
The target company’s Scale of Daily Operations indicates the vendor’s operational bandwidth and helps to know whether it would be a good match for a business or a merger. Operational due diligence covers areas like staffing levels, human resource activities, or insurance policies held by the target company. Headcount check can be done by validating the target company’s data 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, or checking through the labor department (https://www.epfindia.gov.in) to ensure that the target company is not a shell company. Operational due diligence helps understand the drivers of the target company such as competencies, capabilities, potential, efficiency, etc. so that the buyer becomes well equipped to determine future profitability.
Reputational
A customer reference and a cursory check on any search engine help you identify any reputational risks that may be of concern. Reputation DD enables a company, or any business to make informed business judgments about potential transactions and relationships. Reputational DD also seeks relevant background checks and business intelligence information on the target company and other project parties. It gathers the most important information regarding the target company.
Media Signals are considered important in informing valuation and strategies related to investments, deals, mergers, and acquisitions. You can verify the target company’s crucial information by using media data for enhanced due diligence or alternatively through SignalX. If ”knowledge is power”, then use Reputational DD to protect and maximize the business opportunity. The due diligence gives an in-depth understanding of the target company to the acquiring company.
It is highly unlikely that you will find a buyer who does not want to conduct due diligence on your business, therefore, it is advisable that you prepare for this almost inevitable process. Completing your own due diligence prior to putting your business up for sale can pay dividends in the long term. If the top executive of Siemens Gamesa had properly conducted due diligence on the target company or had outsourced the work to some platform that conducts due diligence for business entities, the executive must not have been fired.
Due Diligence requires you to scan diligently through a ton of documents that will protect your business or a firm from future repercussions. The data from regulators are noisy and can take a great deal of effort when sorted through manually. Thankfully, automation eliminates fatigue and provides an enhanced assessment in a shorter time. SignalX automates over 200 comprehensive and deep checks on your counterparties. If you’re looking to put in place a comprehensive vendor screening initiative, let’s talk!
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