The Need of Due Diligence in Mergers and Acquisitions

Company Law project Praveen (200928) VIII Semester

Contents
Acknowledgement .................................................................................................................................. 3 Why Merger & Acquisitions (M&A)? ...................................................................................................... 5 INTRODUCTION ....................................................................................................................................... 6 Origin of the term Due Diligence ......................................................................................................... 6 Due Diligence in Detail ............................................................................................................................ 6 Due diligence Transactions ..................................................................................................................... 7 Due Diligence Considerations, Process & Timing ................................................................................... 9 Case study ............................................................................................................................................. 13 The need of Due Diligence - conclusion ................................................................................................ 18 Bibliography .......................................................................................................................................... 19

Acknowledgement
I would like to thank Mr.Dayanda Murthy, Faculty for Company Law, for his valuable suggestions regarding this topic and always encouraging and motivating me to pursue the research required for this project. And for his encouragement I would always thankful to him. Through this project I have learnt lot about procedural and theoretical aspects of Indirect tax and without this my course paper of company law would be incomplete. I hope, I have fulfilled all the requisite criteria for the submission of end semester project. Praveen (200928)

Preface
The need of due diligence in Mergers and acquisitions (M&A) can be explained only when we understand M&A, so an introduction regarding this is given, then the birth of due diligence process starts depending upon the path the company choses for its expansion, organic or inorganic. Then in this project the origin of due diligence is given and the difference it has now from the securities bill enacted in U.S. then the general framework of due diligence is explained with Due diligence investigation check list. And the process and investigation is explained with Mock case study applying the checklist and emphasizing on the need of Due-Diligence in M&A.As this project is based on my derived opinion and my opinion is based on the materials I referred I have not put any footnotes but I have listed what are the sources I referred in attempting this project and opinions expressed here are my sole deductions.

Why Merger & Acquisitions (M&A)?

Its for the growth of the company. Growth means the increased revenue, profits or assets of a company for a period of time The period of time can be charted down as quarterly or yearly or over a decade. Growth can be of two kinds. Organic and Inorganic Organic growth is where the company builds its in-house competencies through gaining competitive advantage through line of products, innovation or competitive pricing. Inorganic growth is where a company takes the leverage on products, innovation of other companies. There is no specific formula for enhancing growth of company. Some opt organic growth and some opt in-organic growth. Examples 1) Apple Inc. has attained growth through organic method where it has rendered innovation and different product lines. 2) Google Inc. has attained growth through inorganic methods, over the years Google Inc. has done more than 100 acquisitions. So wherever there is M&A its an inorganic growth. So this project deals with in-organic growth of companies, because due diligence is one of the essential things that should be performed before merger and acquisition. The factors that are involved in M&A1
Mergers & Acquisition

Acquisition of power

Acquisition of control

Merger & Amalgamatio n

A review of M&A in India Hari kishan,CCI,2009

INTRODUCTION
In an M&A process, any responsible management will require a comprehensive assessment of the possible legal risks related to the corporate status, assets, contracts, securities, intellectual property etc. of the target company concerned. The ideal structuring of the transaction, whether pre-deal or post-deal depends in numerous deals not only on financial and tax considerations but also on legal matters. In addition, the implementation of the ideal transaction structure often requires complex corporate legal documentation. The negotiation of the transaction will in most cases require the intervention of a legal expert as numerous legal pitfalls need to be tackled as early as at the negotiation table. The drafting of the transaction contracts and related documents cannot be done without the special attention from a business-minded lawyer.

Origin of the term Due Diligence

The term "due diligence" first came into common use as a result of the United States' Securities Act of 1933. This Act included a defence at Sec. 11, referred to as the "Due Diligence" defence, which could be used by broker-dealers when accused of inadequate disclosure to investors of material information with respect to the purchase of securities. So long as broker-dealers exercised "due diligence" in their investigation into the company whose equity they were selling, and disclosed to the investor what they found, they would not be held liable for nondisclosure of information that was not discovered in the process of that investigation. The entire broker-dealer community quickly institutionalized, as a standard practice, the conducting of due diligence investigations of any stock offerings in which they involved themselves. Originally the term was limited to public offerings of equity investments, but over time it has come to be associated with investigations of private mergers and acquisitions as well. The term has slowly been adapted for use in other situations.

Due Diligence in Detail

Due diligence is a program of critical analysis that companies undertake prior to making business decisions in such areas as corporate mergers/acquisitions or major product purchases/sales. The due diligence process, whether outsourced or executed in-house, is in essence an attempt to provide business owners and managers with reliable and complete background information on proposed business deals, whether the deal in question is a proposed acquisition of another company or a partnership with an international distributor, so

that they can make informed decisions about whether to go forward with the business action. The [due diligence] process involves everything from reading the fine print in corporate legal and financial documents such as equity vesting plans and patents to interviewing customers, corporate officers, and key developers. The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business action under consideration. The due diligence process is applied in two basic business situations: 1) transactions involving sale and purchase of products or services, and 2) transactions involving mergers, acquisitions, and partnerships of corporate entities. In the former instance, purchase and sales agreements include a series of exhibits that, taken in their entirety, form due diligence of the purchase. These include actual sales contracts, rental contracts, employment contracts, inventory lists, customer lists, and equipment lists. These various "representations" and "warranties" are presented to back up the financial claims of both the buyer and seller. The importance of this kind of due diligence has been heightened in recent years with the emergence of the Internet and other transformative technologies. Indeed, due diligence is a vital tool when a company is confronted with major purchasing decisions in the realm of information technology. A due diligence investigation should answer pertinent questions such as whether an application is too bulky to run on the mobile devices the marketing plan calls for or whether customers are right when they complain about a lack of scalability for a highend system. In cases of potential mergers and acquisitions, due diligence is a more comprehensive undertaking. The track record of past operations and the future prospects of the company are needed to know where the company has been and where its potential may carry it.

Due diligence Transactions

Due Diligence can be defined as 1. "The examination of a potential target for merger, acquisition, privatization or similar corporate finance transaction normally by a buyer. 2. A reasonable investigation focusing on material future matters. 3. An examination being achieved by asking certain key questions, including, do we buy, how do we structure the acquisition and how much do we pay?

4. An examination aiming to make an acquisition decision via the principles of valuation and shareholder value analysis. The Due Diligence process (framework) can be divided into nine distinct areas: Compatibility audit Financial audit Macro-environment audit Legal/environmental audit Marketing audit Production audit Management audit Information systems audit. Reconciliation audit It is essential that the concepts of valuations (shareholder value analysis) be linked into a due diligence process. This is in order to reduce the number of failed mergers and acquisitions. In this regard two new audit areas have been incorporated into the Due Diligence framework the Compatibility Audit which deals with the strategic components of the transaction and in particular the need to add shareholder value and the Reconciliation audit, which links/consolidates other audit areas together via a formal valuation in order to test whether shareholder value will be added. In business transactions, the due diligence process varies for different types of companies. The relevant areas of concern may include the financial, legal, labour, tax, IT, environment and market/commercial situation of the company. Other areas include intellectual property, real and personal property, insurance and liability coverage, debt instrument review, employee benefits and labour matters, immigration, and international transactions. IPO: Due Diligence During the due diligence phase, the company, its underwriters, and their attorneys will focus on the registration statement. This phase will require the company to thoroughly review its

business and to substantiate all claims in the registration statement. For example, if a company claims that it "will have significant first-mover and time-to-market advantages as a software-based solution in the Internet postage market," the company must be able to back up that claim. Indeed, the Securities and Exchange Commission may ask for such data. This review may also uncover additional information that needs to be addressed or disclosed. Besides inspecting the registration statement, the underwriters and counsel for both parties will also question company officers and key employees. This will include a thorough discussion of the company's business and marketing plans, revenue projections, product development road map, and intellectual property portfolio, with an emphasis on identifying potential pitfalls. The due diligence team will also speak with third parties, such as customers, retailers, and suppliers. After all, problems with partners in the supply and distribution chain can cascade back to the company itself. For example, a financially troubled customer may tie up a company's inventory in a bankruptcy court proceeding, or a supplier of a key component may face an extended shutdown as it irons out Y2K-related problems with its factory automation software. This attention to detail is required for both brand-new dot.com companies and well-seasoned corporations alike. Even Goldman Sachs, a veteran investment banking firm, provided this litany of risk factors in its registration statement. Example: Goldman Sachs Registration Statement

Due Diligence Considerations, Process & Timing

Buyer Due Diligence (DD) on a business (going concern) acquisition is the process of verifying that a prospective buyer is purchasing what he THINKS he is purchasing, and that the information he has been provided thus far by brokers and sellers is accurate within a reasonable degree of tolerance to the buyer. Due to serious concerns about confidentiality, disruption of current and future business, and time and expense, in depth DD is generally conducted after a binding agreement is in place and earnest money has been provided. Earnest money is refunded only if specific contingencies cited in the agreement are not met, (such as financing) or if due diligence uncovers material facts in dispute with the prior representations on which an Offer, or at least an LOI (letter of intent) was based. Some degree of exploration and analysis of the business, its viability, and its fit with the buyer

prospects experience, skills, and financial resources should begin the minute a buyer starts considering the opportunity. No one in the process wants to waste time, money and energy on a deal that cannot or will not happen. Many times the exploration process will not get past the first look at the offering prospectus or first meeting, as one side or the other recognizes this deal is not mutually beneficial. If there are brokers or alternative advisors representing the buyer and seller, he or she will understand the buyers need for information to make a decision, and also the need to respect the sellers confidentiality. So, the process will go step by step with additional information provided as a buyer is apparently more qualified and serious. This article focuses on the DD that will occur when a buyer gets past the initial stages and has come to some terms with the seller. Once there is an agreement in place, DD is a mandatory step in purchasing any business. Put simply, a buyer must do his homework, and know precisely what he is buying. This may be relatively painless with an honest seller and well organized business, presented by a professional broker. But, it can be a trying process, especially if a business is not well organized, the seller has something to hide, and/or a buyer is not both reasonable and prepared for the investigation. Buyers are encouraged to engage the assistance of a CPA with some small business experience to make the process far more efficient and productive. In depth due diligence is not a free look period in which a buyer can decide if he likes or does not like anything at all about the business. Extensive DD simply cannot occur with every prospect on a business. The seller cannot be asked to commit the kind of time and energy, and expense for advisors, potential exposure to employees, vendors and customers required for due diligence of his on-going business unless a buyer is committed to the purchase. Measurable contingencies and due diligence requests should be precisely listed at the outset of the process, often in the LOI or Offer document, or through the provision of a DD list. The objective is to ensure the buyer gets all the material facts required to make a fully informed decision and assessment of the true condition of the business while not disrupting the sellers business unduly. To this end, timing is critical. Generally, a buyer has 2 -3 weeks to accomplish this process while working around the schedules of the seller, the sellers accountant, and their own accountant. It is best to work out some type of planned schedule in advance so everyones expectations are met and we do not have disagreements or unnecessary delays.

Pre-Offer or LOI, most buyers will already have obtained and reviewed financial statements

and tax returns in order to define the price and terms that will work for the deal. If not, this is step one. Many businesses require outside financing, and no deal will take place without this, so at least a loan proposal is commonly required before any other DD that involves the sellers time begins. If a lender is providing financing, the buyer essentially has a secondary DD partner; the lender will be conducting their own DD, and they generally have a lot of experience with this. Financials will be analysed, and the fact that the tax returns were indeed filed and accepted by the IRS will be verified by the lender. Once a buyer has a loan proposal, or even better, a loan commitment, the parts of due diligence that open the seller up to exposure and potential business damage, can begin. If there are any other major contingencies, these should be tackled next. For example, insurance is an issue for many businessesworkers comp, liability, fleet, contractors. It is often best to start with the current providers, but only with the sellers permission and even an introduction. Financial DD should be scheduled during this time, as it will generally entail coordinating meetings with several people. Often the best route is to have the sellers CPA meet with the buyers CPA, with any information not available at the CPAs office to be provided by the seller. If the sellers accounting records are available via QuickBooks or Peachtree Accounting, and do not contain the type of proprietary info that should not be handed over until closing, the buyer will have the luxury of looking at the accounting records at their own leisure. Otherwise, this may be done with some restrictions in the accountants or sellers office. If any reports, customer or vendor accounts appear unusual in any way, a paper trail can be followed to track orders, billings, deposits, etc. Financial DD on most small businesses can be accomplished in 1-2 days of focused work if everyone co-operates. The closing attorney or buyers attorney will do a lien and law suit search, and work with the seller to clear any old liens that may be incorrectly showing as active. Other liens will generally be cleared at Closing with payments made directly to lenders or creditors by the Closing attorney with funds from the transaction. If any problems are uncovered, the buyer will be informed.

Employment, asset, and operations questions not answered prior to DD should be addressed to the seller and/or their broker for responses. This is sometimes done in an interview session, or simply via e-mail, fax, etc. If the business has sellable inventory, this will need to be counted or the final amount being purchased somehow agreed-upon. The method needs to be decided ASAP so that an outside firm can be retained if needed. The inventory value should

be finalized the night before closing. Often a last minute adjustment cannot be made within the third party loan amount, so the parties need to decide how adjustments to the estimated inventory will be handled.

If there are key employees or customers that must be interviewed prior to closing, these meetings will only take place when all other contingencies have been met, unless the seller has already informed these people in advance of his intentions. The seller does not want the potential of a major change to disrupt his business unless the deal is virtually certain to close. The seller does not want to have to present a new person as the next owner of his business, only to have to take it back next week. Generally, employees find out that a business has a new owner after closing at a meeting, with refreshments. The new owners and the seller reassure the employees that THEY are the reason for the success of the business, and are very much wanted and needed by the new owners. If the new owner treads slowly in making major changes, most often all employees will stay on, as they have no reason to leave a job that they need and like, and lose their source of income. Buyers should have time to evaluate all employees in the working environment before deciding to terminate existing staff, especially since often times the new owner does not know how to run the business without those employees.

Customers of a business are typically only concerned about one thing: are their needs being met? They do not care if Joe or Sam owns the business, so long as your plans do not upset their prior working relationship with the business. Quality, service, on-time, at the price they were quoted, etc. is why they deal with the business in question. If there is an existing written contract, it may or may not be invalidated by a sale. Buyers should have their attorneys advise them as to the nature of the contract, with input from the seller. Many times, the contract will continue under new owners; or it may be assumable, or the buyer may need a new contract. If a new contract is required, the buyer clearly needs assurance that they can obtain a contract that can be signed subject to closing on the new business. Most businesses do not inform any of their customers about a change in ownership until after a sale. In fact, in order to ensure a continuity of relationships and a smooth transition, many sellers introduce their buyers as a partner who has begun working with them so that they can grow the business and better serve that customers needs. The seller remains in the background in case of any questions, and soon the customers are just as comfortable with the new owner as they were with the old owner . . . because their needs are being met!

The buyer also has many transitional tasks that are not so much DD on the business as set up requirements to ensure that the business will run smoothly the day after closing. These often involve an accountant and/or attorney who assists with the establishment of a new legal entity to purchase and hold the business assets, and all related tax IDs, licenses, bank accounts, etc. The seller and broker will also be a good resource for what accounts need to be contacted to ensure continuity of services, utilities, and purchases for the going concern. During due diligence, buyers may find some inconsistencies with what they previously were told or understood, or perhaps some anomalies in the business records. Naturally, these must be questioned, but a buyer should not over-react and assume this is fatal to a deal. Communication errors can and do occur with many parties to a deal, and small businesses often have do it yourself bookkeeping, which can lead to some interesting issues. However, many of these can be resolved. Neither principal should over-react to a DD hurdle or there will be no deal, and neither party gets what they want. Buyers and their advisors should speak with the seller and their advisors about their concerns so that the problems can hopefully be addressed. If a business turns out not to be as originally presented in terms of revenue, profits, personnel, contracts with customers, or assetsfactors which affect the value of a businessthen a renegotiation of price and terms will often be called for. On the other hand, no business is perfect (as the clich goes) and a buyer cannot expect to renegotiate based on a non-material difference. Normally, both sides of the deal will have spent a lot of time, energy and money getting to this point, and will have a true desire to make the deal work.

Case study
A company x wants to merge with company y. Company X and company Y are in the business of aviation but not in the same competitive circle.so X performs the following due diligence on company Y, and below is the possible due diligence report.

"Due Diligence" Investigation Check List 1. CORPORATE MATTERS a. Articles of Incorporation and by-laws of the Company and Seller. Hence company X performs whether it is abiding local laws b. Corporate minute books and stock transfer records of the Company Y. c. Central and state tax returns and related reports of the Company including:

d.

e. f.

g.

i. income tax returns, ii. audit reports of taxing authorities including descriptions of any open issues, iii. real estate tax bills and payment records, iv. personal property tax bills and payment records, v. franchise, license, capital stock, doing business, and similar tax reports, and vi. Any other material documents. Agreements and arrangements between the Company and Seller or any affiliate of the Company or Seller, including: i. stock subscription agreements, ii. loan, line of credit or other financing arrangements, iii. tax sharing agreements or arrangements, iv. overhead allocation agreements or arrangements, v. management services or personnel loan agreements or arrangements, vi. guarantees or keep-well arrangements for the benefit of creditors or other third parties, and vii. Any others. Shareholder agreements relating to stock of the Company or stock owned by the Company. Documents imposing restrictions or conditions on stock transfer or merger, including any arrangements granting rights of first refusal or other preferential purchase rights. Third-party or governmental consent or authorizations required for merger or acquisition.

2. FINANCIAL MATTERS a. Financial statements, including: i. audited financial statements for all periods beginning on or after 19, consisting, in each case, of at least a balance sheet and income statement, ii. interim monthly unaudited financial statements for periods after the latest audited statements, and iii. Working papers relating to the foregoing. b. Bank accounts and depositary arrangements. c. Credit agreements and credit instruments including loan agreements, notes, debentures and bonds, and files relating thereto. d. Performance and financial bonds. e. Letters of credit. f. Instruments or arrangements creating liens, encumbrances, mortgages, or other charges (including mechanics ) on any real or personal property of the Company, including property held indirectly through joint ventures, partnerships, subsidiaries or otherwise.

g. Receivables analysis including aging, turnover and bad debt experience. 3. MANAGEMENT AND OPERATIONS a. Internal management reports and memoranda. b. Policy and procedures manuals including those concerning personnel policy, internal controls and legal and regulatory compliance. c. Budgets, financial projections, business plans and capital expenditure plans. d. Contracts and arrangements for supplies or services, including the following which were entered into or under which work was done during the past ^ years: i. contracts for the sale or purchase of real estate, ii. contracts for the purchase or sale of materials, equipment or other personal property or fixtures, iii. contracts or other arrangements for legal, accounting, consulting, brokerage, banking or other services, and iv. Construction and engineering contracts or subcontracts. e. Proprietary information and documents, including: i. patents and patent applications, ii. copyrights, iii. trademarks, service marks, logos and trade or assumed names, iv. non patentable proprietary know-how, v. federal and state filings relating to any of the foregoing, vi. licensing agreements relating to any of the foregoing (whether the Company is a licensor or licensee), and vii. Confidentiality agreements relating to any of the foregoing. f. Partnership or joint venture agreements to which the Company is a party and any other arrangements with third parties concerning the management or operation of properties, facilities or investments of the Company. g. Reports to management, board of directors or shareholders prepared by outside consultants, engineers or analysts. h. Closing documentation and related files for each prior sale of Company stock and each material asset purchase or sale by the Company during the past ^ years. i. Leases, deeds and related instruments, including without limitation, office premises leases, equipment or vehicle leases, and any such instruments held indirectly through joint ventures, partnerships, subsidiaries or otherwise. j. Agreements or arrangements granting rights of first refusal or other preferential purchase rights to any property of the Company. k. Other material agreements or arrangements. 4. EMPLOYEE MATTERS a. Corporate policies concerning hiring, compensation, advancement and termination.

b. Labour contracts together with a list of all labour unions that have represented or attempted to represent employees of the Company during the past ^ years. c. Agreements with individual employees, including: i. executive employment agreements, ii. bonus, profit-sharing and similar arrangements, iii. postemployment agreements including "salary continuation" and "golden parachute" arrangements, and iv. Covenants not to compete by present or former employees. d. Names of any officers or key employees who have left the Company during the past years. e. Each of the following which the Company maintains or contributes to, together with filings with the Internal Revenue Service, Pension Benefit Guaranty Corporation (PBGC), Securities and Exchange Commission and Department of Labour, including without limitation Forms 5500 and 5310, summary plan descriptions, summary annual reports, IRS determination letters (for qualified plans), and PBGC reportable events: i. Union-sponsored multiemployer plans, ii. Defined benefit plans, iii. Defined contribution plans including: 1. money purchase pension plans, 2. profit-sharing plans, 3. stock bonus plans, 4. employee stock ownership plans, and 5. savings or thrift plans, iv. Health and welfare plans, including: 1. medical, surgical, hospital or other health care plans or insurance programs including HMOs, 2. dental plans, 3. short-term disability or sick pay plans or arrangements, 4. long-term disability insurance or uninsured arrangements, 5. group term or other life or accident insurance, 6. unemployment or vacation benefit plans, and 7. other welfare plans, v. Nonqualified deferred compensation arrangements including: 1. director or officer deferred fee plans, 2. excess benefit plans (providing benefits in excess of internal revenue code limitations for qualified plans), and 3. severance pay plans, vi. Incentive or bonus plans including: 1. stock option plans, 2. stock bonus plans,

3. stock purchase plans, and 4. Cash bonus or incentive plans. 5. INSURANCE a. Insurance policies including those covering: i. fire, ii. liability, iii. casualty, iv. life, v. title, vi. workers' compensation, vii. directors' and officers' liability, and viii. Any other insured events or matters. b. Claim and loss histories, correspondence with insurance carriers and names of all insurance representatives relating to the foregoing. 6. REAL ESTATE AND EQUIPMENT AND OTHER PERSONAL PROPERTY a. List of real estate (with legal descriptions), equipment and other personal property owned, leased or in the process of being acquired or sold by the Company, with the cost and book value of each item. b. Real estate, equipment and other personal property leases and conditional sale agreements. c. Information relating to title on all property listed in the items above, including motor vehicle title documents. d. Appraisals of real estate, personal property and equipment. 7. GOVERNMENTAL REGULATION a. Licenses, permits, filings or authorizations obtained from, made with or required by any governmental entity. b. Correspondence with any governmental regulatory authority. c. Accident or injury reports to federal, state, local and foreign governmental entities. 8. LITIGATION AND CLAIMS a. Pending or threatened litigation, regulatory investigations, governmental actions, arbitrations, or notices of violation or possible violation, including proceedings in which the Company is a plaintiff or claimant, and the names and addresses of legal counsel advising or representing the Company in each matter. b. Files and records relating to the foregoing including opinions and evaluations. After all these checklists are verified then Company X decides whether it should merge or not. Hence the chance of success in merger increases.

The need of Due Diligence - conclusion

As stated above, the complete details of the company is evaluated and the health of company is determined, the need of due diligence increases with the money involved in the deal and through due diligence a good bargain can be struck by identifying the unnoticed litigations and expiry of patent should be identified and hence the investment option is more safe and calculated risks can be taken. On the other side it should be taken care that due diligence shouldnt amount to insider trading and so the companys should be careful when giving out the information and it should be monitored at every possible stage.

Bibliography
Web source www.mergersandacquisitions.in http://www.chinalawblog.com/xmlrpc.php www.indiacorpblog.blogspot.com www.lyonsolutions.com www.preservearticles/m&a.com www.legalserviceindia.com www.cciindia.org www.forbes.com

Other sources Live competition- shubhangi Mehta,DNA