How often in day-to-day practice before we go out shopping, we do create a checklist for product we plan to buy, its key specifications, value of money that it delivers and the longevity it promises. The same principle applies in the corporate industry when practices of diversification and creating a potential portfolio exists. Big corporates often take their businesses to a new vertical when they encroach into various profit gearing segments keeping in mind the long terms market sentiments.
The key driving force for owning stakes in Corporates indulged in seemingly unrelated business is that buying an existing business typically involves more upfront costs but on the contrary it offers less risks associated as over the period of time the running business creates a Goodwill and market standing of its own. A history of financials, a potential workforce and valuable IPR’s could be an add-on. It has been seen as a versatile practise that founders do sell their business ventures that sometimes rushes as a negative sentiment in the market. It’s not at all important that business be sold only because it entails some negative value with it. There may be plenty of reasons for the same, from financial crunches to lack of market competencies and synergies. It’s the time that cash rich Corporates see an opportunity to tune in the struggling business with effective balance of potential investment and future strategy.
Due Diligence: An exercise
In its simplest definition, means process of investigation, verification and examination of various Legal as well as financial database a Company holds which includes a vast check on its history with regard to financial performance, its assets and obligations and the reputation it holds in the market. Before making any investment the potential buyer needs to step into the shoes of the potential seller and make a thorough check on the key determinants that would be able to drive the Company. For the sake of determining various benefits that could be derived through the deal and investigating into the shortcomings, a panel of due diligence experts needs to be engaged for carrying out various financial and legal checks on the Target Company. The key step involved in due diligence is the valuation of business model of the Company taking into account its various financial database and performance. Have a business valuation performed to determine how much the business is worth, and consider how the current owner’s connections and expertise may affect that value. In a business-to-business company, a business sale could cause the former owner’s clients to leave, which would seriously impact the value of the business. Not only the financial but also the compliance part of various legislations needs to be taken into account. For e.g, the pending litigations against the Company, non-compliance of various laws applicable to the Company varying from Companies Act, to MRTP Act, SEBI Regulations and what not.
Legal Due Diligence:
It is an exercise to review all the legal and statutory documents that a Company holds, to overview compliance with all the laws that are applicable to the Company, whether on general basis or industry specific basis. It would be this due diligence, combined with financial due diligence that would derive the actual valuation of the business and would help in landing up a fair price value. The backing sentiment behind a legal due diligence is to seek and understand all the potential risks to which the Company is exposed as the buyer would always want to know the risks and the ways in which it could be met and adhered.
Objectives:
Performing an expert legal due diligence saves costs to the buyer and enriches them with potential information on the threats and risks involved and well as conducting SWOT analysis that would drive the investment and buy-in. It involves going through the documents from the scratch and ascertain any non-compliances with regards to applicable laws and carry on investigation of the obligations of the Company including its debts, leases, pending lawsuits, employee agreements, vendor agreements, security interest created on their assets and other disputed property and papers. Generally specifying it includes the following:
Ø Assessing and quantifying the main legal risks
Ø Provide solution to the risk’s so assessed and devising measures to mitigate it through various measures.
Ø Get to the bottom of all the legal contracts ever entered into and decoding it to ascertain any liabilities arising out of the same.
Ø For a Company that is listed, it should comply with SEBI Regulations.
Ø Compliance related to the industry specific laws such as Aviation laws, Food Laws, Banking Regulations and so on.
Key aspects to consider:
Before getting into the intricacies of legal due-diligence one must create a comprehensive checklist that takes into account various aspects of key fundamentals on which the corporate structure relies. This could be either the organizational management of a specific Company or its by-laws that forms a key ingredient in day-to-day running of the business activities. Some of such aspects and documents that needs assessment in both letter and spirit includes:
Organizational Structure
- Organizational Chart and management philosophy engaged in running the business.
- Corporate by laws, which could be also held up in the Articles of Association of the Company, which again is a key ingredient in running and optimizing the Company and has the set of rules which needs to be adhered to in day to day operations of the Company.
- The stakeholders, not to mention are the key people who reflect the overall growth and performance of the Company. A key study of stakeholders mainly the Angel and institutional investors would speak a lot about the Company’s efficiency and the way it delivers to multiply their investments.
- Minutes are the secret treasure to any Company’s past activity. They reflect the decisions taken by the Company in the past and are the key records for any existing value plan and activity. The minutes include the resolutions passed by the Company in its Board meetings, Shareholders meeting and the decisions made therein. Therefore, a thorough reading and understanding of the minutes is needed to synchronize the acts done by the Company in the past and its results.
- Conduct discussions with various committees formed in the Company, may it be Risk Management committee, Audit committee, Independent Director’s committee and so on. It also gives a true and clear picture about the trends being followed in a particular organization and the basic structure that is relied upon for conducting various compliances and management tasks.
Contractual Obligations
The most time-consuming and critical part of any due diligence exercise is the study undertaken to review the various contracts and arrangements undertaken and entered into between the corporates with other body corporates or with its own suppliers, employees/workmen, and other third parties. These contracts entered into between the parties creates legal obligations on either sides and hence give a fair view of the impact of such contracts on the day-to-day business operations as well as long-term viability and future growth prospects. Hence, reviews of such contracts becomes a legal necessity which includes:
Ø Suppliers contracts
Ø Shareholders Agreement
Ø Asset purchase Agreement
Ø Loans, Guarantee and credit arrangements
Ø Partnership and Joint Venture Agreements
Ø Settlement Agreements
Ø Non-compete Agreements
Ø Franchise Agreements
Ø Employment Agreements
Ø Works contract
Ø Security Agreement
Litigation
As aware, since the Companies enter into various aforesaid contracts, it is to be seen whether any dispute exists between the parties to any binding terms of such contracts. Litigation is a prospect that determines the value earned and lost in the market due to existing dispute. Therefore, any existing dispute between the parties could be a big hit for the growth and value prospect of the Corporate. Supposedly, if any management dispute exists, in such a case the day-to-day working would be affected that would indirectly take a toll on the revenue generating capacity of the Company due to poor management. Therefore, litigations arising out of any contract or arrangement needs to be taken care of either by amicable settlement or by way of court proceedings.
Summing up
Due diligence is an investigation to target any risk from a legal perspective. This process occurs before acquiring a business or company. The purpose is to have knowledge of the risks prior to purchase.
From a legal viewpoint, the more knowledge of the business, helps a buyer to make an informed decisions.
The result of legal due diligence will help explain the current situation of the business, identify the risks and structure the acquisition. Understanding, the organization and the exposure it reflects to the outside world, both in Goodwill and financial aspect are an important aspects for a buyer to keep in mind before entering the deal. Soundness of business model and well complied structure would be an edge that could lead to creation of various synergies. Due diligence help investors to get an accurate view on what the Company has done so far and how it might fit into a broad portfolio or investment strategy.
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