This article is written Navya Chopra,BA LL.B Student at Vivekananda Institute of Professional Studies during her internship at LeDroit India.
ABSTRACT
Mergers and acquisitions have evolved as one of the most efficient strategies to reorganise businesses in order to gain competitive advantages. They have shown to be one of the fastest methods for organisations to achieve a competitive edge in a highly competitive global economy. But before undertaking such a transaction, the buyer will want to ensure he has clarity in understanding what he is buying. Essentially, due diligence is the process of thoroughly evaluating commercial agreements from a variety of perspectives before making a final choice. This is more of an investigation procedure for evaluating assets and liabilities, and it also looks into the potential commercial as well as economic worth of the company or firm where due diligence is necessary. For its successful conduct, a capable team of legal and financial professionals is selected to follow the process of due diligence and to make the necessary considerations for a fruitful merger or acquisition.
Keywords: due diligence, mergers and acquisitions, M&A
INTRODUCTION
Mergers and acquisitions (hereinafter referred to as ‘M&A’) are an external method for businesses to achieve real growth. Traditional techniques of organic development, such as new products, markets, and efficiency, can only help a company grow to a certain level. M&A is seen as a beneficial instrument for companies looking to swiftly expand their income sources. A merger or acquisition can often result in the formation of new companies with more promising financial and strategic prospects.
In a merger, one firm combines with another and loses ownership, while another dominating corporation obtains higher value and can absorb or merge with another, whereas in an acquisition, the receiving company buys the interests of acquired shareholders and ceases to have an interest. There is an acquiring company and an acquired company in an acquisition. The acquiring firm buys the shareholders’ stake in the acquired company. As a result, a merger is an arrangement in which two or more firms are merged and their ownership is transferred to one company. Both firms’ interests are pooled in this situation. During an acquisition, a firm’s ownership is transferred to another company in the form of tangible or intangible assets, such as a controlling interest in share capital or voting rights.
This resource explains due diligence in M&A transactions and why is it necessary to be done. Further, it discusses the process of due diligence and the key considerations it involves. Finally, it elaborates on the view of Indian Legislation on it.
DUE DILIGENCE
Before committing to the transaction of a merger or an acquisition, the buyer will want to make sure he understands what he’s buying, what obligations he’ll be taking on, the nature and scope of the seller’s contingent liabilities, problematic contracts, and a variety of other issues. This is especially true in private firm purchases, when the seller has not been subjected to public market scrutiny. Due diligence is a process of inquiry or investment opportunity that aids the customer in ensuring the quality of the product they are purchasing. It is the process of doing appropriate verifications and measures in order to detect and prevent any potential future danger.
It enables the buyer to double-check relevant information about the seller, such as contracts, money, and customers. By gathering this information, the consumer is better prepared to make an informed decision and close the agreement with a sense of certainty. Due diligence begins when the letter of intent (LOI) is signed. Prior to entering into a legal contract or a business transaction, each reasonable individual or corporate organisation must conduct due diligence.
Conducting complete due diligence before making any business investment or purchase is a fiduciary obligation ascribed to company officials. It is a thorough review of all essential parts of a company’s operations. Due diligence must be performed on all aspects of the business, including financial, operational, tax, commercial, tax, IT, integrity, social, environmental, health and safety, regulatory, and so on.
NEED FOR DUE DILIGENCE
When it comes to an M&A transaction, due diligence is essentially a tool that provides the buyer with reliable and complete background information on the proposed deal, as well as assisting in the discovery of any potential liabilities or discrepancies, allowing the buyer to make a more concrete and informed decision about the transaction. M&A necessitate a reasonable amount of due diligence by the buyer, as it is critical for the buyer to understand what it will be buying and what all obligations it will assume with the purchase, as well as the nature and extent of the target company’s liabilities, litigation issues, and so on, before committing to the transaction.
Strategy planning, rigorous selection and screening of potential targets, due diligence, negotiations, and integration are all similar parts in any acquisition. Many M&A process models concentrate their stages on these fundamental functions. Formulate, Locate, Investigate (Due Diligence), Negotiate, Integrate, Motivate are the steps in the transaction flow model. Stage 3: Investigate/due diligence is crucial in determining if a company should proceed with a M&A. The results of the due diligence step are utilised to identify negotiation terms, bid pricing, and offer a foundation for first integration suggestions. Furthermore, the due diligence step is critical in evaluating whether or not a transaction will be successful. The problem, according to Perry and Herd, is not that an organisation will fail to do due diligence for a sale, but rather that they will fail to do it efficiently.
The merger between Dai-Ichi Sankyo and Ranbaxy is an excellent example of the significance of due diligence. Dai-Ichi Sankyo first paid Ranbaxy $4.6 billion for 63 percent of company stock, but then wrote down the value of the deal by $3.6 billion. The reason for this is because when Ranbaxy was directed to shut down all of its pending and prospective medication applications from its Ponta Sahib factory in 2009, they were never fully informed of the scope of the Food and Drug Administration’s (FDA) investigation. The first-to-file atorvastatin, which had piqued Dai Ichi’s interest, was riddled with issues. Dai-Ichi ended up losing a lot of money since they didn’t do enough due diligence.
DUE DILIGENCE PROCESS
For the safety and security of both firms, doing due diligence before any commercial deal or transaction is absolutely necessary. As a result, it is crucial to understand how due diligence might be carried out. Because most business transactions, whether local or international, are exceedingly complicated in nature, there will never be a single standard technique of completing due diligence. The most popular approaches for conducting due diligence are as follows:
- Questionnaire – This strategy is useful for gathering basic information about any target company. Whether it’s to assess its overall well-being or its financial health, as well as any prospective threats, etc.
- Representations and Warranties – Another method is the representations and warranties method through which the seller can be asked to make certain warranties in the commercial contract, for the future safety and security of the company.
- Review – The third method is to review, in an integrated manner, the financial analysis of the seller’s business with the analysis of the legal risks which could be associated with the transaction.
This must be done in a methodical manner so that one team can appropriately analyse the information gathered. The following procedures are commonly used to do this: presentation of data in a ‘data room’ or the submission of data in the form of a questionnaire.
The Data Room approach involves presenting a huge amount of data to interested parties in order for them to examine, appraise, and undertake due diligence on it. This procedure necessitated the display of a substantial amount of data. This strategy has been effectively employed for disinvestments via the tender route, and the seller is able to maintain and guarantee that all bidders are treated equitably and have uniform access to the same data or information through this procedure. As a result, all of this information, as well as the appropriate papers, is provided to the sellers in a Data Room. Any prejudice in the provision of information or documents might result in the bidding process being cancelled. This is especially true of disinvestments by the governments or government-owned firms that are subject to judicial scrutiny under Indian law.
The second strategy is presenting a questionnaire to the target organisation, which is then used to conduct additional one-on-one talks. Following that, lawyers prepare a due diligence report that can be used to effectively negotiate any vexing question regarding the representations and warranties that must be included in the sale and purchase or financing agreement, the disclosures that must be made, and the amount, if any, to be set aside.
THE DUE DILIGENCE CHECKLIST: KEY CONSIDERATIONS
Prior to completing due diligence, it is critical to have a strategy in place for who will be accountable for conducting the due diligence. But it must be noted that the scope and content of due diligence are determined by the company’s industry.
Firstly, there are the initial parameters wherein every management requires a preliminary assessment of the areas of critical importance for the success of any transaction, which may include the target’s, key staff, suppliers, and customers’ continuity after the purchase.
Then comes the team selection of financial and legal professionals is created to work alongside the Board of Directors to reach to a decision that is best for every party involved.
Thirdly, there is preparing for the preliminary inquiry and conducting it. The major goal is to detect any deal-breaker difficulties ahead of time, before any money or other critical resources are invested in lengthy research procedures. Some of these issues may be contingent liabilities, statutory non- compliances, et cetera.
Fourthly, the due diligence report is created, the entire aspect of which, as well as its subsequent success, is fully dependent on making an educated decision, which can only be the outcome of a well-planned, integrated, and coordinated comprehensive inquiry process. In general, there are two types of due diligence reports used by professionals: long form due diligence reports, which include briefs on the nature and type of all documents received and whether they are in compliance or non-compliance, and red flag due diligence reports, which only provide information on potential risk and non-compliance in the company.
Finally, after all of the tasks have been done satisfactorily, the due diligence team must get a statement or certificate from the target business that certifies the completeness of the given information and all documents, as well as that the target company has withheld no significant data.
INDIAN LEGISTLATION
The Securities and Exchange Board of India, as well as many provisions of the Companies Act, 2013, require directors to act in the company’s best interests. While doing so, he is expected to use caution and expertise. Furthermore, under The Companies Act, 1956, the term ‘amalgamation’ was used interchangeably with the phrase ‘merger,’ but neither term is specifically defined.
The Supreme Court ruled in Nirma Industries and Another v. Securities Exchange Board of India that, under Regulation 27 (d) of the SEBI, 1997, an investment firm must conduct proper due diligence on the target business before investing. The Court noted that Nirma Industries was aware of different litigations, denying Nirma Industries’ claim of ignorance of litigation and investment risks.
Holding a similar view, the US Supreme Court held the directors personally liable in the case of Smith v. Van Gorkom for approving a merger proposal that guaranteed shareholders a premium of 39-62 percent over market price. The Court opined that the directors failed to exercise reasonable care and also stressed that the Board participation needs to be carefully planned and structured when a major corporate transaction such as the sale of the company needs to be made.
CONCLUSION
Hence, any and all M&A deals require a thorough due diligence procedure to be successful. The primary goal of due diligence is to verify assumptions about risk identification and value. The scope of the inquiry should be adapted to the nature of the transaction. Owing diligence is critical, and it cannot be overstated that the majority of acquisitions fail due to insufficient due diligence, which leads to the buyer overpaying, facing substantial integration issues, or taking on unanticipated liabilities.
Due diligence teams are increasingly being required to determine if the deal’s planned value can be realised, whether the predicted timescale can be met, and whether the related risks can be efficiently handled. It is self-evident that the due diligence process must be meticulously supervised and monitored in order to maximise the deal’s chances of success.
