Due Diligence

Process of Merger & Acquisition:

 Process of merger and acquisition involves corporate strategy, corporate finance and
management
 It involves consolidation of companies i.e., business combination, division and
demerger of two or more companies
 In the case of merger through a court route, once the scheme is sanctioned by the
court/tribunal after due process of law and the scheme is filed with the Registrar of
Companies, it is irreversible
 It carries the stamp of final approval by a judicial authority and is acceptable to the
public, shareholders, stakeholders, registering authority
 Merger & Acquisition process is normally preceded by formulation of strategy,
identification of cost benefit analysis, carrying out due diligence, conducting valuation
and considering the aspects of stamp duty and other applications
 Moreover, the integration issue after the merger exercise is also to be taken care of

Prerequisites of Merger and Acquisition:

1. Due Diligence: It refers to the investigating effort made to gather all relevant facts
and information that can influence a decision to enter a transaction or not. Exercising
due diligence is not a privilege but an unsaid duty of every party to the transaction.
M&A due diligence helps individuals avoid legal hassles due to insufficient
knowledge of important details
2. Business Valuation: Business valuation or assessment is the first step of merger and
acquisition. This step includes examination and evaluation of both the present and
future market value of the target company
3. Planning Exit: In the process the management must evaluate all financial and other
business issues like taking a decision of full sale or partial sale along with evaluating
on various options of reinvestments
4. Structuring Business Deal: After finalizing the merger and the exit plans, the new
entity or the take-over company must take initiatives for marketing and creating
innovative strategies to enhance business and its credibility. The entire phase
emphasises on structuring of the business deal
5. Stage of Integration: This includes both the company coming together with their own
parameters. It also defines the parameters of the future relationship between the two

Due Diligence:
● Due diligence is an investigation of a business or person prior to signing a contract,
or an act with a certain standard of care
● It can be a legal obligation, but the term will more commonly apply to voluntary
investigations
● Due diligence is integral to business. It is exercised in a simple over-the-counter
transaction or a complicated merger and acquisition transaction
● The theory behind due diligence holds that performing this type of investigation
contributes significantly to informed decision making by enhancing the amount and
quality of information available to decision makers
 ● Thus, a due diligence is an investigation or audit of a potential investment
● It first came into use because of the US Securities Act, 1933
● A successful due diligence depends largely on the cooperation of the proposed
seller. This is possible in the case of 'friendly' takeovers
● The collection of the information relating to the target company is not an easy task
specifically when the target company does not cooperate in the matter

Types of Due diligence:

1. Legal Due Diligence: Legal Due Diligence is used to ensure that there are no legal
issues in buying a business or investing in it. In this, the solicitors will review the
important legal documents of the target firm such as employment contracts, board
meeting minutes, articles and memorandum of association
 Tax Due Diligence: This is aimed at ensuring that there are no past tax liabilities
in the seller firm that might have materialized due to mistakes or deception and
could hold the acquirer liable for it
 IP Due Diligence: IP due diligence is focused on establishing what rights the
company may have in various intellectual property and where it might rely on the
intellectual property of another entity

2. Operational Due Diligence: Operational due diligence (ODD) is the process by which a
potential purchaser reviews the operational aspects of a target company during mergers
and acquisitions. The ODD review looks at the main operations of the target company
and attempts to confirm (or not) that the business plan that has been provided is
achievable with the existing operational facilities

3. Commercial Due Diligence: This aims at understanding the market the target business is
operating in. This looks at the forecast of the market growth in future and the target’s
position in the market with relation to its competitors

4. IT Due Diligence: This aims at identifying if there are any IT issues in the target business.
Investigates matters such as scalability of systems, robustness of the processes, the
level of documentation, compliance with legislation & ability to integrate various systems

5. HR Due Diligence: This aims at understanding the impact of human capital on the
proposed deal. This looks at employment records, compensation schemes, HR
processes

The due diligence process should incorporate the following areas, to assess the nitty-gritty of
the transactions of the takeover and to opt for or opt out of the takeover deal:
● Industry Analysis
● Management Analysis
● Financial Analysis
● Intellectual property rights
● Taxes
● Manufacturing
● Litigation
Managing the Due Diligence process:
Some important steps that may be of immense help, may need to be taken by the acquiring
company before they are ready to finalize an offer
 Constitute a due diligence team of technical, legal, financial and taxation experts, etc.
 Assign the task to each of the members and the coordination among the members
be supervised by a senior level officer
 Collect the data of the target company with reference to the:
▪ corporate records
▪ promoter’s holding
▪ stockholder information
▪ IP contracts
▪ History of litigation
▪ Insurance information
▪ Financials and leases
 Analyse the above information/ statistics, assess the prospects and the benefit
 Follow the regulatory requirements as mentioned in the Companies Act, 2013 and
the SEBI Regulations

Contractual Issues:
Conducting contract due diligence both before & after a merger or acquisition is critical for
success of a business transaction. The state of a business’s contracts holds important
information about value of the business, as well as potential liabilities. The contracts
checklist for M&A due diligence addresses ways to address issues uncovered during pre-
transaction review & processes to implement once the merger or acquisition moves forward
1. Business risks: Non-compete clauses restrictions can impose disadvantageous limits
on the acquiring business. This can affect the overall value of the merger or
acquisition
2. Transaction complications: Some contracts set complicated conditions over a
transfer. Not providing sufficient notice, for example, could be a breach of the
contract requirements. In some cases, a contract may not be transferable, and the
companies will have to figure out an alternative solution
3. Legal risks: Contracts that have already been breached or are likely to be breached
soon pose immediate risks to the purchasing company. It’s also important for the
legal team to consider provisions that could make it difficult to transition the accounts
through the merger or acquisition process
4. Contracting risks: This often-overlooked area addresses how incoming contracts
comply with the purchasing company’s standards for contractual relationships. The
two companies may have worked under different standards for how much liability
was acceptable
5. Valuation: After having done the due diligence process, the next step is to value the
business for the purpose of deciding the swap ratio. A company will transfer
ownership only when the fair market value is determined to the satisfaction of the
sellers. Similarly, the buyer company will be ready to pay for the price if it is in the
beneficial interest of its owners too. The valuation of assets & liabilities of the
business entity depends upon the various factors
General principles of Business Valuation:
1. Principle of Time Value of Money: This principle suggests that the value can be
measured by calculating the present value of future cash flows discounted at the
appropriate discount rate
2. Principle of Risk and Return: This principle believes that the investors are basically risk
averse and on the other hand expects a higher amount of wealth. Higher the risk, higher
the possibility of return and vice versa
3. Principle of Substitution: The market with competitive forces is very important to decide
the price consideration. The risk averse investor will not pay more than that of the
substitute available in the market
4. Principle of Alternatives: This principle suggests that one should explore the various
alternatives available in the market and should not rest only on one option
5. Principle of Expectation: Cash flows are based on the expectations about the
performance in future and not the past. In the case of mature companies, we may
assume that the growth from today or after some certain period would be constant
6. Principle of Reasonableness: Takes into consideration various aspects like nature of
business, historical background, brand image, book value of stock, earning capacity etc.

Valuation Approach:
The business valuation approach may consist of several models to provide a reliable value.
These are business analysis, accounting and financial analysis, forecasting and valuation
itself. The most popular methods of valuation amongst other includes Asset based valuation,
Earnings based valuation and Market based valuation

Methods of Valuation:
1. Super Profit Method:
This approach is based on the concept of the company as a going concern. The value of
the net tangible assets is taken into consideration, and it is assumed that the business, if
sold, will in addition to the net asset value, fetch a premium
 The super profits are calculated as the difference between maintainable future
profits and the return on net assets
 For example, the acquirer may write off all R&D expenditure, whereas the target
might have capitalised the development expenditure, thus overstating the
reported profits

2. Contingent Claim Method:

Contingent Claim valuation uses option pricing models to measure the value of assets
that have share option characteristics. Some of these assets are traded financial assets
like warrants, and some of these options are not traded and are based on real assets.
Projects, patents and oil reserves are examples. The latter are often called real options.

3. Accounting Professionals Experts:

The accounting professionals use the various accounting ratios which are beneficial in
deriving the swap ratios. These accounting ratios may be Dividend Payout Ratio (DP
Ratio), Price Earnings Ratio (PE Ratio), Debt Equity Ratio, Net Assets Value (NAV)
4. Relative Method:
The Relative Valuation estimates the value of an asset by looking at the pricing of
‘comparable assets’ relative to a common variable such as earnings, cash flows, book
value or sales

Section 247 of the Companies Act:

It is a new section and seeks to provide that valuation in respect of any property, stocks,
shares, debentures, securities, goodwill or any other assets or net worth of a company or its
assets or liabilities shall be valued by a person having such qualification and experience and
registered as a valuer, in accordance with such rules as may be prescribed