Due Diligence: what is it, when and what is it used for?

If you are planning to buy or sell a business, as well as to merge (acquire) a company, then you need a comprehensive check of the investment object — Due Diligence.

Due Diligence: what is it, when and what is it used for?

What is Due Diligence?

The term Due Diligence was introduced into legal circulation in the United States at the beginning of the 20th century. Initially, it meant the procedure for disclosing information by a broker to an investor about a company whose shares are traded on the stock exchange. Currently, this term refers to the collection and analysis of information in order to assess the state of a business object and minimize various risks associated with investment. In various special fields of knowledge and practice, this term may have other meanings.

Classification (typing) due diligence can be carried out according to the nature of the object of study. In this regard, stands out:

  • due diligence of intellectual property objects, other intangible assets;
  • real estate due diligence;
  • due diligence of various corporate entities, such as hedge funds, holding companies, trust funds (trusts), other similar corporate or quasi-corporate structures.

When should I conduct Due Diligence?

Conducting due diligence — one of the functions of a comprehensive business research. The procedure helps to establish a trusting relationship in connection with the conclusion and conduct of a major transaction between counterparties. Due diligence is usually carried out when buying a business or part of it, when buying large objects (real estate, land), when selling a business, as well as when merging companies.

What are the goals of Due Diligence when selling or buying a business?

First of all, due diligence is aimed at an objective and full-scale verification of the planned transaction and its commercial attractiveness. In any transaction or investment project, the reliability and completeness of information about the object plays an important role. This allows business partners or investors to evaluate in more detail all the advantages and disadvantages of such a project.

Lack of due diligence can lead to poor financial results after a change of ownership, lawsuits and proceedings, tax and financial audits, and other unpleasant consequences.

What risks does Due Diligence help to avoid?

The purpose of the due diligence procedure — avoid or minimize existing business risks, namely:

  • acquisition of a company (block of shares) at an inflated cost;
  • default by the debtor enterprise;
  • loss of property, money;
  • causing harm (losses), incl. intangible assets, such as goodwill;
  • initiating lawsuits and their adverse consequences;
  • seizure of property or application of other interim measures;
  • recognition of the transaction as invalid;
  • foreclosure on property, securities (shares);
  • bringing to tax, administrative or criminal liability;
  • corporate conflicts (takeover, takeover, litigation);
  • loss of intellectual property (trademark, industrial design, invention, know-how, commercial idea, business plan, etc.);
  • political risks and the risk of loss of administrative resources (changes in legislation, changes in the official on which the success or stability of the respective project depended, criminal prosecution);
  • unfair actions of competitors (collusion with contractors, initiation of "custom" tax, operational audits, pricing policy, lobbying of interests, etc.);
  • failure or loss of relevant permits, licenses, approvals, etc., on which the project, transaction, etc. depends

All parties to the transaction are interested in the objective and competent conduct of these procedures.

What is included in the Due Diligence procedure?

During the provision of due diligence services, the customer can choose an audit consisting mainly of three stages (in some cases two: audit + legal expertise).

Stage 1. Evaluation of the investment object

The purpose of this stage of work — show the true value of the business depending on the options for its further use (market, investment or liquidation).

Stage 2. Audit of the accounting and tax accounting system

The purpose of the audit is to conduct a financial audit, an examination of the company's activities, as well as the allocation of tax benefits and risks.

At this stage, the following work is carried out:

  • Analysis of the structure of income and expenses of the audited company;
  • Evaluation of the internal control system;
  • Analysis of fixed assets, financial investments, receivables and payables, company stocks;
  • Analysis of loan agreements and liabilities, analysis of contingent liabilities, completeness and reliability of accounting for assets and liabilities.

The final stage of the — highlighting potential tax risks and rewards, as well as identifying and quantifying potential tax liabilities that a company has.

Stage 3. Due diligence

The task of the stage is to conduct a legal and legal examination of the company's constituent documents, in order to maximize the risks associated with its purchase.

Lawyers carry out the following complex of works:

  • Overview of constituent documents, their legal status;
  • Overview of corporate governance documents, decisions of collegial governing bodies and main powers of attorney;
  • Analysis of transactions with shares (stakes) of the company, information about shareholders, their property and non-property rights;
  • Analysis of the legitimacy of the company — availability of necessary licenses, permits, certificates;
  • Labor relations analysis.

Lawyers also evaluate the main contracts of the company in order to identify adverse consequences for the buyer.

What is the result of Due Diligence?

  • Business valuation report.
  • Analysis of the structure of the company's income and expenses for the analyzed period;
  • Assessment of the internal control system in terms of document flow related to the company's expenses. Selective analysis of the quality and completeness of documents confirming the company's expenses;
  • Analysis of fixed assets: total composition, accrued depreciation, revaluation results (if any);
  • Analysis of the company's financial investments (structure, timing, documentary evidence);
  • Analysis of receivables, incl. unconfirmed;
  • Analysis of accounts payable, incl. overdue;
  • Analysis of loan agreements and obligations, the composition of creditors / lenders and the amount of funds raised, the conditions for attracting loans and borrowings;
  • Analysis of contingent liabilities (fines; penalties; guarantees issued to secure debts of third parties; endorsed bills; claims brought against the company; pledges and other real encumbrances of the company's property);
  • Analysis of the completeness and reliability of accounting for assets and liabilities reflected off the company's balance sheet;
  • Identification, compilation and, if possible, quantification of all significant tax risks, unaccounted for and (or) potential tax liabilities that the company has.
  • Legal report.

Who conducts Due Diligence?

Conducting due diligence usually requires an integrated approach. Of course, the complexity depends on the nature of the acquired object. Legal and economic aspects — this is the minimum set of relationships to be investigated in the process of due diligence.

The check can be carried out both by the buyer himself, and with the involvement of consultants and experts. The team must necessarily include financial/accounting and legal staff, but it can also include economists, engineers, environmental experts and other specialists. The successful implementation of the procedure depends on the clear and coordinated work of appraisers, auditors and lawyers, as well as on the timely presentation of reliable information by the seller.

Upon completion of all stages of teamwork aimed at a comprehensive verification of the legality and commercial attractiveness of the planned transaction or investment project, based on the information provided and processed, the performer of the due diligence procedure generates a conclusion that allows investors to draw conclusions and evaluate all the advantages and disadvantages of the analyzed cooperation , so necessary for subsequent decisions. This work should be entrusted to the appropriate specialists. One of such professional teams operating in the international market, — this is Russian-Eurasian Business Broker (REAB).

4/18/23
Julia Taraday, REAB Consortium
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