Have you heard of the FTX crash? The second-largest crypto exchange in the world filed for bankruptcy on 11th November leaving approx one million customers/investors with 180 billion dollars in loss. The crash is touted as the Lehman Brothers moment in the crypto world. The same crash has brought cryptocurrency prices to an all-time low. What could have prevented all this bloodshed is Binance (the world’s biggest crypto exchange) acquiring FTX (a bailout package). But within 24 hours of Binance’s announcement to acquire FTX, it reneged.
Their commercial due diligence saved them. Initially, Binance officials were under the impression that it is the liquidity crunch that is choking FTX.com, but under their commercial due diligence, they discovered tons of bad leverage between Alameda Research and FTX.com, both entities owned by their founder, Sam Bankman-Fried. Binance’s commercial due diligence saved it from a certain loss of billions, if this doesn’t establish the necessity of commercial due diligence, nothing can!
What is Commercial Due Diligence?
Commercial due diligence (also known as M&A due diligence or corporate due diligence) is the process under which the acquirer entity/buyer (venture capital, private equity firms or conglomerates, and businesses in the same industry) runs various checks on the acquiree entity (also called the target entity) to ensure that the deal is compliant with the laws and is financially viable. Though rare, sellers also sometimes perform commercial due diligence on the buyers called “sell-side due diligence”.
Multiple checks are conducted on the target (or on the buyer) including:
- Financial Checks,
- Operational Checks,
- Administrative Checks
- Contracts Checks,
- Taxation Checks,
- Litigation Checks,
- Related Parties Checks,
- Vendors Checks,
- Reputational Risk Checks,
- Market Signals Checks,
- Sanctions Checks,
- Licenses/Regulatory Checks
and many more depending upon the business type and requirements of the deal. Basically, collecting all the necessary information about each & every aspect of a target’s business and converting that information into useful insights for negotiating the deal, is what comprises an exhaustive commercial due diligence process.
Why is Commercial Due Diligence Important?
1. Preventing Possible Losses and Fraud
In the aforementioned case of FTX, what protected Binance from acquiring a financially shady company was its commercial due diligence. On the other hand, there have been instances where even big guns like Oracle, Barclays, Deutsche Bank, etc have been fined millions by regulatory authorities for corruption, bribery, and regulatory compliance issues, all because they couldn’t undertake proper due diligence.
A proper commercial due diligence report (also called a pre-deal due diligence report) helps you check the disposed-off and ongoing litigations on the target. Are there any sanctions imposed on them? Are they on the radar of any law enforcement agency, who are the ultimate beneficiaries of the business, are there any unscrupulous related party transactions going on, etc?
2. Aids Negotiation
An exhaustive commercial due diligence report empowers the legal team, investment team, and compliance managers of the business with the requisite data to spearhead corporate dealings accordingly.
- What does the core financial ratios of the target like debt-equity ratio, liquidity ratios, quick ratios, and other profitability ratios indicate?
- What are the trends in growth signals, litigations, awards and recognition signals, etc?
- Have they ever been sued for breach of contract?
All these information points enable the legal and investment team to appropriately highlight their concerns to the other side during the negotiations. It also allows the other side to correct/improve upon the highlighted shortcoming wherever possible and avoids/resolves a deadlock in the negotiations. Eg: Settle a long-standing lawsuit or reduce debt in the balance sheet.
3. Increased odds of M&A success
Did you know that despite companies spending USD 2 trillion in acquisitions every year, 70 to 90% of mergers and acquisitions fail? The main reason behind this is that top management is unable to identify the right target or discover the target’s correct valuation or botched post-M&A integration. A comprehensive commercial due diligence report provides you with an objectively calculated multidimensional risk matrix to make well-informed decisions.
Further, if the commercial due diligence report indicates higher risk on a particular parameter, the legal team can accordingly add additional governance in the contract for the same or adjust the price. This keeps the entire transaction agile and helps in managing the racing timelines in a due diligence process.
4. Best Target at Best Valuation
Insights-rich commercial due diligence exercise reports allow you to screen out the targets with red flags at the very outset e.g targets with money laundering or cheating cases, targets without necessary regulatory approvals/licenses, targets with unviable cost matrix, poor liquidity or sales figures, etc. This screening process affords you a pool of safe and quality targets.
The core purpose of any M&A is either to improve the acquirer’s business performance (to either command premium prices in the market or to reduce cost) or to reinvent its business model (to expand the business in new avenues due to eroding profits or higher competition in the existing markets). Having all the critical information on the target in a single commercial due diligence report greatly facilitates the buyer in maintaining this clarity throughout the negotiations.
5. Attracting Higher Investments and Overall Better Contracting
Recently, one of our clients from the manufacturing sector requested us to first run corporate due diligence on itself in order to understand what are the red flags and shortcomings on their profile that can discourage or cause lower valuation before the investors. This helped them identify specific areas they need to improve e.g. to reduce inventory, settle unnecessary litigations, reduce over-reliance on debt, undertake a capital restructuring, etc.
Then they asked us to run a supplier due diligence on each of their vendors with the aim of identifying weak links in their supply chain and replacing them. The results of this dual due diligence exercise were:
- Their supply chain was better optimized and more resilient to disruptions like wars, pandemics, inflation, etc.
- They became less prone to contract defaults by vendors (thus better contract lifecycle management).
- Got inputs for framing a more contemporary and relevant Vendor Policy and Guidelines for the future (thus smooth business operations).
All this translated to them becoming an overall more attractive value proposition to the investors enabling them to land higher funding for business expansion and growth. This is the epitome of how commercial and supplier due diligence has a direct bearing on the organization’s growth and profitability.
Is Commercial Due Diligence Mandatory?
The Indian Scenario
In case of a legal dispute regarding the deal, how do you as a company prove that your corporate dealings were made in good faith without any fault of your own? The definition of “good faith” as provided in Section 52 of IPC is “Nothing is said to be done or believed in ‘good faith which is done or believed without due care and attention”. “Due care” (due diligence in the context of corporate transactions) is an essential part of establishing good faith, which is in turn necessary to build any kind of legal defense.
Many Indian statutory provisions like the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 provide for mandatory due diligence requirements for trustees, asset management companies, and intermediaries and it goes on to enumerate the list of general and specific due diligence to be observed. It also provides for impunity from liability if due diligence has been exercised. For example, under Regulation 18(26), Rights and Obligations of the Trustees, which provides that “Notwithstanding anything contained in sub-regulations (1) to (25), the trustees shall not be held liable for acts done in good faith if they have exercised adequate due diligence honestly”.
Many Indian statutes dealing with economic subject matters provide a great degree of impunity from legal liability. For example, Section 48 of the Competition Act, 2002; Section 85 of the Information Technology Act, 2000; Section 27 of the Securities and Exchange Board of India Act, 1992; Section 24 of the Securities Contracts (Regulation) Act, 1956. To that effect, all these statutes contain a general provision in their Section of “Offences by Companies” which is as follows:
“Provided that nothing contained in this sub-section shall render any such person liable to any punishment if he proves that the contravention was committed without his knowledge or that he had exercised all due diligence to prevent the commission of such contravention“
Thus, the legal landscape of commercial due diligence in India is that while some statutes actively command the business entities to undertake it, most of them provide for a high degree of impunity in case of a legal dispute if the proper due diligence has been exercised.
The Global Scenario
For multinational companies, especially those operating in Western jurisdiction (Europe, UK and US, and Canada), there are laws like the:
- Bribery Act, 2010 (UK);
- Foreign Corrupt Practices Act, 1977 (US);
- Federal Penal Code of, 2006;
- German Criminal Code;
- 5th EU Money Laundering Directives;
- Clean Company Act, 2014 (Brazil);
- Prevention Of Corruption Act, 1960 (Singapore);
- ISO 19600 “Compliance management systems–Guidelines”;
- ISO 37001 “Anti-Bribery Management Systems”.
are in place that places mandatory requirements of conducting proper due diligence on corporate entities to prevent transnational economic offenses like money laundering, terror financing, corruption, tax evasion, etc, and even provide for prosecution in case of failure to do the same. Some of the aforelisted statutes also require the companies to check whether the contract partners and business entities they are transacting with involve any politically exposed person (PEP).
What are the Legal Requirements of Commercial Due Diligence?
There is no specific law that per se lays out the parameters on which you have to perform the corporate due diligence. That depends upon the unique demands of each transaction. Usually, the information that’s required to prepare the commercial due diligence is provided by the seller to the buyer after the signing of the Letter of Intent (LoI), which signals that the buyer is serious about the deal though it is not legally binding. A significant portion of the information is publicly available e.g. financial records, ownership details, disclosure statements, etc on the website of the Ministry of Corporate Affairs.
Other information like the litigation data, vendors (related parties) information, licenses information, etc is provided by the seller on buyers’ request and is verifiable. At SignalX, we utilize 200+ government sources and thousands of renowned private sources to generate holistic commercial due diligence reports within 48 hours of the request. This fast-tracks the due diligence cycle thereby enabling the buyer to weed out factors that can later disturb the deal. This also allows for a shorter exclusivity period for the seller under the “no shop clause” thus not making them miss out on other offers.
Step-by-Step Commercial Due Diligence Process
Identification: Identifying all the acquirable targets/businesses operating in the industry you wish to enter/expand.
Data Collection: Collect the publicly available financial data of that company from the relevant government authorities websites.
Screening: This is the most important step of due diligence. Here, we screen out multiple targets of the second stage based on the criteria tailored for the merger/acquisitions. Based on the inputs received in the second stage, a due diligence report is prepared to filter out the targets with red flags like money laundering, frauds, wilful defaulters, politically exposed persons, unethical accounting practices, etc.
Letter of Intent: We sign the LoI with the selected targets to signal genuine interest in the deal. After this, the buyer demands more information (about connected parties, lawsuits, vendor data, etc) from the seller to make a better-informed decision. Using the inputs from stages 2 and 3, an exhaustive commercial due diligence report is prepared for each target. After that, comparing the risk matrix from the due diligence report of each target, one or two are selected for acquisition.
Negotiations: If the seller passes the due diligence test, the negotiation starts between the legal and investment teams of both sides. The inputs of due diligence reports are heavily utilized even at this stage. The deal’s price is heavily influenced by the risk matrix and other discoveries made in the exhaustive commercial due diligence report.
Finalization of Terms and Signing of the Purchase Agreement: Once the negotiations are concluded, the buyer side prepares the initial draft of the agreement and runs it through the seller side for final consideration. At last, the final agreement is signed and the purchase agreement is thereby executed.
Resource 1: Comprehensive Commercial Due Diligence Checklist
You identify all the businesses/targets that are operating in the industry you wish to expand/enter into and ask them to fill out a standard questionnaire providing basic information about them.
Based on our in-house expertise, we have curated an extensive corporate due diligence checklist using which you can make your own target questionnaire to collect data for the same purpose. It is as follows:
- Basic Information: Name, CIN/LLPIN, Registration number, MCA Sub-category, Type of company, Incorporation date.
- Status: Active/Closed; Latest Balance Sheet; Last Annual General Meeting; Stock Market Status; Corporate Insolvency Resolution Process Status; Compliance Status.
- Contact: Registered address, Office location, email, website
- Business Overview: Products & Services, Associated brands, Industries and Sectors, Market Leaders and Peers.
- Capital Structure: Equity, Preference, Unclassified shares (Authorized; Issued; Subscribed; Paid-up).
- Group Structure and Operational Capability: Management Timeline (appointment and expiry date), Shareholding patterns (Indian; NRI; Foreigner; Govt; PSUs; FIIs; VCs; MFs; Bank; Insurance cos), Key Managerial Personnel (and the percentage of their shareholding), Directors & Auditors Information (present and past).
- Connected Parties: Employees, Vendors, Shareholders, etc.
- Financial Highlights: Core financial ratios highlights (debt-equity ratio, liquidity ratios, quick ratios, asset-turnover ratios, gross-profit margin ratio, operating profit ratios, current ratio, interest coverage ratios, EBITDA multiple, etc), Balance Sheet Analysis, Income Statement Analysis, Cash Flow Analysis, Detailed Financials, Index of Charges
- Regulator Checks:
- Accounting, Payroll & Secretarial Compliance: Ministry of Corporate Affairs (MCA), Securities Exchange Board of India (SEBI), and Securities Appellate Tribunal (SAT);
- Debt Recovery; Insolvency and Bankruptcy: Credit Information Bureau of India Limited (CIBIL); Debt Recovery Tribunal (DRT); Debt Recovery Appellate Tribunal (DRAT); National Companies Law Tribunal (NCLT); National Companies Law Appellate Tribunal (NCLAT); Insolvency and Bankruptcy Board of India (IBBI); Income Tax Appellate Tribunal (ITAT); Appellate Tribunal for Forfeited Property (ATFP); Customs Excise and Service Tax Appellate Tribunal (CESTAT).
- Direct and Indirect Taxes: ITAT, ATFP, and CESTAT.
- Criminal Activity, Money Laundering & Serious Fraud, and other miscellaneous checks: Financial Intelligence Unit (FIU), Serious Fraud Investigation Office (SFIO), Central Bureau of Investigation (CBI), United Nations (UN), Reserve Bank of India (RBI), National Consumer Dispute Resolution Commission (NCDRC), Competition Commission of India (CCI), Employees’ Provident Fund Organisation (EPFO), High Courts and Supreme Court.
- Statutory Checks: EPFO, Goods & Services (GST), and Tax Deductible at Source (TDS).
- Sanctions Checks: UK’s Consolidated Financial Sanctions list (HMT); European Union’s Consolidated list of persons, groups, and entities EU financial sanctions; INTERPOL Wanted List; Switzerland Sanction List (SECO); United Nations Security Council (UN), Consolidated Sanctions list; Bureau of Industry and Security, etc.
- Legal History: Cases against whom in the company, Cases’ Nature (criminal or civil), disposed of/pendency duration, jurisdiction and damages claimed. Cases against connected parties.
- Market Signals: Any negative news in the national or international media.
Resource 2: Documents Checklist For Corporate Due Diligence
- Memorandum of Association (MoA)
- Articles of Association (AoA)
- Incorporation Certificate
- Shareholding Pattern Information
- Financial Statements
- Bank Statements
- Income Tax Returns
- Certificates of Tax Registration
- Receipts of Tax Payment
- Statutory Registers
- Property Documentations
- Operational Records
- Intellectual Property Registration or Application Documents
- Employees’ Documentations
Frequently Asked Questions
What is commercial and operational due diligence?
Commercial due diligence is a process that is conducted on a company in order to evaluate its commercial viability or business opportunity. It includes an analysis of the market to determine the demand for the company’s products and services, the competition scenario, the company’s business model, and go-to-market strategies.
Operational due diligence is conducted to analyze the operational effectiveness of the company. This process involves, reviewing the company’s financial records, supply chain reports, and manufacturing processes. This is done in order to determine the efficiency and scalability of the company.
What are the three 3 types of diligence?
The three main types of due diligence are –
Reviewing and analyzing financial records and documentation, such as balance sheets, income statements, and cash flow statements in order to determine the stability and health of the company’s finances.
In order to guard against any legal concerns, legal diligence entails studying and evaluating legal documents and contracts as well as assessing prospective legal risks and obligations.
Technical due diligence is performed in order to determine a company’s technical features, such as its products, systems, and procedures, and their operation and effectiveness.
What are the 4 due diligence requirements?
Due diligence may include several key components. 4 such requirements are:
Reviewing financial documents: To determine the stability and health of a firm or organization’s finances, you may require studying and assessing financial statements like balance sheets and income statements.
Assessing legal risks and liabilities: This involves reviewing contracts and other legal documents, as well as evaluating potential legal risks.
Evaluating the quality and effectiveness of products and services: This includes inspecting, testing, and assessing the systems and procedures applied in the creation of goods and services by that company.
Assessing the market and competitive landscape: Research and analysis of market trends and competitive environments may be necessary.
What is the main purpose of due diligence?
Due diligence’s primary objective is to gather and analyze the data about a firm so that a decision can be made regarding a business transaction. It helps identify and evaluate potential risks and liabilities, as well as the company’s strengths and prospects, leading to better decision-making.
What are FDD and CDD?
Reviewing a company’s financial records and documentation to determine its financial health and stability is known as financial due diligence. This often involves looking at financial records and evaluating the business’s financial performance.
The commercial due diligence involves reviewing a company’s products, market, and business model to assess its commercial viability and potential for success. It includes researching the market and competitive environment and evaluating the company’s marketing and sales efforts, pricing strategies, and distribution channels.