Background Material

on
Due Diligence

Committee on Internal Audit

The Institute of
Chartered Accountants of India
(Set up under an Act of Parliament)
 O 3 901 21

Background Material
on
Due Diligence
 The Institute of Chartered Accountants of India
All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any
form, or by any means, electronic, mechanical, photocopying, recording, or otherwise, without
prior permission, in writing from the publisher.

First Edition: January 2008

Price: Rs 350

ISBN No. 978-81-8441-015-0

E-mail: cia@icai.org
Website: http://www.icai.org

Published by
Vijay Kapur, Director
The Institute of Chartered Accountants of India
‘ICAI Bhawan’, Indraprastha Marg
New Delhi - 110 002 INDIA

Cover & Illustrations

Narendra Bhola

Realisation
Sterling Preferred Printing
Background Material
on
Due Diligence

Committee on Internal Audit

The Institute of
Chartered Accountants of India
(Set up under an Act of Parliament)
 Contents

Foreword
Preface

CHAPTER 1
Introduction to Due Diligence.....................................................................01

CHAPTER 2
Approach to Due Diligence ..........................................................................07

CHAPTER 3
Due Diligence for Mergers and Acquisitions ...........................................12

CHAPTER 4
Due Diligence for Venture Capital Investment.......................................99

CHAPTER 5
Due Diligence for Franchisee Arrangement ..........................................104
 Contents

CHAPTER 6
Challenges and Risks Covered in Due Diligence Process ..................108

CHAPTER 7
Work Approach for Due Diligence............................................................117

CHAPTER 8
Summary.........................................................................................................132

APPENDICES
I Open House Discussion - with Sample
Questions and Answers ..................................................................137

II Group Exercise.................................................................................169

III Glossary of Salient Terms..............................................................171

Answers to Questions in Chapter One.....................................................174

 Foreword

W
ith the all round steady growth being witnessed by the Indian economy,
dramatic restructuring of companies in the form of amalgamations,
acquisitions, mergers and joint ventures has become common. It is in
this context that assessing the potential risks of a proposed transaction by inquiring
into all relevant aspects of the business to be ventured has become indispensable.
Thus the importance of 'Due Diligence'.

The Institute on its part has been working quite proactively to help members
sharpen their skill sets in all the emerging areas of professional relevance by way of
technical literature as well as conferences, workshops etc. I am pleased to note that
the Committee on Internal Audit of the Institute is issuing this comprehensive
background material on 'Due Diligence'.

I congratulate CA. Abhijit Bandyopadhyay, Chairman, Committee on Internal

Audit and other Committee members on the issuance of this publication.

I am sure that this book will be of immense help to the members and other interested
readers.

29th January, 2008 CA. SUNIL H. TALATI

New Delhi President, ICAI
 Preface

T
he Committee on Internal Audit has immense pleasure in placing before the
members the background material on “Due Diligence”.

Corporate acquisitions/mergers/takeovers have become a part of business strategy

to grow rapidly and widely. Due Diligence is used to investigate and evaluate a
business opportunity. It involves an analysis carried out before acquiring a
controlling interest in a company. Irrespective of the nature of takeover, be it hostile
or friendly, it is quite normal for the buyers to seek an independent due diligence
report in respect of their target acquisitions. Here lies the scope of a professional to
conduct due diligence process on behalf of their clients for proper evaluation of the
vendor.

In light of this recent development, it is felt that the members require to be equipped
to avail the emerging opportunity of undertaking due diligence exercise.
Accordingly, to meet this purpose, the committee has brought out this Background
Material on Due Diligence for assistance of the members. It is also aimed at being
used as a background material for Training our members in this area which
requires specialised skill.

Through this background material an attempt has been made to answer many of the
queries that may be raised by the investigating Chartered Accountants. With a view
to providing appropriate guidance in a manner that is easily understood by all the
readers, this background material is divided into eight main chapters sequentially
as Introduction to Due Diligence, Approach to Due Diligence, Due Diligence for
Mergers & Acquisitions, Due Diligence for Venture Capital Investment, Due
Diligence for Franchisee, Challenges and Risks Covered in Due Diligence Process,
Work Approach for Due Diligence, and Summary. In addition, the material consists
of Appendices containing Open House discussion- with sample questions and
answers, Group Exercise, and Glossary of Salient Terms for better understanding of
the readers.

I am extremely grateful to CA. Amitava Basu, for sparing time out of his
professional and personal preoccupations and sharing his wealth of experience in
the area of due diligence in the form of this Background Material. I am obliged to CA.
Sunil H. Talati, our President and CA. Ved Jain, our Vice President for giving me
this opportunity. I also wish to thank my colleagues in the Committee on Internal
Audit, CA. Charanjot Singh Nanda, CA. Shanti Lal Daga, CA. Rajkumar S. Adukia,
CA. Amarjit Chopra, CA. Sanjeev K. Maheshwari, CA. Mahesh P. Sarda, CA. Atul
C. Bheda, CA J. Venkateswarlu, CA. Anuj Goyal, Shri Manoj K. Sarkar CA.
Prashant S. Akkalkotkar, CA. Krishan Lal Bansal, CA. Vivek R. Joshi, CA. Shyam
Lal Agarwal, CA. Brij Bhushan Gupta, CA. Anil Jain and CA. Satyavati Berera for
their invaluable guidance and support in giving final shape to this Background
Material. I would also like to place on record my sincere thanks to Mr. Vijay Kapur,
CA. Puja Wadhera and the whole team of CIA secretariat for their untiring effort to
bring out this publication.

I am confident that this Background Material will go a long way in helping the
members understand the fundamental concepts of Due Diligence and sharpen their
skill sets in this area.

CA. ABHIJIT BANDYOPADHYAY

28th January, 2008 Chairman
Kolkata Committee on Internal Audit
1 Introduction to
Due Diligence

Introduction
A worldwide earthquake of activity is shaking the foundations of traditional business
thinking. It is generating a tidal wave of economic as well as social growth and
prosperity. Economic value and wealth creation has accelerated to unprecedented
levels. Global capital market is expected to grow about 10 times in less than 10 years,
unleashing undreamed of possibilities and solutions to longstanding problems.
Though capital and trade have faced shifts around the world for centuries, certain
powerful factors such as faster communication and decision-making, emerging global
investors and financial markets, and converging consumer expectations across
previously distinct regions have permanently altered the face and pace of economic
activity.

Under these circumstances dramatic restructuring of companies in the form of

amalgamations, acquisitions, mergers, and joint ventures has almost become a
norm. New business structures through public-private partnerships, concession
arrangements, etc. also have emerged. It is in this context that assessing the
potential risks of a proposed transaction by inquiring into all relevant aspects of the
past, present and predictable future of the business to be ventured has become
2 Background Material on Due Diligence

quintessential. This exercise is referred to as 'Due Diligence'.

What is Due Diligence ?

Due diligence is used to investigate and evaluate a business opportunity. It implies
a general duty to exercise care in any transaction. Most legal definitions of due
diligence describe it as a measure of prudence activity, or assiduity, as is properly to
be expected from, and ordinarily exercised by, a reasonable and prudent person
under the particular circumstance; not measured by any absolute standard but
depends on the relative facts of the special case. In other words, making sure one
gets what one thinks he/ she is paying for. Due diligence is a process of investigation,
performed by investors, into the details of a potential investment such as an
examination of operations and management and the verification of material facts. It
entails conducting inquiries for the purposes of timely, sufficient and accurate
disclosure of all material statements/information or documents, which may
influence the outcome of the transaction. Due diligence involves an analysis carried
out before acquiring a controlling interest in a company to determine that the
conditions of the business conform with what has been presented about the target
business. Also, due diligence can apply to recommendation for an investment or
advancing a loan/credit.

Need for Due Diligence

When a business opportunity first arises, it continues throughout the talks, initial
data collection and evaluation commence. Thorough detailed due diligence is
typically conducted after the parties involved in a proposed transaction have agreed
in principle that a deal should be pursued and after a preliminary understanding
has been reached, but prior to the signing of a binding contract. There are many
reasons for carrying out due diligence including:
+ To confirm that the business is what it appears to be;
+ To identify potential 'deal killer' defects in the target and avoid a bad business
transaction;
+ To gain information that will be useful for valuing assets, defining representations
and warranties, and/or negotiating price concessions; and
+ To verify that the transaction complies with investment or acquisition criteria.
 Introduction to Due Diligence 3

Difference Between Due Diligence and Audit

It needs to be underlined that due diligence is different from audit. Audit is an
independent examination and evaluation of the financial statements of an
organization with a view to express an opinion thereon. Whereas, due diligence
refers to an examination of a potential investment to confirms all material facts of
the prospective business opportunity. It involves review of financial and non-
financial records as deemed relevant and material. Simply put, due diligence aims
to take the care that a reasonable person should take before entering into an
agreement or a transaction with another party.

Some Basics
The two questions that frequently arise in the context of due diligence for venturing
into a target business are :
1) What is expected from the due diligence process?
2) How can the confidential information be protected while still moving the
process forward?

The answer to these questions may vary depending on a number of characteristics

of the acquiring company and the target business, that include size, maturity,
process orientation, public or private, and competition for the deal. However, in
general, the following are the common matters the due diligence process is expected
to cover:
a) General Corporate Matters
b) Financial, Accounting and Taxation
c) Technology and Intellectual Property
d) Product/Service Offerings
e) Operations
f) Sales and Marketing
g) Human Resources and Personnel
h) Legal and Regulatory.

For each of the items listed above, there is need for proper documentation and
prioritisation. Also, it is important to see projections, reports and other documents
4 Background Material on Due Diligence

actually used by the target company, as opposed to specially created projections and
reports just for this process. Eventually, anything that could be material enough to
affect the valuation of the business is to be carefully examined and considered. As it
may not be possible to know what is material until the exercise proceeds, the initial
due diligence list can be overly long with a number of items that may be irrelevant.
This involves visiting the offices of the target company and speaking to most of the
top management team.

Apart from due diligence from the buyer's side, there is also usually a requirement
of similar exercise from the seller's side. This aspect covers three main items as
discussed below:
a) Gauging the seriousness of the potential buyer:
This involves evaluating the financial ability of the potential buyer to acquire
and run the business:
+ Does the buyer have cash to make a cash deal?
+ Does the buyer already carry a large debt burden or has the ability to finance
the deal?
+ In case of a public limited company is it feasible to consummate a stock deal?
+ Does the buyer have a clear and realistic plan on how the deal will be
structured and financed?

b) Evaluating the means of initial contact:

+ Was it through a senior executive or board member or through a person with
less authority?
+ If it is through an intermediary, how credible is the intermediary and is it
formally representing the buyer?

Protecting Confidentiality of the Information

Staging the flow of confidential information based on the overall progress of the
transaction is one of the best means of protection. In other words, less sensitive
information should be shared initially, and as the potential buyer progresses and
shows seriousness; more sensitive information could be shared. It forces the
potential buyer to earn the more sensitive information and limits the number of
 Introduction to Due Diligence 5

parties who see the confidential records.

The phasing of information flow could follow the pattern mentioned below:
+ The first phase consists of information that are already in public domain.
+ The next phase consists of information that is typically heavier on current and
historical matters than on forward-looking projections. Quite a bit of
confidential company information is disclosed at this stage, but very little that
is competitively sensitive.
+ The third phase involves the most sensitive company information, including
projections, customer information and any other information requested by the
buyer deemed too sensitive to share earlier in the process.
+ Finally, the accounting and legal due diligence is usually at the end of the
process. This phase is last more for reasons of larger number of people involved
and cost than for confidentiality reasons.

Warning Signs
Throughout the process, it is essential for the target seller to continually evaluate
the potential buyer. This can be achieved by focusing on aspects such as:
+ The Due Diligence Team - size of the team, time spent by the team, composition
of the team for example, whether professionals such as investment bankers,
lawyers and accountants have been deployed for the exercise.
+ Activities and Apparent Intention of the Team - the seller should assess whether
the buyer's team is apparently only fishing for information that is not critical to
the deal but could be important to a competitor
+ Level of People Involved - the seller should assess the level of people involved
from the potential buyer's side. Typically, there is mostly management level
involvement in the early process and more operational people and specialists
come later.
6 Background Material on Due Diligence

QUESTIONS

Question 1.1
What does Due Diligence mean?

Question 1.2
What does Due Diligence require?

Question 1.3
How is Due Diligence conducted?

Question 1.4
How much Due Diligence needs to be conducted?

Question 1.5
Can Due Diligence efforts be overdone?

Question 1.6
How Much Time is allocated for Due Diligence Completion?

Question 1.7
How should tasks within the Due Diligence efforts be prioritised?

Question 1.8
How to maintain confidentiality during a Due Diligence engagement?

Question 1.9
Does Due Diligence ensure that a business transaction will be successful?
2 Approach to
Due Diligence

Due Diligence is the process whereby a potential investor accesses the target
company's books and records to verify that all of the information provided thus far is
true and accurate. Often, people think that due diligence is simply an exercise to
verify the financial position of the company. While this is true to some extent, a proper
and effective due diligence goes past the financials.

The Right Approach to Due Diligence

Is this the time to look for things that are wrong with the business? Is this the time
to strictly verify numbers? Is this the time to disprove what the investor has been
told by the target company? While each of these approaches is somewhat valid none
are absolute. While the investor would want to employ a part of each of these
strategies, an effective due diligence is when one can really "check things out". This
exercise is to be used to determine whether the future looks bright for the business
and the industry. To do so, the investor must investigate far more than the financial
aspect. Sure, the various financial statements will give the investor a picture of the
past and perhaps a glimpse of the future but the past is over and done with. The
investor must, therefore, thoroughly review the company's sales, marketing,
employees, contracts, customers, competition, systems, suppliers, and legal and
8 Background Material on Due Diligence

corporate issues. The investor wants to complete the due diligence exercise knowing
exactly what one is getting into, what needs to be fixed, what the costs are to fix and
if one is the right person to be at the helm to put the plans in place to make a great
future for the business.

Due Diligence Period

Target companies normally try to negotiate the shortest due diligence period
possible. However, it is impossible to understand a business in a short time. Even
for the smallest of companies, an investor would ordinarily need no less than 20
working days. Since a proper investigation reaches farther than just financials the
investor must negotiate for adequate time to accumulate the information. For this
purpose, the target company should be clearly communicated all that would be
investigated. It should also be made clear to the target company that if it truly
wants the deal to move forward it must allow the potential investor adequate time to
do the proper investigations.

Preparation
Preparation for due diligence begins the moment it is believed that the business
may be worth pursuing. After the investor meets the target company's authorities
the first time and believes that one may be interested one should begin to organise
one's plan. The first step in this direction is preparing lists and noting areas and
specific details related to the business that need further review. Once the investor
gets closer to a decision to go for the deal detailed, "to do" lists need to be maintained,
broken down for each aspect of the business (i.e. Financials, Employees, Sales,
Contracts, etc.). The target company should be kept informed of when the investor
anticipates beginning the due diligence. Lists of the materials needed from the
target company should be first assembled and never the due diligence exercise
should begin until the investor has received all of the supporting documents that
one needs from the target company.

Getting the Target Company and its Staff to Cooperate

The target company must let its people know that they are to provide one with full
access to all files and complete cooperation throughout the investor's
investigation.
 Approach to Due Diligence 9

What if Surprises are Found

This should probably be titled: "What to do "WHEN" surprises are found" because this is
likely to happen. On the contrary, if surprises are not found, it may imply that the
examination has not been thorough enough. The Due Diligence team needs to deal with
each on its own and make sure that each is thoroughly investigated so that the facts are
foolproof. However, the exercise should not be bogged down with minor issues and these
have to be taken as "part of the due diligence package". Unless something is found that
cannot be resolved or is so detrimental that even if the target company significantly
lowers the acquisition price, the potential buyer would still walk away from the deal, it is
best to take all of these obstacles in stride. Do not publicise them; investigate them. A few
issues do not mean that the business is bad. The items or issues must be appropriately
weighed with reference to the impact against the future viability of the business. It
should be remembered that the goal is to learn what the potential buyer would be getting
into and what the future can be with the investor in charge. The option always exists for
the investor to renegotiate once the investigation is completed. The investor will be in a
much stronger position if one can go to the entrepreneur with very specific concerns,
which require reevaluation and renegotiation. With this in mind, the findings should not
be discussed with anyone except the accountant or other advisors.

Applications
Most business managers routinely develop critical relationships with new suppliers
and customers without much forethought. However, making assumptions about
the integrity and ethical standards of the customers and suppliers can leave the
business vulnerable. Businesses sometimes find themselves in difficult situations
that could have been avoided had they conducted thorough background checks. For
example, a “friend” might have been hired to run a new startup, not knowing that he
had defrauded a former employer. The mistake of giving him sole signing authority
on the startup's accounts may result in victimisation about six months later.
Another example could be of an individual from another country claiming that he
can broker a substantial financing for the potential buyer, who then engages his
services. It is, however, subsequently learnt that this engagement is far beyond the
scope of his experience and capability, and that there are some unsavory aspects to
the people he represents.

Integrity Due Diligence therefore, is a process of gathering and analysing

10 Background Material on Due Diligence

information to assess whether or not one wants to do business with a person or

company. This intelligence will allow one to make informed decisions and can
reduce or eliminate any number of possible risks.

There is a host of legal and ethical information available to help one protect oneself
and the business. Most people think that checking references or “asking around” is
enough. However, when someone provides with a reference, he usually nominates
someone he has hand picked. To get a truly objective feedback a different and much
deeper approach is needed to be taken. A comprehensive review could include areas
such as:
+ Civil litigation history - These records are available on a jurisdiction-by-
jurisdiction basis, so knowing where to look is very important.
+ Writs of execution - A writ is issued when a judgment has been issued in a civil
trial but has not been paid. A writ may be the only evidence of an important case.
+ Criminal records - An important check, but it should not stop there. Much of the
fraudulent or unethical behaviour in business are civil matters that do not
result in criminal prosecution or charges.
+ Current charges - A criminal records check will indicate only prior convictions.
It also needs to be known if there are any current charges that have not yet gone
to court.
+ Corporate affiliations - What are other associations? What is the nature of the
involvement? What is the history and reputation of these businesses?
Commercially available databases of corporate information can help, as can
state and national level records.
+ News media - A full range of media should be checked; from small local
newspapers to the national dailies, as well as industry periodicals and
international sources.
+ Internet - The Internet has provided a publishing medium to the masses.
Someone may have communicated information about the potential business
partners that is not in the press but from which one might benefit.
+ Credit reports - Available through credit-rating companies such as CRISIL,
ICRA, etc. credit reports can provide a lot of useful information on companies
and individuals. Personal credit reports are available only with signed consent,
but this is not a requirement for obtaining a credit report on a company.
 Approach to Due Diligence 11

+ Insolvency filings - Have the individuals ever filed for, or been petitioned into
insolvency ? What were the circumstances?

When Should Integrity Due Diligence be Considered

When an investor is looking to enter a new business relationship, it should be
considered important to conduct background checks. Examples include:
+ Reviewing potential suppliers
+ Entering into a licensing agreement
+ Reviewing prospective joint venture partners
+ Entering new markets
+ Reviewing existing customers
+ Reviewing potential merger or acquisition targets
+ Reviewing individuals who wish to broker opportunities for investing company,
including financing, property development, new markets, etc.

The time and money invested in integrity due diligence just might save the investor
from a significant business risk.
 Due Diligence

3 for Mergers
and Acquisitions

Mergers, Acquisitions and Takeovers

Expansion either by entering a new market or through expansion in an existing
market is becoming a common trend. In that context, Indian business houses are
increasingly resorting to mergers and acquisition as a means to growth.

Mergers result in combination of two or more companies into one, wherein the all or
all except one merging entities loose their identities. No fresh investment is made
through this process. However, an exchange of shares takes place between the
entities involved in such a process. Generally, the company that survives is the
buyer, which retains its identity, and the seller company is extinguished.

A merger can also be defined as an amalgamation of all assets and liabilities of one
company transferred to the transferee company in consideration of payment in the
form of equity shares of the transferee company or the venture or cash or of a mix of
above modes of payments.

An acquisition, on the other hand, is aimed at gaining a controlling interest in the

 Due Diligence for Mergers & Acquisitions 13

share capital of the acquired company. It can be enforced through an agreement

with the persons holding a majority interest in the company's management or
through purchasing shares in the open market or purchasing new shares by private
treaty or by making a take over offer to the general body of shareholders.

The takeover, which is essentially an acquisition, differs from the merger in its
approach to business combination. In the process of takeover, the acquisitioning
company decides the maximum price and form that is to be offered to the acquired
and hence takes lesser time in completing the transaction than in mergers. In
merger transactions, the consideration is paid for in shares whereas in a takeover,
the consideration is in the form of cash. However, mergers and takeovers can be
treated as similar process since in both cases at least one set of shareholders looses
an executive control over a company, which they otherwise hold.

Mergers and acquisitions are prominent in the business world and due diligence is a
vital aspect of that activity. Due diligence is used by Mergers and Acquisitions
(M&A) professionals, to cover the data-gathering exercise which is a necessary
precursor to any M&A deal.

Due diligence is undertaken by the buyer in an attempt to gain an understanding of

the business that it is proposing to acquire (the target). It is also one of the key
means by which the buyer seeks to gain information that it will use to negotiate the
final price, a change in the terms of the deal, or both.

Price Negotiations
"Due diligence is an essential data-gathering exercise for any M&A deal."
Typically, the potential buyer will make an offer for the target company that is subject to
a range of conditions, including due diligence. In spite of the fact that it always happens
this way, the final price is more than likely going to be lower; and, that lowering is more
than likely going to be the result of what is found in due diligence. There has hardly been a
price negotiated upwards as a result of issues emerging from due diligence.

Strategic Secrecy
Traditionally, due diligence is a battleground. The seller wants to keep certain
14 Background Material on Due Diligence

information away from the potential buyer until the latest possible moment. In
particular, the seller will not want to disclose commercially sensitive information
such as customer names and actual prices. This is more likely if the buyer is a trade
competitor rather than an institutional buyer since trade competitors may pose as
potential buyers just to gather valuable information from the seller. In any event, if
the seller reveals too much too soon, it can kill the value of the deal.

Another aspect of this competitive issue is the problem of multiple disclosures in the
course of a sale exercise. An important issue is if ten bidders see the same
information, whether the value of that information gets diluted ten-fold. After the
deal is done and the business is sold, in spite of the confidentiality agreements that
will have been made between the seller and the (nine) other potential buyers, those
potential buyers will not obviously be able to un-learn what they have learned.
They will know things, which, although un-useable in any overt way because of the
confidentiality agreements, might be used covertly or even inadvertently.

Be Prepared
Sellers should consider how much due diligence they should undertake before
letting potential buyers anywhere near the target. The last thing the seller wants is
a nasty surprise being discovered by a potential buyer as they sift through the due
diligence material.

"Trade competitors often pose as potential buyers just to gather valuable

information."

In fact, sellers should do more due diligence than buyers. The seller should know
everything there is to know about the target company, the buyer should only get to
know a limited range of things. The seller should control the information flow. That
is only possible if it knows what information exists.

Caveat Emptor
Typically, buyer-side due diligence exercises are too broad and too unfocused on the
real value issues underlying the proposed deal. That is, there is too much reliance on
the volume of information that is requested and not enough consideration of the
 Due Diligence for Mergers & Acquisitions 15

specific aspects of the business upon which the 'buy' decision is, was or will be based.

Due diligence exercises tend to focus on the past (not least because there is a mass of
information on that). For example, how did the target company perform one, two,
three, or even five or six years ago, what are the accounts like for those years?
Further, some key issues, such as tax liability and other potential liability issues
can be found in the historical paperwork. However, if the buyer is valuing the
business on the basis of its future prospects, it should spend considerable time
assessing whether the target company has the ability to deliver on those prospects.

Other aspects normally investigated into by the potential buyers are the condition
of the machinery and equipment, the state of the order book and current contracts,
research and development activities of the seller, target-customer and target-
supplier relations, There is a host of forward-looking information which should be
looked at in great detail but which is often ignored or relegated to the 'if we have
time' pile.

Discreet Disclosure
For the seller, due diligence is typically seen as a necessary evil. However, there is
an alternative view. While accepting that, for the reasons given above, full
disclosure is not wise, the seller should consider whether more disclosure, rather
than less, is good for both price and potential liability.

At times, the seller may take a stand that though, during due diligence, the
potential buyer may decide to walk away from the deal, the initial price offered
cannot be changed. A seller can only take that confident stance if it has done its own
due diligence. In addition, a buyer will only entertain that approach if it is allowed
to undertake extensive and deep due diligence.

Things to Consider
Both the seller and the potential buyer should, therefore, think long and hard about
due diligence. Sellers should consider the value and process implications of high
quality, pre-sale due diligence. Identifying all the skeletons in the cupboards, as
well as all the potential gold mines, will (in either case) have a positive effect on the
16 Background Material on Due Diligence

negotiations.

Potential buyers, on the other hand, should identify the value in the deal, assess as
to why the business is being sought. Whereas history of the business is important,
far more so will be the ability of the business to perform in the future, in the hands of
the buyer and to the standard expected and paid for. Due diligence should be
directed towards those issues.

Sample Due Diligence Check List

At the beginning of the due diligence process, the following documents are normally
requested:
+ The latest business plan
+ Product data sheets and literature
+ Analysis of competitors
+ Organisational chart
+ Capitalisation structure and shareholder information
+ Historical balance sheet cash flow and income statements since inception
+ Forecast balance sheet, cash flow, and income statements (possibly up to 5
years)
+ Current operating budgets compared to actual
+ Detailed budget and revenue forecasts
+ Tax filings
+ Description of leases.

In carrying out due diligence exercise for merger and acquisition, the checks generally
followed are provided in Annexure 'A' to this Chapter. Further in Annexure 'B' to
this Chapter, a specimen checklist for preliminary legal due diligence is given, and
Annexure 'C' contains specimen checklist for commercial due diligence.

Sample Due Diligence Report

Based on the checks carried out in accordance with the guidelines provided in the
check list as set out in Annexure 'A', the advisor or the public accountant entrusted
 Due Diligence for Mergers & Acquisitions 17

with the due diligence exercise is required to submit a report to the client, viz., the
potential buyer. However, a specimen report of due diligence for a prospective
investment is set out in Annexure 'D' to this Chapter.
18 Background Material on Due Diligence

ANNEXURE - A
SAMPLE DUE DILIGENCE CHECKLIST

The following due diligence checklist is only a sample, and may differ from the actual
list used during the deal process. Some of the information may not be relevant to
every situation, and will not be required by the buyer.

A. Organisation of the Company

1. Describe the corporate or other structure of the legal entities that comprise
the Company. Include any helpful diagrams or charts. Provide a list of the
officers and directors of the Company and a brief description of their
duties.
2. Long-form certificate of good standing and certificate of incorporation.
Listing all documents on file with respect to the Company, and a copy of all
documents listed therein.
3. Current by-laws of the Company (i.e. Articles of Association)
4. List of all jurisdictions in which the Company is qualified to do business
and list of all other jurisdictions in which the Company owns or leases real
property or maintains an office and a description of business in each such
jurisdiction. Copies of the certificate of authority, good standing
certificates and tax status certificates from all jurisdictions in which the
Company is qualified to do business.
5. All minutes for meetings of the Company's board of directors, board
committees and shareholders for the last five years, and all written actions
or consents in lieu of meetings thereof.
6. List of all subsidiaries and other entities (including partnerships) in which
the Company has an equity interest; organisational chart showing
ownership of such entities; and any agreements relating to the Company's
interest in any such entity.

B. Ownership and Control of the Company

1. Capitalisation of the Company, including all outstanding capital stock,
convertible securities and similar instruments.
 Due Diligence for Mergers & Acquisitions 19

2. List of shareholders of the Company, setting forth class and number of

shares held.
3. Copies of any voting agreements, shareholder agreements, proxies,
transfer restriction agreements, rights of first offer or refusal, preemptive
rights, registration agreements or other agreements regarding the
ownership or control of the Company.

C. Assets and Operations

1. Annual financial statements with notes thereto for the past three fiscal
years of the Company, and the latest interim financial statements since
the end of the last fiscal year and product sales and cost of sales (including
royalties) analysis for each product which is part of assets to be sold.
2. All current budgets and projections including projections for product sales
and cost of sales.
3. Any auditor's (internal and external) letters and reports to management
for the past five years (and management's responses thereto)
4. A detailed breakdown of the basis for the allowance for doubtful accounts.
5. Inventory valuation, including turnover rates and statistics, gross profit
percentages and obsolescence analysis including inventory of each
product, which is part of assets to be sold.
6. Letters to auditors from outside counsel.
7. Description of any real estate owned by the Company and copies of related
deeds, surveys, title insurance policies (and all documents referred to
therein), title opinions, certificates of occupancy, easements, deeds of trust
and mortgages.
8. Schedule of significant fixed assets, owned or used by the Company,
including the identification of the person holding title to such assets and
any material liens or restrictions on such assets.
9. Without duplication of separate intellectual property due diligence
checklist from Section D below, schedule of all intangible assets (including
customer lists and goodwill) and proprietary or intellectual properties
owned or used in the Company, including a statement as to the entity
holding title or right to such assets and any material liens or restrictions on
such assets, include on and off balance sheet items.
20 Background Material on Due Diligence

D. Intellectual Property
List of all patents, trademarks, service marks and copyrights owned or used by the
Company, all applications and copies thereof, search reports related thereto and
information about any liens or other restrictions and agreements on or related to
any of the foregoing.

E. Reports
1. Copies of any studies, appraisals, reports, analysis or memoranda within
the last three years relating to the Company (i.e. competition, products,
pricing, technological developments, software developments, etc.)
2. Current descriptions of the Company that may have been prepared for any
purpose, including any brochures used in soliciting or advertising.
3. Descriptions of any customer quality awards, plant qualification/
certification distinctions, ISO certifications or other awards or certificates
viewed by the Company as significant or reflective of superior
performance.
4. Copies of any analyst or other market reports concerning the Company
known to have been issued within the last three years.
5. Copies of any studies prepared by the Company regarding the Company's
insurance currently in effect and self-insurance programme (if any),
together with information on the claim and loss experience there under.
6. Any of the following documents filed by the Company or affiliates of the
Company and which contain information concerning the Company: annual
reports, and quarterly reports.

F. Compliance with Laws

1. Copies of all licences, permits, certificates, authorisations, registrations,
concessions, approvals, exemptions from all governmental and other
operating authorities any applications therefore, and a description of any
pending contemplated or threatened changes in the foregoing.
2. A description of any pending or threatened proceedings or investigations
before any court or any regulatory authority.
3. Describe any circumstance where the Company has been or may be
accused of violating any law or failing to possess any material licence,
 Due Diligence for Mergers & Acquisitions 21

permit or other authorisation. List all citations and notices from

governmental or regulatory authorities.
4. Schedule of the latest dates of inspection of the Company's facilities by
each regulatory authority that has inspected such facilities.
5. Description of the potential effect on the Company of any pending or
proposed regulatory changes of which the Company is aware.
6. Copies of any information requests from, correspondence with, reports of
or to, filings with or other material information with respect to any
regulatory bodies, which regulate a material portion of the Company's
business. Limit response to the last five years unless an older document
has a continuing impact on the Company.
7. Copies of all other studies, surveys, memoranda or other data on
regulatory compliance including, spill control, environmental clean-up or
environmental preventive or remedial matters, employee safety
compliance, import and export licences, common carrier licences,
problems, potential violations, expenditures, etc.
8. State whether any consent is necessary from any governmental authority
to embark upon or consummate the proposed transaction.
9. Schedule of any significant import or export restrictions that relate to the
Company's operations.
10. List of any export, import or customs permits or authorisations,
certificates, registrations, concessions, exemptions, etc., that are required
in order for the Company to conduct its business and copies of all
approvals, etc. granted to the Company that are currently in effect or
pending renewal.
11. Any correspondence with or complaints from third parties relating to the
marketing, sales or promotion practices of the Company.

G. Environmental Matters
1. A list of facilities or other properties currently or formerly owned, leased,
or operated by the Company and its predecessors, if any.
2. Reports of environmental audits or site assessments in the possession of
the Company.
3. Copies of any inspection reports prepared by any governmental agency or
22 Background Material on Due Diligence

insurance carrier in connection with environmental or workplace safety

and health regulations relating to any such facilities or properties.
4. Copies of all environmental and workplace safety and health notices of
violations, complaints, consent decrees, and other documents indicating
non-compliance with environmental or workplace safety and health laws
or regulations, received by the Company from local, state, or central
governmental authorities. If available, include documentation indicating
how such situations were resolved.
5. Copies of any private party complaints, claims, lawsuits or other
documents relating to potential environmental liability of the Company to
private parties.
6. Listing of underground storage tanks currently or previously present at
the properties and facilities listed in response to item 1 above, copies of
permits, licences or registrations relating to such tanks, and
documentation of underground storage tank removals and any associated
remediation work.
7. Descriptions of any release of hazardous substances or petroleum known
by the Company to have occurred at the properties and facilities listed in
response to Item 1, if such release has not otherwise been described in the
documents provided in response to Items 1-6 above.
8. Copies of any information requests, or other notices received by the
Company relating to liability for hazardous substance releases at off-site
facilities.
9. Copies of any notices or requests described in Item 8 above, relating to
potential liability for hazardous substance releases at any properties or
facilities described in response to Item 1.
10. Copies of material correspondence or other documents (including any
relating to the Company's share of liability) with respect to any matters
identified in response to Items 8 and 9.
11. Copies of any written analyses conducted by the Company or an outside
consultant relating to future environmental activities (i.e., upgrades to
control equipment, improvements in waste disposal practices, materials
substitution) for which expenditure significant amount is either certain or
reasonably anticipated within the next five years and an estimate of the
costs associated with such activities.
 Due Diligence for Mergers & Acquisitions 23

12. Description of the workplace safety and health programmes currently in

place for the Company's business, with particular emphasis on chemical
handling practices.

H. Litigation
1. List of all litigation, arbitration and governmental proceedings relating to
the Company to which the Company or any of its directors, officers or
employees is or has been a party, or which is threatened against any of
them, indicating the name of the court, agency or other body before whom
pending, date instituted, amount involved, insurance coverage and
current status. Also describe any similar matters which were material to
the Company and which were adjudicated or settled in the last ten years.
2. Information as to any past or present governmental investigation of or
proceeding involving the Company or the Company's directors, officers or
employees.
3. Copies of any consent decrees, orders (including applicable injunctions) or
similar documents to which the Company is a party, and a brief
description of the circumstances surrounding such document.
4. Copies of all letters of counsel to independent public accountants
concerning pending or threatened litigation.
5. Any reports or correspondence related to the infringement by the
Company or a third party of intellectual property rights.

I. Significant Contracts and Commitments

1. Contracts relating to any completed (during the past 10 years) or proposed
reorganisation, acquisition, merger, or purchase or sale of substantial
assets (including all agreements relating to the sale, proposed acquisition
or disposition of any and all divisions, subsidiaries or businesses) of or
with respect to the Company.
2. All joint venture and partnership agreements to which the Company is a
party.
3. All material agreements encumbering real or personal property owned by
the Company including mortgages, pledges, security agreements or
financing statements.
24 Background Material on Due Diligence

4. Copies of all real property leases relating to the Company (whether the
Company is lessor or lessee), and all leasehold title insurance policies (if
any).
5. Copies of all leases of personal property and fixtures relating to the
Company (whether the Company is lessor or lessee), including, without
limitation, all equipment rental agreements.
6. Guarantees or similar commitments by or on behalf of the Company, other
than endorsements for collection in the ordinary course and consistent
with past practice.
7. Indemnification contracts or arrangements insuring or indemnifying any
director, officer, employee or agent against any liability incurred in such
capacity.
8. Loan agreements, lines of credit, lease financing arrangements,
installment purchases, etc. relating to the Company or its assets and
copies of any security interests or other lines securing such obligations.
9. No-default certificates and similar documents delivered to lenders for the
last five (or shorter period, if applicable) years evidencing compliance with
financing agreements.
10. Documentation used internally for the last five years (or shorter time
period, if applicable) to monitor compliance with financial covenants
contained in financing agreements.
11. Any correspondence or documentation for the last five years (or shorter
period, if applicable) relating to any defaults or potential defaults under
financing agreements.
12. Contracts involving cooperation with other companies or restricting
competition.
13. Contracts relating to other material business relationships, including:
a) any current service, operation or maintenance contracts;
b) any current contracts with customers;
c) any current contracts for the purchase of fixed assets; and
d) any franchise, distributor or agency contracts
14. Without duplicating the intellectual property due diligence check list as
outlined in Section D above, contracts involving licensing, know-how or
technical assistance arrangements including contracts relating to any
 Due Diligence for Mergers & Acquisitions 25

patent, trademark, service mark and copyright registrations or other

proprietary rights used by the Company and any other agreement under
which royalties are to be paid or received.
15. Description of any circumstances under which the Company may be
required to repurchase or repossess assets or properties previously sold.
16. Data processing agreements relating to the Company.
17. Copies of any contract by which any broker or finder is entitled to a fee for
facilitating the proposed transaction or any other transactions involving
the Company or its properties or assets.
18. Management, service or support agreements relating to the Company, or
any power of attorney with respect to any material assets or aspects of the
Company.
19. List of significant vendor and service providers (if any) who, for whatever
reason, expressly decline to do business with the Company.
20. Samples of all forms, including purchase orders, invoices, supply
agreements, etc.
21. Any agreements or arrangements relating to any other transactions
between the Company and any director, officer, shareholder or affiliate of the
Company (collectively, “Related Persons”), including but not limited to:
a) Contracts or understandings between the Company and any Related
Person regarding the sharing of assets, liabilities, services, employee
benefits, insurance, data processing, third-party consulting,
professional services or intellectual property.
b) Contracts or understandings between Related Persons and third
parties who supply inventory or services through Related Persons to
the Company.
c) Contracts or understandings between the Company and any Related
Person that contemplate favourable pricing or terms to such parties.
d) Contracts or understandings between the Company and any Related
Person regarding the use of hardware or software.
e) Contracts or understandings regarding the maintenance of equipment
of any Related Person that is either sold, rented, leased or used by the
Company.
f) Description of the percentage of business done by the Company with
26 Background Material on Due Diligence

Related Persons.
g) Covenants not to compete and confidentiality agreements between the
Company and a Related Person.
h) List of all accounts receivable, loans and other obligations owing to or
by the Company from or to a Related Person, together with any
agreements relating thereto.
22. Copies of all insurance and indemnity policies and coverages carried by
the Company including policies or coverages for products, properties,
business risk, casualty and workers compensation. A summary of all
material claims for the last five years as well as aggregate claims
experience data and studies.
23. List of any other agreements or group of related agreements with the
same party or group of affiliated parties continuing over a period of more
than six months from the date or dates thereof.
24. Copies of all supply agreements relating to the Company and a
description of any supply arrangements.
25. Copies of all contracts relating to marketing and advertising.
26. Copies of all construction agreements and performance guarantees.
27. Copies of all secrecy, confidentiality and non-disclosure agreements.
28. Copies of all agreements related to the development or acquisition of
technology.
29. Copies of all agreements outside the ordinary course of business.
30. Copies of all warranties offered by the Company with respect to its
products or services.
31. List of all major contracts or understandings not otherwise previously
disclosed under this section, indicating the material terms and parties.
32. For any contract listed in this Section state whether any party is in
default or claimed to be in default.
33. For any contract listed in this Section state whether the contract requires
the consent of any person to assign such contract or collaterally assign
such contract to any lender.

NOTE: Remember to include all amendments, schedules, exhibits and side letters.
Also include brief description of any oral contract listed in this Section.
 Due Diligence for Mergers & Acquisitions 27

J. Employees, Benefits and Contracts

1. Copies of the Company's employee benefit plans as most recently amended,
including all pension, profit sharing, thrift, stock bonus, ESOPs, health
and welfare plans (including retiree health), bonus, stock option plans,
direct or deferred compensation plans and severance plans, together with
the following documents:
a) all applicable trust agreements for the foregoing plans;
b) copies of all determination letters of tax authorities for the foregoing
qualified plans;
c) latest copies of all summary plan descriptions, including
modifications, for the foregoing plans;
d) latest actuarial evaluations with respect to the foregoing defined
benefit plans; and
e) schedule of fund assets and unfounded liabilities under applicable
plans
2. Copies of all employment contracts, consulting agreements, severance
agreements, independent contractor agreements, non-disclosure
agreements and non-compete agreements relating to any employees of the
Company.
3. Copies of any collective bargaining agreements and related plans and
trusts relating to the Company (if any). Description of labour disputes
relating to the Company within the last three years. List of current
organisational efforts and projected schedule of future collective
bargaining negotiations (if any).
4. Copies of all employee handbooks and policy manuals
5. The results of any formal employee surveys.

K. Tax Matters
1. Copies of returns for the three prior closed tax years and all open tax years
for the Company together with a work paper therefore wherein each item is
detailed and documented that reconciles net income as specified in the
applicable financial statement with taxable income for the related period.
2. Audit and revenue agents reports for the Company; audit adjustments
28 Background Material on Due Diligence

proposed by the Tax Authorities for any year of the Company or protests
filed by the Company.
3. Settlement documents and correspondence for last six years involving the
Company.
4. Agreements waiving statute of limitations or extending time involving the
Company
5. Description of accrued withholding taxes for the Company.

L. Miscellaneous
1. Information regarding any material contingent liabilities and material
unasserted claims and information regarding any asserted or unasserted
violation of any employee safety and environmental laws and any asserted
or unasserted pollution clean-up liability.
2. List of the ten largest customers and suppliers for each product or service of
the Company.
3. List of major competitors for each business segment or product line.
4. Any plan or arrangement filed or confirmed under the bankruptcy laws
5. A list of all officers, directors and shareholders of the Company.
6. All annual and interim reports to shareholders and any other
communications with them.
7. Description of principal banking and credit relationships (excluding payroll
matters), including the names of each bank or other financial institution,
the nature, limit and current status of any outstanding indebtedness, loan
or credit commitment and other financing arrangements.
8. Summary and description of all product, property, business risk, employee
health, group life and key-man insurance.
9. Copies of any judgment or suit searches or filings related to the Company in
different states conducted in the past three years.
10. Copies of all filings with the Securities Exchange Board of India or foreign
security regulators or exchanges.
11. All other information material to the financial condition, business, assets,
prospects or commercial relations of the Company.
 Due Diligence for Mergers & Acquisitions 29

ANNEXURE - B
PRELIMINARY LEGAL DUE DILIGENCE
CHECKLIST

Table of Contents

Introduction
1. General Information
2. Corporate Organisation and Structure
3. Management
4. Share Capital and Ownership
5. Secretarial and Regulatory
6. Financial Accounts
7. Banking Facilities/Borrowing From Third Parties, Financial Grants
8. Taxation
9. Employment Matters
10. Property
11. Business and Operational Matters
12. Contracts
13. Intellectual Property
14. Legal Proceedings, Disputes and Investigations
15. Insurance Policies
16. Environmental Matters
17. Product/Service Liabilities
18. Impending Legislative Changes
19. Compliance with Special Industry Sector Legislation.
30 Background Material on Due Diligence

LEGAL DUE DILIGENCE CHECKLIST

AND
PRELIMINARY ENQUIRIES

Introduction
The following list sets out the information and documents which are initially
required in order to conduct the legal due diligence in relation to the proposed
subscription to new shares of [ABC] by XYZ (the Investor).

In this Checklist:
Company means ABC Limited;
Promoter means the promoters of the Company; and
Subsidiaries means subsidiaries of the Company

In this checklist, the relevant questions have been placed on the left hand side of the
page. The responses to the questions may be inserted in the response column on the
right hand side of each question.

For ease of reference all questions should be answered, where appropriate in the
negative. In the event any question requires a detailed response, the same may be
separately annexed and referenced to the left of the concerned question. Wherever
the response to any question includes any documents, these may be similarly
annexed and referenced. Similarly, all answers and documents to which you refer
should be clearly marked with the section and question to which they relate. Where
you provide documents, please provide in your answer a brief identification
(including identifying to which company the documents relate) where this is not
clear from the heading of the document itself. Unless otherwise specified, please
provide all information with reference to the Company as well as each Subsidiary.

Where the item requested does not exist or is otherwise inapplicable, please indicate
so in the response column. Please also state the reason why it is inapplicable. If in
doubt the questions should be answered according to the spirit of information
requested rather than merely the letter and too much information rather than too
 Due Diligence for Mergers & Acquisitions 31

little should be given. Where the same information and documents are to be
supplied in response to two or more different questions, there is no need to repeat
your response provided all necessary cross-references are made.

When any specific foreign law, legislation or practice is not referred to in this
document and the Company or any Subsidiary operates or has operated in a foreign
jurisdiction, each of the enquiries in this document shall apply to such company or
companies in relation to its foreign activities and presence as if, where the context
admits or requires, references to Indian law, practice and legislation were
references to similar law practice or legislation applicable in the relevant foreign
jurisdiction in which such activities are or were performed.

After completing the response to the questions on each page, please initial each page
before forwarding the response to us.

Where documents are requested to be sent along with the response to this checklist,
please provide copies rather than originals. Please arrange to have originals provided
at the time of physical verification by us. Further, please ensure that a person so
authorised by the Company certifies all copies of documents provided, as true copies. It
would also be helpful if you would provide any documents requested in lever arch files
with an index correlating to the numbering system used in this list.

Please ensure that all responses are, to the extent possible, complete. Further
queries may need to be raised depending on the content of the replies.

During the course of, or subsequent to, the completion of this due diligence exercise,
you may be requested to provide certificates as to the completeness and accuracy of
the information provided. However, please note that the answers to questions
raised in these enquiries or the certificates mentioned above would not comprise
formal disclosures for the purposes of any representations or warranties sought by
the investor in the legal documents. Any such formal disclosure will be required to
be made in the legal documents and such disclosures will be expected to be clear,
concise, full and fair disclosures against the relevant warranties.
32 Background Material on Due Diligence

If you have any queries in connection with this due diligence

checklist/questionnaire please contact XYZ at YYY Limited, Delhi at the telephone
number or the e-mail addresses mentioned on the cover.
 Due Diligence for Mergers & Acquisitions 33

GENERAL INFORMATION

Sl. No. Question Response

1.1 Briefly describe the history of the Company and

the Subsidiaries since their incorporation,
including the details of the acquisition of the
Subsidiaries by the Company.
1.2 Briefly describe the business of the Company
and the Subsidiaries, specifically detailing
product and service lines.
1.3 Please provide the full registered name of the
Company and each Subsidiary
1.4 Please provide the date of incorporation and the
registration number of the Company and each
Subsidiary.

CORPORATE ORGANISATION & STRUCTURE

Sl. No. Question Response

2.1 Please provide details (with a description of the

nature and size of such interest) of any interest
(including any partnerships, collaborations,
associations of persons, sole proprietorships, joint
ventures or other entities or interest groupings)
held in any enterprise by any of the following:
(i) Any Promoter of the Company; or
(ii) Any company in a group of companies of which
any Promoter is a part ("the Group"); or
(iii) Any individuals [not covered under sub-clause
(c) above] having a controlling interest in the
Company or it Subsidiary or in the Group.
2.2 Please provide a list of the following (if any):
34 Background Material on Due Diligence

Sl. No. Question Response

(i) Subsidiaries of the Company (as defined in

section 4 of the Companies Act, 1956);
(ii) Companies under the same management as
the Company (as defined in Section 370 (1-B)
of the Companies Act);
(iii) Other interests (including options) held by
the Company or its Subsidiary or any of its
directors in other companies or businesses
(including joint ventures, partnerships,
consortiums, or other profit sharing
arrangements), stating percentage of total
issued capital.
2.3 Where the Group comprises more than two
companies, please provide a structure chart of
the Group companies.
2.4 Please provide organisational and ownership
charts or similar information relating to the
Company and each Subsidiary.
2.5 Please provide the following details of
relationship between the Company, Promoters,
its Subsidiaries and their promoters, affiliated
companies, families and friends:
+ Details of cross shareholdings.
+ Details of trading relationship.
+ Details of shared facilities.
+ Details of financing arrangements.
+ Details of direct or indirect investments and
the reason for each direct and indirect
investment.
2.6 Please supply copies (or details where unwritten)
of agreements or other documentation relating to
any joint venture, partnership, consortium or
 Due Diligence for Mergers & Acquisitions 35

Sl. No. Question Response

other profit sharing arrangement to which the

Company or any Subsidiary is a party (including
those with other companies in the Group or
between the Company's shareholders).
2.7 The following details in respect of every
undertaking in which the Company or any
Subsidiary has a direct or indirect interest, if the
book value of that interest represents at least 5%
of the capital and reserves of the
Company/Subsidiary or if that interest accounts
for at least 5% of the net profit or loss of the
Company/Subsidiary, and any other
undertakings in which the Company or any
Subsidiary has an interest which is liable to have
a significant effect on the Company's/
Subsidiary's assets and liabilities, financial
position or profits and losses: the name and
address of the registered office;
+ the field of activity;
+ the proportion of capital held;
+ the issued capital;
+ any obligations or arrangements to make
further investments or to disinvest;
+ the reserves;
+ the profit or loss arising out of ordinary
activities, after tax, for the last financial year;
+ the value at which the Company/Subsidiary
shows the interest in its accounts;
+ any amount of dividends received in the
course of the last financial year in respect of
shares held;
+ any amount still held to be paid up or shares
36 Background Material on Due Diligence

Sl. No. Question Response

held; and
+ the amounts of the debts owed to and by the
Company/Subsidiary with regard to the
undertakings.

MANAGEMENT

Sl. No. Question Response

3.1 Please provide the following information in

relation to the management of the Company and
its Subsidiaries:
(i) Names of the members of the board of
directors and a brief summary of their
experience and details of directorships held.
(ii) Details of interests in shares, options,
warrants, etc. issued to any of the directors
or shareholders of the Company and/or the
Subsidiaries.
(iii) Details of any interests of directors and
shareholders of the Company and / or its
Subsidiaries or affiliates or relatives of any
of the aforesaid in all transactions and
contracts that were effected or entered into
by the Company or its Subsidiary since
incorporation.
(iv) Details of any outstanding loans granted by
the Company or its Subsidiary to any of the
directors and also any guarantees provided
by the Company or its Subsidiaries for their
benefit.
(v) D e t a i l s o f a n y n o n - a r m ' s l e n g t h
 Due Diligence for Mergers & Acquisitions 37

Sl. No. Question Response

transactions between directors and the

Company or its Subsidiaries and any other
company promoted by the promoters of the
Company or its Subsidiaries and the
Company or its Subsidiaries.
(vi) Are there any restrictions upon the
directors' dealings in the Company and its
Subsidiaries' shares?
3.2 Names of the secretary and other key officers of
the Company and the Subsidiaries.

SHARE CAPITAL & OWNERSHIP

Sl. No. Question Response

4.1 Please provide particulars of share capital of the

Company and the Subsidiaries, showing their
authorised and issued and paid up capital, and
details of number and classes of shares with
their principal characteristics.
4.2 In the case of the Company as well as each
Subsidiary, please provide a summary of any
events or transactions that have changed the
amount of the issued capital of the concerned
company since its incorporation.
4.3 Please provide details of any issued capital still
to be paid up (in respect of the Company as well
as each Subsidiary), including statements of:
+ The number or total nominal value;
+ The types of shares not yet fully paid up,
broken down (where applicable) according to
the extent to which they have been paid up.
38 Background Material on Due Diligence

Sl. No. Question Response

4.4 Please detail any expected dilution effect of any

exercises of conversion rights, options, warrants,
etc.
4.5 Provide Copies (or details here unwritten) of and
agreements or documents connected to the
Company or any Subsidiary relating to:
+ Any agreement or commitment to create,
issue or transfer shares (including loan
capital and share options);
+ Any rights of pre-emption;
+ Any share conversion rights;
+ Any share option or warrants;
+ Share pledge or similar arrangements
affecting the shares of the Company and the
Subsidiaries;
+ Any undertakings (e.g. non disposal
undertakings) given by shareholders
concerning the holding of shares in the
Company and/or the Subsidiaries;
+ Any other rights to unissued share capital;
put or call provisions;
+ Any hedges that the Company has taken out,
against calls, conversions or exercises of
options or warrants etc.
4.6 Please provide a schedule of all shareholders
with direct or indirect holdings in the Company
and each Subsidiary showing number of shares
held and stating whether held beneficially or
otherwise. If any of the shareholders are
individuals, please also provide details of any
such individuals who may be under any
disability, for example infants, bankrupts, or
 Due Diligence for Mergers & Acquisitions 39

Sl. No. Question Response

where probate or letters of administration are

pending. Please also specify any such holdings,
which the company knows are held directly, or
indirectly by members of a family or other
connected persons.
4.7 Please list the names of the persons who, directly
or indirectly, jointly or severally, exercise or could
exercise control over the Company, including the
particulars of the proportion of their voting
capital. (Please include details of any lenders who
hold charges over any shares in the Company).
4.8 Trustee shareholders
In the case of members of the Company or any
Subsidiary who hold their shares on trust,
please provide the following:
+ A copy of the relevant trust instrument;
+ Advice whether any of the trustees are
resident outside India and, if so, their place
of residence;
+ The date(s) on which the shares were
transferred to the original trustees by the
settler;
+ The full name and address of the settler;
+ If any such transfer was made within the
last five years, please confirm that the
settler, to the best of the vendor's
knowledge, was not insolvent at the date of
any transfer nor made insolvent as a result
of it. Please also provide corroboration of
this from the settler's professional advisers;
+ Please confirm that, to the best of the
vendor's knowledge, the settler has not been
40 Background Material on Due Diligence

Sl. No. Question Response

adjudicated bankrupt since the date of the

transfer(s);
+ Advice whether, to the best of the vendor's
knowledge, any such transfer was intended
either wholly or in part to defeat the settler's
creditors.
4.9 Please provide copies of any governmental or
regulatory approvals obtained by the Company
or any Subsidiary or available with the Company
or any Subsidiary in relation to the acquisition or
transfer of shares of the Company or any Subsidiary.
4.10 Please provide copies of any court orders or other
demerger or merger orders obtained by the
Company and each Subsidiary in connection
with the acquisition or disposal of any business.

SECRETARIAL & REGULATORY

Sl. No. Question Response

5.1 Please provide copies of the following :

(i) Certificate of Incorporation of the Company
and its Subsidiaries (including any previous
certificates of incorporation and
amendments thereto, whether on account of
change of name or otherwise).
Certificate of commencement of business (if
applicable) of the Company and each
Subsidiary.
Memorandum and Articles of Association of the
Company and its Subsidiaries (incorporating
any amendments) together with copies of all
 Due Diligence for Mergers & Acquisitions 41

Sl. No. Question Response

resolutions amending the Memorandum and

Articles of Association and consents required
by law to be annexed thereto.
5.2 Please provide a confirmation from the
Company and its Subsidiaries that all the
business that it has carried out is in accordance
with the Memorandum of Association and the
object clause in the Memorandum of Association
permits the Company/Subsidiary to carry on the
business as is currently conducted.
5.3 Please list the addresses of registered office and
principal place of business (if different) of the
Company and its Subsidiaries.
5.4 Provide a brief description of all branches,
agencies, places of business and establishment
of the Company and its Subsidiaries, including a
brief description of the business carries out and
the number of personnel involved.
5.5 Please provide the address at which the statutory
registers and books are kept, and the address
where our personnel, if required can view them.
5.6 The Company and each Subsidiary are to
confirm that all the statutory registers as
required under the provisions of the Companies
Act, 1956 are being maintained by the Company
and the Subsidiary respectively and are unto
date, including the following registers:
+ Register of minutes of meetings of the Board
of directors (and any committees of the
Board) of the Company and each Subsidiary.
+ Register of Minutes of Meetings of
shareholders of the Company and each
Subsidiary.
42 Background Material on Due Diligence

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+ Register of members and register of transfers

(or equivalent) and other statutory registers
(required to be maintained under the
Companies Act, 1956) of the Company and
each Subsidiary.
+ Register of Charges (along with instruments
of charges created by the Company and each
Subsidiary).
+ Register of Members.
+ Register of Contracts, Companies and Firms
in which directors are interested.
+ Register of Directors, Managing Director,
Manager and Secretary (along with
contracts of terms of appointment of the
Managing Director/ Manager).
+ Register of Director's shareholdings.
+ Register of Loans to Companies under the
same management.
+ Register of Investments.
+ Register of Deposits accepted from the public.
5.7 Meetings
Please provide the address where our personnel
can inspect minutes of meetings and agenda
papers presented to the following bodies of the
Company and each Subsidiary during the last 18
months:
+ Shareholders
+ Directors
+ Directors' committees
+ Management committees
 Due Diligence for Mergers & Acquisitions 43

Sl. No. Question Response

5.8 Reports:
Please provide copies of all quarterly, annual
and other periodical reports and other
communications to the shareholders of the
Company and each Subsidiary including the
following:
+ Annual Reports of the Company /Subsidiary
for the last three years.
+ Copies of all circulars to shareholders and
any other report or communication sent to
shareholders of the Company/Subsidiary
during the last three years.
+ Any other information distributed to the
shareholders of the Company/Subsidiary
during the last five years.
5.9 Please provide copies of any reports prepared
during the last five (5) years or any other
relevant reports on the Company or its
Subsidiary, for example market research,
accountant's report, environmental report.
5.10 Copies of all prospectuses and placement
memoranda relating to any securities offering
by the Company or any Subsidiary during the
last three years.
5.11 Copies of any legal notices that have been
published by or in respect of, the Company and
each Subsidiary during the last three years.
5.12 Copies of all agreements required to be filed
with the registrar of Companies under any
provision of the Companies Act 1956 (including
sections 75, 192).
5.13 Copies of all documents filed at (i) Registrar of
Companies and (ii) the Securities and Exchange
44 Background Material on Due Diligence

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Board of India within the last three] years.

5.14 Copies of documents filed with the Registrar of
Companies in relation to any amendment to the
Articles of Association of the Company and its
Subsidiaries
5.15 Please provide copies of all government or
regulatory consents for the Company and its
Subsidiaries including without limitation the
following:
+ Relating to the investment or proposed
investment in other company.
+ Shops and Establishment Act Registrations.
+ Professional Tax registrations/challans for
last payments.
+ Registrations under Service Tax rules and
show cause notices in this regard.
+ Compliance with the provisions of section
372 or 372A as applicable for loans,
investment and guarantees.
5.16 Copies of any necessary consents in relation to
any loans or guarantees made by or given in
favour of non-Indian parties, and copies of any
related agreements and correspondence.
5.17 Copies of documentation and correspondence
relating to any governmental or regional
incentives, subsidies or grants made available in
relation to the Company and its Subsidiaries or
aspect of their business.
5.18 Please provide a full list, together with full copies
of, all licences, permits or other authorisations
issued to the Company and its Subsidiaries by
any government agency and any related
 Due Diligence for Mergers & Acquisitions 45

Sl. No. Question Response

agreements and correspondence.

5.19 Please provide copies of any documents filed
with any relevant securities regulatory
authority by the Company or any Subsidiary.
5.20 A list of all performance bonds, guarantees or
similar security arrangements entered into by or
on behalf of the Company and its Subsidiaries in
connection with any of the licences or
authorisations held by them.
5.21 Copies of any reports, notices or correspondence
relating to any alleged violation, non-
compliance or infringement by the Company and
its Subsidiaries of any government regulation,
licence, permit or other authorisation.
5.22 Details of any determinations, declarations or
directions given by any relevant regulatory
authority, and of obligations or promises made
by the Company or its Subsidiaries to such
regulatory authorities, including the dates from
which the concerned company is bound under
each of these determinations, directions,
obligations or promises.
5.23 Please provide, in relation to the Company and
the Subsidiaries:
+ Copies of any agreement or arrangement
with any company (whether intended to be
legally enforceable or not) relating to the
prices or conditions for the sale of products
or provision of services, or for the purchase
of supplies (for example, cartels).
+ Copies of any agreements or details of any
arrangements in force restricting the
freedom of the company to provide and take
46 Background Material on Due Diligence

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goods and services.

+ Copies of any agreements registered under
the Monopolies and Restrictive Trade
Practices Act, 1969.
+ Copies of internal competition compliance
programmes if any.
+ Copies of any undertakings or orders made
to competition authorities nationally.
5.24 Please provide confirmations that the Company
and Promoters have authority to:
+ Undertake; and
+ Close this transaction.
5.25 Please supply details of any governmental and
other consents required for the implementation
and closing of the transaction.
Listing
5.26 Are the shares or other securities of the
Company or any Subsidiary listed on any stock
exchange in India or abroad?
5.27 Please provide copies of the listing agreement as
well as all correspondence in relation to the
listing of such securities.
5.28 Has the listing of these securities been
suspended for any reason at any time? If yes,
please provide details thereof.
5.29 Has there, at any time, been any actual or
alleged violation of the terms of the listing
agreement in relation to such securities?
5.30 Are any approvals required from the relevant
exchange(s) for any further issue of securities by
the Company/Subsidiary.
 Due Diligence for Mergers & Acquisitions 47

FINANCIAL ACCOUNTS

Sl. No. Question Response

6.1 Balance Sheets of the Company and each

Subsidiary of the last three years duly certified
by the Auditors.
6.2 Please provide us with any management
accounts and audited accounts prepared since
last annual balance date.
6.3 Please provide copies of all breakdowns,
analysis, commentaries and reports prepared in
relation to audited annual accounts and
management accounts.
6.4 Details of any actual or Contingent Liabilities of
the Company/Subsidiary, whether as original
contracting part to, as a guarantor of any party
to, or their liability in respect of any freehold or
leasehold property or license connected
therewith. Please also complete Schedule II in
respect of the Company and each Subsidiary.
6.5 In respect of the Company and each Subsidiary,
please provide a record of dividend payments
during the last five years (including dividends
per share, the number of shares entitled to the
dividends at the times they are declared or paid,
and the gross amount of the dividends paid).
6.6 Does the Company or any Subsidiary have a
dividend policy? If yes, please provide a copy of
the same.
6.7 In relation to the Company and each
Subsidiary, please provide a schedule of
dividends declared relative to net profits.
48 Background Material on Due Diligence

BANKING FACILITIES/BORROWING
FROM THIRD PARTIES, FINANCIAL GRANTS

Sl. No. Question Response

7.1 Please provide:

Accounts
+ Names and branch addresses of all banks and
financial institutions with whom the Company
and Subsidiaries hold accounts (including all
current, deposit and trust accounts)
+ Titles and numbers of each account.
+ Copies of all existing direct debits, standing
orders or similar instructions.
+ Current balance of each account.
+ Copies of latest statement for each account.
+ Copies of mandates for each account.
7.2 Borrowing
Please provide details of all borrowing by the
Company and each Subsidiary, whether under
term loan or overdraft facilities, bonds, loan
stock issues, bills of exchange, commercial paper
or similar instruments (including share capital
redeemable within 10 years of issue), acceptance
credit, documentary credit or bill discounting
facilities, interest rate swaps, currency swaps,
financial options, financial contracts or other
similar instruments and finance leases any other
forms of debts financing (e.g. receivables,
financing or factoring arrangements). This
should include inter-group borrowings and loans
from directors, employees or shareholders.
Without limitation to the above, please provide:
A schedule of loan capital and other financing
showing maturities, interest rates, any security,
 Due Diligence for Mergers & Acquisitions 49

Sl. No. Question Response

and whether committed or uncommitted. (See

Schedule I).

Copies of all agreements relating to any

borrowings by the Company and Subsidiaries
and details of all existing or anticipated breaches
of the terms of such agreements by the
Company/Subsidiary together with copies of all
extant notices, demands or other
communications from the relevant lender to the
Company/Subsidiary.
Particulars and (where applicable) copies of all
mortgages, debentures (whether convertible or
not), debenture trust deeds, instruments by way
of security charges, pledges, liens, encumbrances,
conditional sale or other title retention or trust
arrangements, deeds of postponement,
preferential rights or other agreements or
arrangements the effect of which is to create a
security over the assets or any part thereof of the
Company or Subsidiaries, together with copies of
all extant notices, demands or other
communications from the beneficiary of the
relevant security to the Company or Subsidiaries.

Schedule of loan capital and other financing

showing maturities, interest rates, any security,
and whether committed or uncommitted.

Details of the Company's and the Subsidiaries'

contingent liabilities.

Details of lenders' rights to convert loans into

50 Background Material on Due Diligence

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equity in any circumstances.

Confirmation that the Company and Subsidiaries
are in compliance with their loan agreements,
credit facilities, debt securities and loan capital.

Details of any issued loan stock/preference capital.

Details of all balances outstanding.

Copies (or details where unwritten) of any
default notices served on the Company and
Subsidiaries together with details of any non-
compliance with the borrowing and security
documentation referred to above.
Confirmation whether it is intended that any
borrowings will be repaid before completion of
this transaction.
Confirmation that the current level of banking
facilities generally is adequate for the
Company's working capital purposes for the
next 12 months.
Details of amounts outstanding. Highlighting
covenants or events of default restricting :
+ Future borrowings;
+ Negative pledges;
+ Issue of equity;
+ Change of control; and
+ Change of management.
7.3 Financial Grants or other Assistance
Please provide copies of documentation for (or
details where unwritten of) financial grants or
other assistance from a governmental or other
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Sl. No. Question Response

body by the Company or any Subsidiary.

7.4 Guarantees, Indemnities, Letters of Credit
Please provide copies of :
+ Any guarantees, sureties, indemnities or
counter-indemnities (including Letters of
Comfort, extant notices, demands or other
communications from such third parties) given
by the Company or Subsidiary in respect of the
obligations of another party (including
shareholders of the Company or Subsidiary).
+ Guarantee given by Promoters
+ Bank Guarantees for the obligations of the
Company/Subsidiary
+ Any bond executed by the Company/
Subsidiary for its obligations
+ Any guarantees, sureties and indemnities
provided by any third party in respect of the
obligations of the Company/Subsidiary
together with any security documentation.
All letters of credit issued in favour of third parties
on application of the Company/ Subsidiary.
7.5 Confirmation that the Statutory Auditors have
not commented on the compliance of mandatory
accounting standards in terms of section 211(3C)
of the Companies Act, 1956.
7.6 Details of all loans made to or by the Company,
including all loans and indebtedness to directors,
officers, employees or shareholders of any of the
Company and each Subsidiary or any other
companies in which any such director, employee
or shareholder is interested, together with copies
of all loan documentation.
Loan/Guarantee to/in favour of Directors;
52 Background Material on Due Diligence

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Loan/Guarantee to/in favour of Employees;

Loan/Guarantee to/in favour of connected
concern or person
7.7 Copies of all hire purchase or instalment
purchase agreements, finance leases, letters of
credit, performance and other bonds and similar

TAXATION COVERED BY ACCOUNTING

DUE DILIGENCE EMPLOYMENT MATTERS

Sl. No. Question Response

9.1 Please provide details of organisation charts for

employees of the Company and its Subsidiaries,
including a list of key personnel as well as details
of the number of full-time and part-time
employees and whether these employees are
permanent or temporary. Please also provide us
with the following details for each such company:
+ Total number of employees;
+ Average numbers employed and changes
therein over the last three financial years (if
such changes are material)
+ Management Structure, organisation chart
and responsibilities/authorities of key
personnel.
9.2 Copies of all employment and golden parachute
agreements, consultancy agreements, and all
agreements with present or former employees in
respect of confidentiality, non-competition or
indemnities for the Company and each
Subsidiary. Please also provide:
 Due Diligence for Mergers & Acquisitions 53

Sl. No. Question Response

+ Details of compensation structure

+ Standard Employment Agreement
+ Service Agreement with Directors
+ Non-compete and confidentiality agreement
+ Letters of confirmation
+ In case of contract labour, copies of contracts
executed with contractors and terms and
conditions on which labour is taken of
contact basis.
9.3 Copies of all share option, share incentive, profit
sharing or similar arrangements for employees
of the Company and the Subsidiaries, including
copies of the ESOP Plan
9.4 Details of the pension, provident or life
assurance schemes operated by the Company or
its Subsidiaries or in which they participate.
Employees' Provident Fund Miscellaneous
Provisions Act, 1952.
Group Insurance.
9.5 Details of any other benefits provided by the
Company and or its Subsidiaries to their
respective employees.
Health and other benefits.
Voluntary retirement schemes.
Redundancy policies.
Retrenchment schemes of the company
Terms and conditions on which employees hold
shares in the company (if any)
9.6 All employment booklets, manuals or other
literature regarding terms and conditions of
employment generally furnished to employees,
54 Background Material on Due Diligence

Sl. No. Question Response

including details of grievance and disciplinary

procedures, normal working hours, guaranteed pay,
health and safety procedures and policy, and sick
pay. (for the Company and each Subsidiary)
9.7 All union and collective bargaining agreements
and all other agreements with employee
representatives, and minutes of meetings with
any of such bodies. (for the Company and each
Subsidiary)
9.8 Details of any industrial action or disputes within
the last three years (or such shorter period for
companies incorporated for less than three years).
(for the Company and each Subsidiary)
9.9 Details of wrongful, unreasonable or unfair
dismissal or race, sex, age, disability, religious or
other discrimination claims within the last five
years and related correspondence. (for the
Company and each Subsidiary).

PROPERTY

Sl. No. Question Response

10.1 Please provide details of all freehold property

owned or occupied by the Company and its
Subsidiaries. If freehold property occupied by the
concerned company is not owned by it, details of
the ownership and the terms upon which the
property is occupied.
type of interest (freehold, leasehold or other);
tenure of interest; Type of activity conducted at
the property;
 Due Diligence for Mergers & Acquisitions 55

Sl. No. Question Response

Details of encumbrances on the properties of the

Company and or its Subsidiaries, if any;
Details of any dispute relating to the properties.
10.2 Please also detail all leasehold property occupied
by the Company and or its Subsidiaries,
including term, rent and any other material
provisions.
Details of tenanted premises in possession of the
Company and or its Subsidiaries and rent
receipts in respect of such tenanted premises.
Escalation clause
Termination clause
Extension clause
Stamp duty and registration
Revenue records and municipal tax paid receipts
10.3 Please provide details of all licences to occupy
property held by the Company and or its
Subsidiaries, including copies of all concerned
documents.
10.4 Please provide details of any leases, tenancies or
licences to occupy granted by the Company and
or its Subsidiaries, including term, rent and any
other material terms together with copies of all
concerned documents.
10.4 Please provide copies of any appraisal or
valuation reports or surveys on any material
properties owned or occupied by the Company or
a Subsidiary.
10.5 Please provide a schedule of all material plant,
machinery and equipment, motor vehicles and
other tangible assets and movable property used
by the Company and each Subsidiary, indicating
56 Background Material on Due Diligence

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the ownership and nature thereof and the

material terms of any financial lease or security
agreement pursuant or subject to which the same
may be leased or owned. These must include (by
way of illustration).
All plant and machinery required for the purpose
of manufacture of the Products Computer and
accessories (whether outright purchase of hire
purchase, lease etc.).
Vehicles (whether outright purchase of hire
purchase, lease etc.).
Office equipment (whether outright purchase of
hire purchase, lease etc.).
Documents underlying the abovementioned assets.

BUSINESS AND OPERATIONAL MATTERS

Sl. No. Question Response

11.1 Identify the critical technologies used or to be

used by the Company and the Subsidiaries in
their respective businesses (Technologies)
including, but not limited to:
+ Software;
+ Hardware;
+ Integrated Circuitry;
+ Any technologies that are under development.
11.2 Confirm as to whether the choice to use any of
these particular Technologies by the Company or
its Subsidiaries has limited the future direction
of such company's business in any way.
 Due Diligence for Mergers & Acquisitions 57

Sl. No. Question Response

11.3 Provide copies of any agreements or, if no

agreement exists, provide details of any
arrangement that the Company or its
Subsidiaries has entered into with any suppliers
of equipment and/or infrastructure that includes
any exclusivity arrangements.
11.4 Provide details of the source of the rights of the
Company and the Subsidiaries to use each of the
Technologies i.e. in relation to each of the
Technologies advise if it was purchased, leased,
licensed, developed internally or developed
externally and assigned or licensed to the
Company or its Subsidiaries.
11.5 For purchased Technology - please supply the
relevant purchase agreements (and any
amending or supplemental documentation).
11.6 For leased Technology - please supply the
relevant lease (or hire purchase) agreements
(and any amending or supplemental
documentation).
11.7 For licensed Technology (usually software) -
please supply the relevant licence agreements
(and any amending or supplemental
documentation).
11.8 For Technology developed externally or
internally by a contractor (i.e. not an employee of
the Company/Subsidiary) - please supply the
relevant development agreements (and any
amending or supplemental documentation).
11.9 To the extent available (and not provided in
response to the foregoing questions above) -
please supply the following agreements (and any
amending or supplemental documentation)
58 Background Material on Due Diligence

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between the Company or its Subsidiaries and

any third party:
(i) technical services agreements;
(ii) agreements, memoranda of understanding,
letters or intent or otherwise for manufacture,
supply, purchase or lease of any critical
equipment;
(iii) licences for critical software or other
technology;
(iv) technology development agreements;
(v) framework agreements;
(vi) technical consultancy agreements,
as well as any amendment agreement, side letter
or a description of a verbal understanding for
amendment of any of the foregoing agreements.
11.10 Please supply all maintenance, repair, support,
training and other consultancy services
agreements in relation to the Technologies.
11.11 Please advise as to what extent other value-
added services have been planned and/or
implemented by the Company or its Subsidiaries
and whether the Technologies required for these
services are in place.
11.12 To what extent do the Company and Subsidiaries
market their services and to what extent do they
use distributors or re-sellers?
11.13 Provide a list of the major (i.e. more than 5% of
goods or services supplied in any six month
period) suppliers (identifying product or service)
of the Company and each Subsidiary.
11.14 A schedule of all material plant, machinery and
equipment, motor vehicles and other tangible
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Sl. No. Question Response

assets used by the Company and the Subsidiaries,

indicating the ownership and nature thereof and
the material terms of any financial lease or
security agreement pursuant or subject to which
the same may be leased or owned.
Computer and accessories (whether outright
purchase of hire purchase, lease etc.).
Vehicles (whether outright purchase of hire
purchase, lease etc.).
Office equipment (whether outright purchase of
hire purchase, lease etc.).
Documents underlying the abovementioned assets.

CONTRACTS

Sl. No. Question Response

12.1 Copies of all material contracts to which the

Company or any Subsidiary is or was a party
relating to the acquisition or sales of shares or
businesses, joint ventures, partnership or
investments in other entities, or reorganisations
including the following agreements:
Share purchase agreement
Subscription Agreement
Assignment Agreement
Slump Sale agreement
Shareholders Agreement
Joint Venture Agreement
Accquisition Agreement
12.2 Copies of all licence, distribution, franchise,
agency, research and development, marketing,
60 Background Material on Due Diligence

Sl. No. Question Response

consulting and management contracts granted to

or by or entered into by the Company or any
Subsidiary and all other contracts:
material to the business of any company; or
Containing long-term, unusual or onerous
provisions; or
Containing exclusivity, non-competition or
confidentiality provisions; or
Where change of shareholding could give
grounds for termination or is otherwise relevant,
(to the extent not otherwise covered above).
12.3 Details of breaches of any contracts by the
Company or any Subsidiary whether outstanding
or in the past including the following:
Breach of contract with a customer;
Breach of contract with a supplier;
Breach of contract with a licensor
12.4 Please provide details and documentation of any
outstanding quotation or tender for a major
contract made to or submitted by the Company or
any Subsidiary as well as any incomplete project
or assignment.
12.5 Copies of all contracts with directors or officers of
the Company and the Subsidiaries or the
companies' shareholders or with any affiliate.
12.6 Copies of all agreements of the Company and
Subsidiaries with governments and government
agencies, including, without limitation.
Software Technology Part of India.
Local Authorities.
Special arrangement for any facility for the
business of company.
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12.7 A brief outline, in respect of each type of trading

activity, of the method by which the Company and
its Subsidiaries documents its arrangements with
customers i.e., Standard Terms of Supply;
Does the company supply customers on a standard
supply order form? If so, please provide a copy.
Approximately what percentage of customers
would this form apply to?
Does this form contain all terms and conditions of
purchase when used or does a standard set of
conditions, an order acknowledgement form,
sales brochure or other document also contain
some of the terms and conditions?
Customers' Terms of Purchase;
Do some customers use their own purchase order
form or other documentation?
Approximately what percentage of customers
would use their own form?
In respect of each Company and Subsidiary,
please list any major customers, i.e. those
accounting for more than five per cent of sales
and provide copies of documentation with them.
12.8 Long Term Contracts: In respect of the Company
and each Subsidiary:
Please provide copies of any contracts with
customers having duration of more than six months.
Please provide copies of any power of attorney or
similar authority granted by Company and
Subsidiaries to a third party, or granted to the
Company or Subsidiary by a third party.
Non-Compliance with Agreements/Change Of
Control.
62 Background Material on Due Diligence

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12.9 Please provide details of any non-compliance by

either the Company/Subsidiary or the other
party in respect of any agreement (whether
written or unwritten) entered into by the
Company/Subsidiary.
12.10 Please provide a list of any agreements or
arrangements, which are subject to termination
or variation, require prior consent or notification,
or are contravened or otherwise affected by the
transfer of shares in the Company or any
Subsidiary.

INTELLECTUAL PROPERTY

Sl. No. Question Response

13.1 Please provide a schedule of all patents, trademarks,

service marks, trade names, copyrights, know-how
and registered designs owned by or licensed to or by
or used by the Company or any Subsidiary and all
other intellectual property of the Company and all
Subsidiaries, and copies of all relevant registrations,
applications, consents, licences and sub-licences.
13.2 Details of software licence royalties to be paid by
the Company or any Subsidiary to the licensor
(past, present and future payments)
13.3 Trademark registration of the logo, name etc of
the Company/Subsidiaries.
13.4 A list of authors, contributors, independent
contractors and employees involved in the
development of the Company and the
Subsidiaries' intellectual property, and copies of
any related employment, commissioning or
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Sl. No. Question Response

development agreements and related records

and correspondence.
13.5 In respect of the Company and its Subsidiaries, a
list of all proprietary products not protected by
patents or registered copyrights, trademarks,
etc. and steps taken to ensure their secrecy.
13.6 Details of any opposition proceedings, petitions
or challenges to any of the Company's and the
Subsidiaries' intellectual property.
13.7 Details of any infringement or alleged
infringement of the intellectual property rights of
any Company or Subsidiary, or of any such rights
of others by any Company or Subsidiary, and
related correspondence and documentation.
13.8 All assignments of intellectual property rights by
or to the Company or any Subsidiary.
13.9 All technical assistance, know-how and similar
agreements relating to the Company and the
Subsidiary.
13.10 Details of all software and hardware used by the
Company and the Subsidiaries, indicating the
licensor/owner of any software used and details of
any royalties or continuing payments required to
be made for the use of any software.
13.11 Details of all contracts taken out by the Company
and the Subsidiaries relating to the maintenance
of computer hardware and software.
13.12 Details of the security and backup arrangements
put in place by the Company and Subsidiaries to
protect the information maintained by computer
and to retrieve information in the event of a
computer system shutdown, and of the type and
range of information stored by computer.
64 Background Material on Due Diligence

Sl. No. Question Response

13.13 Details of any governmental or data protection

related licences held by the Company or any
Subsidiary regarding the storage, transmission
or usage of computer-held information.
13.14 Details of arrangements relating to the source
codes of any software developed, owned or used
by the Company and Subsidiaries, and of records
relating to its creation.
13.15 Ownership of Intellectual property arising of the
product development by the Company or
Subsidiaries
13.16 Details of all trademark searches or other research
on trademarks or other designations which are the
same or similar to marks or designations used by
the Company or any Subsidiary.
13.17 Details of any material known or suspected
problems with the computer systems of the
Company or Subsidiaries (e.g. viruses, defects in
functioning and material bugs) and details of
assessment procedures undertaken to assess
such computer systems.
Security breaches
System shutdown
13.18 Provide a full list of Internet domain names
registered in the name of the Company or any
Subsidiary or used in the course of the their
businesses including:
Key domain names: name registration
Negative registration
(Whether registered in the name of individuals
instead of the company)
 Due Diligence for Mergers & Acquisitions 65

LEGAL PROCEEDINGS, DISPUTES AND INVESTIGATIONS

Sl. No. Question Response

14.1 Please provide details of all pending or threatened

or anticipated claims, litigation, arbitration
proceedings, or governmental investigations and
proceedings (domestic or foreign), including
parties, damages and other remedies sought,
nature of action, details of any actual or potential
breaches of contract (all kinds of contracts
including those detailed in the Financial, Business
and operation matters, Intellectual property, and
other sections) or infringement of rights by or
against the Company and all Subsidiaries
including the following :
Disputes with customers.
Disputes with third parties.
Disputes with suppliers.
Disputes relating to intellectual property
infringement.
Disputes relating to recoveries.
Disputes with Employees of the company
Disputes with Income tax, Customs, and other
authorities.
Others.
14.2 Please furnish copies of all pleadings and other
material documents relating to material
litigation, arbitration and governmental
proceedings in connection with the Company and
Subsidiaries.
14.3 Please attach a schedule of all orders, writs,
decrees, injunctions, judgements, awards or
rulings (including consent decrees and
judgements) by any court, arbitration panel or
66 Background Material on Due Diligence

Sl. No. Question Response

governmental agency affecting the Company or

any Subsidiary.
14.4 Please provide copies of all correspondence
relating to any threatened governmental
investigation or alleged violation of law or
regulation by the Company or any Subsidiary.

INSURANCE POLICIES

Sl. No. Question Response

15.1 Please provide details of all material insurance

policies taken out by or on behalf of the Company
and all Subsidiaries and also furnish copies of all
contracts, policies and certificates of insurance
including the following :
Fire
Theft
Burglary
Professional liability
Key employee
15.2 Please provide copies of any reports or
correspondence regarding the adequacy of any
insurance coverage, reservation of rights or denial
of liability or coverage under any such policies.
15.3 Please provide confirmations from the Company
and its Subsidiaries as to the adequacy of such
company's insurance.
15.4 Please detail the Company's and the Subsidiaries'
claims records, rejections and provide copies of
related reports and correspondence.
15.5 Please complete Schedule III for the Company
and each Subsidiary.
 Due Diligence for Mergers & Acquisitions 67

ENVIRONMENTAL MATTERS

Sl. No. Question Response

16.1 Please provide copies of all internal and external

reports concerning environmental matters
relating to current or former properties of the
Company and its Subsidiaries.
16.2 Please furnish copies of all permits relating to
environmental matters and of any statements or
reports by the Company and its Subsidiaries to
any governmental, central or local department of
environmental regulation or any similar body.
16.3 Please provide copies of all approvals and
permissions obtained by the Company or any
Subsidiary under:
The Environmental Protection Act;
Air (Prevention and Control of Pollution) Act, 1981;
Water (Prevention and Control of Pollution) Act,
1974.
16.4 Please furnish copies of all notices, complaints,
suits or similar documents sent to, received by or
served upon any of the Company or Subsidiaries
by any governmental, central or local
department of environmental regulation or any
similar governmental, central or local regulatory
body, authority or agency.
16.5 Please provide us with all correspondence, reports
and other details pertaining to the notices,
complaints, suits, etc mentioned at [16.4] above.
68 Background Material on Due Diligence

PRODUCT/SERVICE LIABILITIES

Sl. No. Question Response

17.1 Please provide a brief outline of the method by

which the Company and each Subsidiary
documents its product/service warranties or
guarantees given to customers (if any). Please
provide copies of the documentation used,
including any warranty cards issued.
17.2 Have there been any product/service warranty
claims against the Company or any Subsidiary in
the past? If so, please provide details, including
present status.
17.3 Is the Company or any Subsidiary indemnified
for any product/service warranties or guarantees
by any of its suppliers? If so, please provide
details, including copies of the agreements with
such suppliers.

IMPENDING LEGISLATIVE CHANGES

Sl. No. Question Response

18.1 Are you aware of any impending legislative

changes, which might affect the Company, or any
Subsidiary? If so, please provide details of the
legislation as well as the possible impact upon
the Company or the Subsidiary.

COMPLIANCE WITH SPECIAL INDUSTRY SECTOR LEGISLATION

Sl. No. Question Response

19.1 Are any of the products manufactured by the

Company reserved for the small-scale sector as
per the Industrial Policy?
 Due Diligence for Mergers & Acquisitions 69

SCHEDULE ONE
FINANCE1

Date of Issue/ Facility2 Amount

Long-term

Committed3

Drawn

Undrawn

Uncommitted4

Drawn

Undrawn

Short-term

Committed2

Drawn

Undrawn

Uncommitted4

Drawn

Undrawn

1. Include all forms of debt financing (e.g. loan facilities, issues of bonds, receivables financing, factoring
arrangements).
2. Please provide details of the term to run for each facility or loan.
3. Where the issuer has already received the funds or the issuer has an enforceable right to draw the funds, subject only
to fulfilling conditions, which it is able to fulfill.
4. Date on which the underlying claim will be released (e.g. the debt guaranteed will be repaid).
70 Background Material on Due Diligence

SCHEDULE TWO
CONTINGENT LIABILITIES1

Brief Description2 Amount3 Expiry Date4

1. Include all contingent liabilities (e.g. guarantee).

2. Nature (e.g. “guarantee”), identity of beneficiary (e.g. “in favour of XYZ Bank”) and identity of person incurring
the underlying obligation (e.g. the person guaranteed).
3. Maximum amount of the possible claim.
4. Facilities where either the issuer has received the funds, but the lender can require payment on demand, or
where the issuer has no contractual right to drawn the funds.
 Due Diligence for Mergers & Acquisitions 71

SCHEDULE THREE
INSURANCE

Name of Insurer Property Insured First loss % of value insure

72 Background Material on Due Diligence

ANNEXURE C
SPECIMEN CHECK LIST FOR
COMMERCIAL DUE DILIGENCE

Please prepare a folder containing the information requested below. This

checklist is to be placed at the top of the folder and should indicate against
each question either an explanation or the reference number of the
document in the folder that supports the explanation or both. In case a
question is not applicable please indicate as such. All documents in the
folder should be numbered and the folder should be indexed.
1. General
i. List of companies/firms which are a part of the business group to which the
target company belongs.
ii. Brief note on the history of the company being invested in, including
reference to its foundation and expansion.
iii. Brief note on present business and activities, including list of business
locations; please provide details for separate product/service verticals
embedded solutions, infrastructure for power and software solutions.
iv. Any recent reports on the company's activities prepared internally or by
outside consultants (such as analyst reports, information memorandum,
valuation reports etc.).
v. Copies of any literature prepared by the company illustrating its products,
operations, history etc.
vi. Any agreements or documents recording arrangements between
shareholders of the company.
vii. A list of all licenses and registrations held by the company specifying
number, validity period, purpose, granting authority and other relevant
details. Copies of the same may also be enclosed.
viii. Minutes of meetings of the board of directors, shareholders and
audit/operational committees since incorporation.
ix. Brief note on the internal control environment in the division.
x. Details of bankers, lawyers, consultants and other professional advisers.
xi. Transactions/agreements with affiliates and related parties especially
 Due Diligence for Mergers & Acquisitions 73

with respect to prices, payment terms, etc.

xii. All statutory registers and returns filed required to be maintained/filed
under the Companies Act.
xiii. Details of intellectual property rights (including trademarks & brands)
held by the company, if any.
xiv. Note on planning and control systems prevalent in the organisation
including controls over non financial systems such as production
planning, quality control, inventory management, sales etc.
xv. Details of statutory records maintained under the Companies Act and
other applicable statutes.
xvi. Transaction documents (agreements) for any prior acquisitions done by
the company or investments in the company.

2. Financial Statements information for the year ended March 31, 200_,
March 31, 200_ and for the nine months ended December 31, 200_.
i. Audited/un-audited financial statements of the Company along with its
reconciliation with management accounts for the year ended March 31,
200_, March 31, 200_ and for the nine months ended December 31, 200_.
ii. Chart of accounts.
iii. Accounting policy at present, in particular with respect to income/sales
recognition, research and development, exceptional and extraordinary
items, acquisition and disposal of assets, differentiating between capital
expenditure & repairs and maintenance, valuation of fixed assets,
capitalisation of interest, inventory/stock valuation, transfer pricing,
preliminary expenses.
iv. Details of changes in accounting policies over last 5 years.
v. Closing audit working files prepared by the Company, as appropriate.
vi. Trail Balance, schedules and groupings supporting the financial
statements for the year ended March 31, 200_, March 31, 200_ and for the
nine months ended December 31, 200_.
vii. Audit management letters for the period under review.
viii. Internal audit reports for the period under review.
ix. Budgets, comparison with actuals and explanation for variances for last
74 Background Material on Due Diligence

two accounting periods i.e. FY0-, FY0- and YTD0-. Specifically revenue
forecast versus. actuals, expenditure forecast versus. actuals and
manpower budget versus. actual headcount.
x. Cash flow statements for the year ended March 31, 200_, March 31, 200_
and for the nine months ended December 31, 200_.

3. Management Accounts
i. Copies of monthly management accounts since April 200_ till date.
ii. Breakdown of above by vertical (separately identifying financials for
embedded solutions, infrastructure for power and software solutions).
iii. Reconciliation of management accounts to statutory accounts for the year
ended March 31, 200_, March 31, 200_ and for the nine months ended
December 31, 200_.
iv. Trading Results.

4. Revenues
i. Split of revenue:
+ Customer wise
+ Product wise/ Service Wise
+ Substation Controllers
+ Distribution Transformer Monitoring System
+ Theft Detection Device
+ Intelligent Automatic Meter Reading
+ General Automatic Meter Reading
+ Spot Billing Machine
+ Computerised Online Data Logging System
+ Energy Audit Services
+ Micro RTU
+ Vertical wise
+ Embedded Solutions
+ Infrastructure for Power
+ Software Solutions
 Due Diligence for Mergers & Acquisitions 75

+ Geography wise and target industry sector

+ Rural electrification
+ Transmission
+ Oil & gas
+ Technology, and
+ Exports.
ii. Historic product/service wise contributions earned and gross margin.
Also provide details of direct costs. Details of profitability for top 5
customers.
iii. Comparison of revenue and contribution reflected in the financial
statements with the Management Information System ('MIS') and
budgets; analysis of reasons for variance.
iv. Average realisations by product/service in last three years for the
customers.
v. Details of the basis for revenue recognition for all the contracts with
customers.
vi. Details of deferred revenues year ended March 31, 200_, March 31, 200_
and for the nine months ended December 31, 200_ and bookings carried
forward to the next year and the next period.
vii. Details on marketing and pricing strategies of the Company; average
realisation per hour per contract/agreement for each key
customer/product/service of the Company.
viii. Revenue per headcount, together with details of employee productivity
(monthly data) for the historic period.
ix. Discount structures and credit terms for major customers; historic
average realization per headcount/service for that customer.
x. Details of customer agreements terms, value, rates, penalties, Service
Level Agreements, committed headcount and volume and bearing of
training costs. Also provide details of revenue by nature of billing cycle,
frequency of billing, milestone based or man hours per month
basis/transaction.
xi. Product wise/service wise/customer wise status of contracts under
negotiation and details of the progress in the same.
76 Background Material on Due Diligence

xii. Details of customer acquisitions in the last two years ended March 31,
200_, March 31, 200_ and for the nine months ended December 31, 200_.
xiii. Details of customer attrition rate; clients acquired from competitors and
clients lost to competitors along with the reasons for the same over the
past for the year ended March 31, 200_, March 31, 200_ and for the nine
months ended December 31, 200_.
xiv. What has been the increase in the size of operation for the existing clients?
xv. Details of other income.
xvi. Details of exceptional and extraordinary income items.
xvii. Pricing movements for the defined historical period together with the
nature of movement; pricing differences between clients and reasons for
the same; pricing band service wise/product wise, if any.
xviii. Budget/Actual analysis of product/service-wise and customer wise sales
and analysis of the reasons for variations.
xix. Revenue sharing arrangements and transfer pricing amongst the
Divisions, if any as per the terms of the respective contracts.
xx. Comparison of revenue and contribution reflected in the financial
statements with the Management Information System (MIS) and
budgets.

5. Customers and Marketing

i. Write up on selling and distribution methods (systems and procedures
followed, etc), factors affecting prices, margins, periods of peak and low
revenue, etc.
ii. Details on marketing and pricing strategies of the Company.
iii. Details of various components of freight, tax and other costs from factory
sales point to the sale point of the customer.
iv. Discount structures and credit terms for major customers; historic
average price realizations.
v. Average price realisation (monthly) per unit for each product of the
Company in the last two years i.e. March 31, 200_, March 31, 200_ and for
the nine months ended December 31, 200_.
vi. List of all significant marketing agreements and contracts with customers.
 Due Diligence for Mergers & Acquisitions 77

vii. List of major customers for individual products along with details of
geographic segments sales (domestic and export) for March 31, 200_,
March 31, 200_ and for the nine months ended December 31, 200_.
viii. Pricing policy for sale to related parties.
ix. List of any claims/disputes with or complaints from customers giving
amounts and background.
x. Details of all returns by customers with reasons for year ended March 31,
200_, March 31, 200_ and for the nine months ended December 31, 200_.
xi. List of all competitors, company market share (present and anticipated),
etc.
xii. Status of order book as on December 31, 200_.

6. Suppliers
i. Purchase policies and procedures.
ii. List of major suppliers in the period ended March 31, 200_, March 31,
200_ and for the nine months ended December 31, 200_ showing nature of
purchase, quantity purchased and amount of purchases.
iii. Pricing policy for purchases from related companies.
iv. List of all significant contracts with the suppliers.
v. Details of purchase at forward prices and forward purchase, if any.
vi. List of any claims/disputes with suppliers giving amounts and
background.

7. Purchases and Consumption Costs.

i. Material expenditure with the respective supply contracts.
ii. Consumption costs for individual products; details of actual consumption
with standard.
iii. Details of the power and fuel cost with respect to. unit rates and
consumption patterns in the last three years.

8. Expenditure
i. Details of average headcount cost per customer/service.
78 Background Material on Due Diligence

ii. Details of average direct cost per customer/service.

iii. Direct costs for individual services detailing all components of costs.
iv. Details of cost structure, breaking it into fixed costs and variable costs.
v. Personnel cost including perquisites and retirement benefits.
vi. Details of incentive/commission policy for sales and other of the Company
and details of the cost during the historical period.
vii. Payment of royalty/ technical know-how fees, if any, along with the terms
of the respective agreements.
viii. Details of repairs, rent, stores and spares consumed, carriage and freight,
finished goods handling expenses, other expenses, etc.
ix. Details of the inventory write-offs in the last three years.
x. Details of provision for bad and doubtful debts in the last three years.
xi. Administrative and other expenses including professional, legal fees,
other expenses.
xii. Details of the selling and marketing costs.
xiii. Basis for allocation of common costs and support expenses.
xiv. Details of financial costs including interest, lease rent and hire charges.
xv. Details of payment of royalty/ technical know-how fees along with terms of
respective agreements.
xvi. Details of provision for bad and doubtful debts in the last three years.
xvii. Balance sheet (Details required as on March 31, 2005-, March 31, 200_ and
for the nine months ended December 31, 200_, unless otherwise specified).

9. Fixed Assets
i. Summary showing principal categories of assets at last year end and most
recent accounting date showing cost, accumulated depreciation, net book
value and depreciation charge for the period.
ii. Details of valuation/revaluation of fixed assets, if any.
iii. Details of charges or lien created against any fixed assets through
guarantees or loan arrangements.
iv. Details of insurance policies and coverage of fixed assets.
v. Details of capital work in progress, if any.
 Due Diligence for Mergers & Acquisitions 79

vi. Contracts for pending capital commitments at last year-end and most
recent date - contracted for and authorised but not contracted.
vii. Copies of leasehold agreements (lease and sub-leases) and tenancy rights,
title deeds and other agreements giving amounts and terms involved
(renewal options for the lease period).
viii. Fixed assets ledger/register and supporting documents for fixed assets.
ix. Physical verification reports and its periodicity.
x. Procedure for authorising and procurement of capital expenditure.
xi. Accounting policy for capitalisation of financial costs and details of
capitalisation of financial costs.
xii. Terms and accounting practice for leased/hired assets; details of financing
arrangements and payments thereof and details of future commitments,
if any.
xiii. Useful life of assets and depreciation computation.
xiv. Details of sale of fixed assets and policy for determining prices.
xv. List of obsolete and idle equipment with cost and net book value attached.
xvi. List of fully depreciated assets.
xvii. Details of any restriction on the use or sale of any asset.
xviii. Foreign exchange fluctuation and accounting thereof.
xix. List of all properties owned or operated that are connected to the business
with details of their book values, usage, title/ lease and rent details.

10. Inventories
i. Details of inventory/stock as on March 31, 200_, March 31, 2006- and
December 31, 2006-.
ii. Inventory details and classification into raw materials; work in process,
finished goods and stores and spares.
iii. Quantitative reconciliation of opening stock, purchases, sales and
wastage, etc. for FY 0-, FY 0- and YTD 0_.
iv. Inventory valuation workings and its basis. Details of overhead and other
costs included in stock values.
v. Age wise details of inventory as on March 31, 200_ and March 31, 200_.
80 Background Material on Due Diligence

vi. Provisioning policy of inventory and details of provision against inventory

as on March 31, 200_ and on December 31, 200_.
vii. Procedure for identification of slow moving and obsolete/unusable
inventories.
viii. Treatment of goods in transit and material at third location and details in
respect thereof as on March 31, 200_, March 31, 200_ and December 31, 200_.

11. Receivables
i. Party-wise break-up of Sundry Debtors with confirmation and
reconciliation statements as on March 31, 200_, March 31, 200_ and
December 31, 200_.
ii. Ageing details of Debtors as on March 31, 200_, March 31, 200_ and
December 31, 200_.
iii. Details of subsequent receipts with supporting documents.
iv. Details of credit terms as per the respective contracts and other
supporting documents with details of changes in the credit terms, if any.
v. Details of provisions for doubtful debts/written off debts and movement in
provisions since incorporation.
vi. Details of subsequent receipts with supporting documents.
vii. Details of dispute in payment/claims filed by customer.
viii. Details of actual collections period versus contractual credit period for
receivables outstanding.
ix. Details of write off of bad debts over the last three years ended on March
31, 0- or later financial period as being followed.
x. Nature and details of transactions with related Company and accounts
ledger of these receivables.

12. Loans & Advances and Other Current Assets

i. Details of Advances recoverable in cash or in kind or value to be received
with supporting documents as on March 31, 200_, March 31, 200_ and
December 31, 200_. Reasons for advancement, ageing, existence and
adequacy of contracts and reasonableness of terms and conditions of each
receivable.
 Due Diligence for Mergers & Acquisitions 81

ii. Details of deposits with Public Bodies and others prepaid expenses with
supporting documents and balance confirmations. Review of the terms of
the deposits, ageing and subsequent clearances thereof.
iii. Details of Fixed Deposits held for disposal and interest accrued on
investments & deposits.
iv. Details of provision for doubtful advances, if any.
v. Details of amounts due from staff and officers and their subsequent
clearances.
vi. Details of other receivables on account including reason for advancement,
ageing, existence and adequacy of contracts and reasonableness of terms
and conditions of each receivable.
vii. Nature and details of transactions with related company and accounts
ledger of these receivables.

13. Cash and Bank Balances

i. List of bank balances and bank accounts as on March 31, 200_, March 31,
200_ and December 31, 200_.
ii. Bank reconciliation statements and confirmations as on March 31, 200_
and December 31, 200_.
iii. Details of the fixed deposit amount providing the date of deposit, interest
rates, etc.

14. Miscellaneous Expenditure to the Extent Not Written-off

Details of accumulated amortization and net book value as on, March 31, 200_,
March 31, 200_ and December 31, 200_.

15. Creditors and Accrued Expenses

i. List of trade creditors at March 31, 200_, March 31, 200_ and December
31, 200_.
ii. Ageing details of trade creditors along with supply contracts (including
the terms of payments) and subsequent payments.
iii. Contracts with the Vendors.
82 Background Material on Due Diligence

iv. Creditors balance confirmation certificates and reconciliation statements

as at March 31, 200_, March 31, 200_ and December 31, 200_ or any other
latest date.
v. Details of accruals with supporting documents and subsequent
clearances.
vi. Details of off Balance Sheet Liabilities (such as leases).
vii. Details of advances received with aging details, subsequent clearances, etc.
viii. Basis of accruals of expenses and other liabilities.
ix. Details of provisions against claims, if any.
x. Hedging policy, if any and details of purchase commitments as on date of
financial statements.
xi. Detailed listing of overdue payables.
xii. Details of any penalties/interest levied on overdue payments, if any.
xiii. Purchase policies and procedures for all operational (ex: content) and
administrative purchases (miscellaneous purchases).
xiv. List of major suppliers in the period showing nature of contract and value
of purchases.
xv. Pricing policy for purchases from related companies.
xvi. List of any claims/disputes with suppliers, background and current status
of the same.
xvii. Any redundancy or liability clauses against the key suppliers like
transportation, food, Server & Switch maintenance vendors etc.

16. Amounts Due to Related Parties

Nature and details of related company dues and account listing of these dues since
the incorporation of the Company

17. Secured and Unsecured Loans

i. Details & terms of working capital loans & other financing from banks &
other parties with their respective repayment schedule. Review of the
outstanding amounts at March 31, 200_, March 31, 200_ and December
31, 200_, current interest rates, period, loan covenants.
 Due Diligence for Mergers & Acquisitions 83

ii. Provide details of default in repayment of loans and interest in the historic
period, if any.
iii. Bank facility letters for encumbrances on assets.
iv. Details of outstanding amounts, current interest rates, period, loan
covenants.
v. Details of any corporate/ personal guarantee extended.
vi. Confirmation from the Bank on the amount outstanding and interest
accrued thereon.
vii. Details of the sales tax deferral scheme, if any.

18. Reserves
i. Provide details of all the reserves at the historic balance sheet dates for
the historical period. Provide the terms for the statutory reserves.
ii. For all reserves, provide details regarding (i) purpose of reserve, (ii) period
reserves were originally established, and (iii) all movements to the
reserve (i.e., roll forward payments against, reversals, transfers, and
reclassifications) for each period during the historical period.

19. Contingencies
i. Significant contracts, correspondence with solicitors, tax offices,
shareholders register.
ii. Details of claims against the Company not acknowledged as debt.
iii. Details of outstanding bank guarantees and bill discounted.
iv. List of charges, pledges, etc. over assets of group.
v. Details of capital commitments, non-cancelable operating lease and other
commitments and contingencies.
vi. Details of litigation disputes against the company, promoters and group
concerns on the company.
vii. List & details of any existing and potential lawsuits/claims - cause,
amounts involved, latest provisions, etc.
viii. Disputes/claims with respect to employees, ex-employees, customers,
vendors, etc.
84 Background Material on Due Diligence

ix. Details of any regulatory claims against the Company.

x. Confirmation from the lawyers about the list of legal issues and current
status of the same.
xi. List of any claims/disputes with or complaints from customers giving
amounts and background.

20. Secretarial Records

i. Minutes of Board of Directors and Shareholders meetings.
ii. Shareholders register.
iii. Register of Directors and Contracts in which Directors are interested.

21. Human Resources

i. Organization structure and reporting relationships as on March 31, 200_
and on March 31, 200_.
ii. Number of employees, grade-wise in each of the vertical and by
department.
iii. Details of time management system, together with details of employee
productivity over the historic period.
iv. List of directors, officers, senior staff (considered key to the business)
showing position, name, age, length of service, skills, salary benefits, etc.
v. HR systems prevalent in the organization, including performance
appraisal systems.
vi. Level-wise headcount movement i.e. month-wise number of employees
joining and leaving the organisation in the last two years, by
department/function. Also provide us with an average replacement time
and cost of replacement.
vii. Employee contracts, service agreements.
viii. Details of employee union activities and note explaining significant Union
activities since incorporation.
ix. Details of any wages/bonus, etc. agreements signed with the employee
unions.
x. Staff movement i.e. month-wise number of employees joining and leaving
 Due Diligence for Mergers & Acquisitions 85

the organisation in the last two years.

xi. Details of key employees who have left the Company in the past two years.
xii. Is manpower hired from third parties? If so, agreements with these parties.
xiii. List of all labor disputes pending as on March 31, 2006 and on December
31, 200_.
xiv. Employee Provident Fund registration certificate, sample monthly
remittance challans,
xv. annual returns and correspondence with the relevant authorities.
xvi. Details of accrual of various retirement liabilities viz. leave encashment,
gratuity, etc. as on March 31, 200_ and on December 31, 200_. Please also
specify how the various retirement benefit liabilities are funded.
xvii. Actuary certificate for the retirements benefits as on December 31, 200_.
xviii. Number of employees education wise at the agent and management level.
xix. The details of the training calendar for the year ended March 31, 200_,
March 31, 200_ and the nine months ended December 31, 200_.
xx. Ratio of full time employed/contracted headcount year ended March 31,
200_, March 31, 200_ and the nine months ended December 31, 200_.
xxi. Training cost/headcount

22. Forecast
Details of the forecast for FY 200_ (reflecting actuals YTD) and FY 200_ along with
detailed assumption on growth assumed in product/service/customer sales, prices,
product-wise sales and margins, customers, geographical sales, sales and
marketing costs, customer returns, raw material mix-quantity and prices, other
administrative costs, interest cost, etc.

Others
23. Technology
i. Note on the Information technology and the overall control environment
of the Company.
ii. Details of software used for staffing & scheduling, planning and any other
key softwares used for the year ended March 31, 200_, March 31, 200_ and
86 Background Material on Due Diligence

the nine months ended December 31, 200_and what is the efficiency of the
scheduling for the top 5 customers.
iii. Are there any knowledge management software being used for the
operations & their details.
iv. How many licenses are available for different software being used?
v. Do you have any documented and implemented Disaster Recovery and
Business Continuity plan.
i. When was last BCP\DRP test performed and details of the same.

24. Infrastructure
i. What has been the build up of capacity over the last for the last two years
i.e. for the year ended March 31, 200_, March 31, 200_ and the nine
months ended December 31, 200_.
ii. What % is the un-utilised capacity?

25. Taxes
Direct Taxes
Summary Information
i. Year-wise summary chart for income tax and wealth tax for past five
years, detailing the following:
ii. Current assessment/ litigation status.
iii. Key disallowances/issues raised by the authorities.
iv. Amount of demands raised by the authorities and paid by the Company.
v. Level of settlement of dispute (i.e. CIT (A)/ ITAT/ HC/ SC).
vi. Taxable profit/ carried forward loss for the year and set off in future years.
vii. Status of brought forward losses/ allowances, if any.

26. Information for Review Period

i. Copies of Return, computation of income, transfer pricing report (along
with transfer pricing study) for three preceding years.
ii. Copies of tax audit report and other annexure for the latest three
assessment years.
 Due Diligence for Mergers & Acquisitions 87

iii. Copies of intimations, assessment orders, submissions made, appellate

orders etc for all open years.
iv. Details of tax benefits claimed by the Company.
v. Year-wise details of amount appearing under the heads 'provision for tax'
and 'advance tax' as at March 31, 200_ and December 31, 200_.
vi. Provisional computation of tax liability for the Financial Year 2000-,
based on which the Company has paid advance tax installments.
vii. Computation of amount appearing as deferred tax asset/ liability as at
December 31, 200_ and March 31, 200_.
viii. Copies of legal opinions, if any, obtained by the Company.
ix. Copies of wealth tax returns (along with all annexure) filed by the
Company for three preceding years.

27. Indirect Taxes

Service Tax
Status of compliance and assessment
i. Statement of domestic revenue streams and whether service tax charged.
Verticals can provide details and sub-divisions thereof or chart on
reasoned positions adopted regarding applicability of service tax.
ii. ST-3 and credit returns filed.
iii. Details of payments to foreign service providers for services rendered in
India .
iv. Details of payments to road transporters.
v. Details of all payments made to and services received from all foreign
service providers.
vi. Any audit objections received by the company after excise/service tax audit?
vii. Agreements for services utilized and rendered by the company.

Customs
i. List of goods, which are generally imported along with tariff classification
and rate of duty.
ii. Bills of Entry for all imports assessed provisionally.
iii. Licenses granted (for import).
88 Background Material on Due Diligence

iv. Licenses granted (under Duty Exemption Scheme).

v. Status on discharge of export obligation and related documentation.
vi. Status on discharge of legal undertaking/ bonds.
vii. Status of show cause notices (“SCN”) issued; submissions made,
adjudication thereon and appeals.
viii. Agreements pertaining to import of know how, technology, drawings,
designs, etc.
ix. Legal opinions obtained, if any.

Excise Duty
i. Status of compliance and assessment.
ii. Registration certificates.
iii. Show cause notices, submissions made, adjudication orders and appeals.
iv. Registers maintained for excise purposes including returns and credit returns.
v. Documentation in support of credit and refund claims in relation to input
duties/ taxes.
vi. Outsourced job works/ relevant agreements for the same.
vii. Exemptions claimed in the review period and those that are currently valid.
viii. Legal opinions obtained, if any.

Sales Tax/VAT
i. Status of compliance and assessment.
ii. Assessment orders for last 3 assessed years (for CST, local sales tax).
iii. Returns filed during the last one-year.
iv. Details of incentives claimed and periodical reports filed, if any.
v. Details of declaration form pending receipt.
vi. Classification determination order, if any.
vii. Copies of all distribution agreement.
viii. SCNs, communications from the sales tax authorities.
ix. Appeal petitions/applications.
x. Application for any sales tax exemption, along with related
documentation.
xi. Legal opinions obtained, if any.
 Due Diligence for Mergers & Acquisitions 89

ANNEXURE D

This specimen report attempts to cover venture finance, investment and a amalgam
type transaction and it should not be construed as one intended for only merger &
acquisition due diligence. The instructor may use this specimen report to explain the
different aspects that a due diligence findings cover and its style of writing.

Sample Due Diligence Report for a Prospective Investment

This report is for the limited usage of the private party that commissioned it, and
remains the property of the author. This report and it's information is not for
distribution, dissemination, or publication in any form or manner, including
excerpts, quotations, summarisation, or paraphrasing, whether written, verbal, or
otherwise. This may not be used by anyone, including the party that commissioned
it, to persuade or dissuade other prospective investors.

1. Economics
In our limited review, we found some items of concern as reported in this section.
These may or may not be indicative of problems, and should probably be followed-up
with questions to the Company for clarification. We can pursue this further if
desired.
+ Evidence of high-end marker - The Plan devotes considerable space to the
general prevalence in the country of __________________ problems, but shows
essentially no data regarding the particular market for people who can afford to
pay Rs._____ to Rs._____ (or more) out of personal funds to deal with it in a
luxury setting. The presumed existence of such a sub-market is the cornerstone
of the whole Plan. This target market may well exist to the point that four dozen
such people can be found every month or two, for years to come, but no evidence
is presented.
+ Inadequate budget to provide deluxe environment - People that are paying this
price range may expect private rooms, and better food and more personal
attention than what is presently included in the Plan. People are to sleep two to
a room, food is budgeted at about Rs._____ per month per person, and the
professional staff is budgeted at about ________________ professional
90 Background Material on Due Diligence

(__________, etc.) for each five guests. Taking into account the 24/7 nature of the
situation, the 1-to-5 ratio is actually even worse, at this would imply each guest
would get about 1 hour per 24-hour day of individual attention, and actually less
when further taking into account that some of the professionals' time will be
spent in group activities, and thus unavailable for individual attention.
Similarly, the Plan appears to provide for very few kitchen staff and
housekeepers, especially in light of the 24/7 setting and the high-end clientele.
There appears to be no budget for a ___________, and a fulltime one would only
allow an average of less than one hour per week per patient. It is the nature of
most such start-up plans (i.e., for a new business model) to not anticipate all
costs, and thus it would be both reasonable and prudent that a non-trivial
allowance should also be provided for “Unanticipated Other Costs” (perhaps
about 15% of the total of identified costs). These budgeting issues suggest lower
profitability than what is indicated in the Plan, or worse, forthcoming client
dissatisfaction with the experience, or, perhaps a lack of
business/operational/management experience (and/or attention to detail) on
the part of the founders.
+ Significant omissions in the budget, or extra fees to the clients - The Plan states
that “ all treatment services” as well as “outside functions” are included in the
very large fee. The Plan describes a significant roster of “Adjunct Services”
which will be available (e.g., __________ services, _____ management,______-
feedback, conditioning, _______, ___________ treatment, ________ services,
etc.), all to be provided by outside contractors. There does not appear to be any
funds in the budget to cover this, which would likely be a significant cost. The
alternative, of charging extra for these items, would not appear to fit well with
the high-priced “all inclusive” portrayal.
+ Treatment pricing is twice as high - The Plan seems inconsistent as to the
average cost per patient, variously citing full term price of Rs.______, a monthly
fee of Rs._____ “an average length of stay of two months” (i.e., Rs._____), and
Rs._____ per month in the P&L spreadsheet. Additionally, as above, will there
be potentially substantial extra fees charged?
+ Plan details for equipment and furnishings not provided - Perhaps it has been
done and simply not included, but we see no list of major assets required, and
associated costs of procurement, nor any estimate of the total funds budgeted.
For example, the facility is in effect going to be operating a small restaurant, if it
 Due Diligence for Mergers & Acquisitions 91

is to include all meals for 48 or so people (plus staff?), three times a day (plus
late-night snacks available for the “deluxe” environment?), seven days a week.
+ Financial results for the ramp-up years - The spreadsheet that we examined
was not labeled as to what year it represented (i.e., the first year, or the fourth
year, etc.), but showed the client load already at essentially full capacity. The
economics of the ramp-up years were not shown in our copy; these years could
possibly be more problematic in terms of cash flow.
+ Higher density per building - The property is reported as ________ acres with
________ existing homes, which are described as capable of housing 6 clients
each. The Plan then provides for an additional ________ homes to be built on the
property, which implies they would have to house ten clients each to reach
planned capacity; this larger group size is not mentioned.
+ Competitive advantage - Being “first to market” (as stated in the Plan as a key
competitive advantage) in this particular situation does not infer much in the
way of lasting competitive advantage, as far as we can tell. Likewise, the Plan
statement that their ________ services … can not be duplicated” rings rather
hollow. There is a strong market and few providers, these may not matter. We
have not spent time to search for possibly pre-existing high-end competitors;
this can be pursued if desired.

2. Usage of Stock Sale Proceeds

In our limited review, we found items of very substantial concern in this section,
which we believe should be clarified in writing with the Company prior to any
investment.
+ Document contradictions - There were two documents provided (“Confidential
Private Placement Memorandum; Rs. 10,000,000; _______, Inc.; Equity Shares”
and “________; Confidential Document; Contact ___________; ________, Inc.”),
and these two documents at times appear to contradict each other, including
with regard to the usage of share sale proceeds. It is our lay interpretation that
the Private Placement Memorandum would be the definitive legally binding
language; if this issue is a concern, an attorney should be consulted for a
professional legal opinion on this issue (which we cannot and do not provide).
For the sake of brevity, our comments with regard to the usage of proceeds apply
primarily to the Private Placement Memorandum (“PPM”) document.
92 Background Material on Due Diligence

+ Half of the proceeds to be raised are targeted to go to what is effectively the

apparent anticipated cost of raising the funds. - This “half” also may well be the
“first half”, i.e., if the full Rs.10 Million is not raised, the first funds (or perhaps
even the first Rs. 5 Million) may go to these ends, leaving even less than half of
what is ultimately raised for the business. This would appear excessive, and
dangerous to the integrity of the stock investment from the investor's
perspective. Of the other half, a significant piece is slated for overhead,
analysis, and other “soft” costs; only Rs.4.2 Million of the Rs.10 Million is
specifically slated for real estate costs, construction, and asset/equipment
requisition. The PPM also states, with respect to the Rs.5 Million that is
earmarked for the cost of raising funds, and all other categories, that “any
unused sums in any of the above categories may be retained by the Company for
any purposes … including … payments to the principals for management fees.”
It is our interpretation, which may be incorrect, that the PPM states, in effect.
That substantial amounts of the Offering may be paid directly to the principals,
in unspecified ways, with no defined oversight or scrutiny.
+ It is not all clear that the funds earmarked from this stock issuance will be used
to purchase any property - The footnote that explains what the “Real Estate
Costs” are does not mention the purchase of any property; rather, it says that
this Rs.4 Million is “Reserved for the pre-payment and continuing of leases …”.
It further mentions “leasehold improvement for space renovations including
architectural drawings and consultation.” This would appear to b a somewhat
cryptic reference to the only lease mentioned, which is the presently leased
_____, 000 square foot office space, which is not part of the residential property
being considered for purchase. The PPM further states “The Company plans to
use the capital provided by this Offering for advertising and marketing,
accounts payable or other working capital and general corporate purposes that
management determines are in the best interest of the Company.” We can find
no place in the PPM where it indicates planned usage of the funds for
acquisition of the real estate and facilities, which acquisition is the supposed
cornerstone of the Plan. Additionally, it states “Management is not restricted in
the application of the funds as provided in this Memorandum under the caption
'Use of Proceeds'.” This is close to a “blank check.” In our view, the charitable
interpretation of these facts is that the PPM document is poorly written. We
regard this as a substantial “red flag.”
+ Stock investment could be at substantial risk if inadequate funds are raised in
 Due Diligence for Mergers & Acquisitions 93

Offering - The Offering is being conducted on a “best efforts, no minimum basis,”

stating that “There is no minimum amount of proceeds that must be raised
before the Company may use the Proceeds of this Offering, … The Company will
have broad discretion in the use of these funds. In yet another area it states
“Whereas the total amount of the offering may not be raised, there is substantial
risk that if the total amount is not raised there may not be sufficient capital to
complete any of the projects contemplated. To that extent, the investor may lose
all of the investment.” While it can certainly be claimed that this is “just legal
boilerplate,” consider two things: 1) subscriptions such as this can be, and often
are, structured such that if a certain threshold amount is not raised, then all the
funds get returned; this PPM is very pointedly not that way; and, 2) the
Company specifically states in the PPM that “The Company has not been
represented by legal counsel in connection with the preparation of this
Offering”. …. so who then wanted the deal structured this way, and that
language included? If there is inadequate funding raised to accomplish the Plan
objectives, the Company is under no obligation to return any funds to
stockholders, and from all apparent writings, it would appear that the
Company has no intention to return funds under such a scenario. This also
plays in to a concern raised in Section 3 below.

3. Ownership, Control, Accountability and Investment Exit

In our limited review, we found items of very substantial concern in this section.
+ Present ownership and control: At present, the majority of the Company's stock
is reported by the Company to be owned by ________ (35.1%), ______ (19.2%),
and _____ (10.6%), collectively 64.9%, with the next largest holder reported at
7.4%. We have absolutely no further information on any of these people,
including even what their first names are. They are not listed as Officers. The
Board of Directors is not identified, and we do not know if it has even been
established at this point. We do not have access at this time to the Articles of
Incorporation, or the Bylaws, which could be critical. The PPM states that
“certain provisions of the Company's Certificate of Incorporation and Bylaws
and of _______ law may delay, defer, or prevent a change of control of the
Company and may adversely affect the voting and other rights of the holders of
Common Stock.”
+ Control by presently subscribing shareholders: The Offering is for 10.0 million
94 Background Material on Due Diligence

shares, and it states that there are presently only 0.2 million outstanding, and
further, that the Company is authorised to issue a total of 25.0 million shares of
equity stock, and that the Board can issue the remaining 14.8 million additional
shares (subject to __________ law) without stockholder approval. The bolders of
these new shares (which could, or may have to be, issued at a vastly lower price)
could then control the majority of the Company's stock. There is no mention that
we saw in the PPM of any election of Directors shortly after the subscription for
the present stock. The PPM states, “The Investors shall not be entitled to
receive a copy of the list of Investors.” It appears to us as a distinct possibility
that unless someone (or a group of parties that knows each other before hand)
subscribes to more than half of the current Offering, that the subscribers to the
Offering may have absolutely no method of influencing the Board, even if 90% of
the shareholders felt the same way.
+ Accountability: near absolute power of the unidentified Board - The PPM
states that if the Company has inadequate funds to carry on it's business,
that it may issue more shares in a attempt to raise additional funds. The new
shares may be of the same, or a different, “series” of stock. Further, the PPM
states that the Board of Directors has the authority, without stockholder
approval (subject to ____________ law), to alter the rights, privileges, and
voting of the shares outstanding (including those being offered in the PPM),
and may apparently do so differently by series (e.g., to give the second series
different rights than the first series). Lastly, the PPM states “the Board of
Directors may authorize and issue Preferred Stock with voting or conversion
rights that adversely affect the voting power or other rights of the holders of
the Common Stock. In addition, the issuance of the Preference Shares may
have the effect of deferring or preventing a change of control in the Company.”
This appears to be unconstrained by any stockholder vote. Our lay
interpretation of this is that the common shareholders do not effectively
control the Board here; this is not a legal opinion, and an attorney may not
agree with out assessment. We see the combination of the items above as a
substantive red flag.
+ Insulation of the Board: The PPM states “The Company's Certificate of
Incorporation and Bylaws contains provisions that limit the liability of
directors … and provides for indemnification of officers and directors under
certain circumstances. Such provisions may discourage stockholders from
bringing a lawsuit against directors for breaches of fiduciary duty and may
 Due Diligence for Mergers & Acquisitions 95

also have the effect of reducing the likelihood of derivative litigation against
directors and officers even though such action, if successful, might otherwise
have benefited the Company's shareholders. In addition, a stockholder's
investment in the Company may be adversely affected to the extent that costs
of settlement and damage awards against the Company's officers and
directors are paid by the Company pursuant to such provisions.” This kind of
provision is not all that uncommon, and is sometimes used by bonafide
companies to discourage frivolous lawsuits and to entire good people to serve
as officers and directors; however, in conjunction with everything else here, it
is worrisome. The PPM also states, “Investors shall not have the right to
receive copies of any federal, state or local income tax or information returns.
… Investors shall not have access to the books and records of the Company.”
Again, this may actually be not uncommon, but in our case, no independent
outside auditors have been named, nor has there been any mention that some
such chartered accountant firm shall be found; only annual reports are
committed to (none quarterly, and nothing as to being audited).
+ Investment: Substantial restrictions apply with respect to any sale of an
investor's stock. Dividends are not assured, even if the Company is profitable.
Prospective distributions to investors are not clearly defined. This is not
necessary uncommon.

4. Founders, Officers, Principals

In our limited review, this section came up largely neutral. There are a couple of
things that would be problematic if they are truly associated with the Principals; we
can pursue this further if desired.
+ Same level of comfort established - In the time allocated for this section, we did
not find any conclusive evidence that any of the principals identified have
problematic records. It should be noted that this is not always easy to find, and
we did not, for example, spend the time yet to check non-current records. We
have not done through background checks. We have, however, done enough
probing to give us some degree of comfort with respect to the principals. We
spent a fair amount of time looking and coming up with nothing, which in
general is a good indication. If through background checks are desired, please
let us know.
+ _____________appears to be bona fide. The proposed Chief _______ Officer.
96 Background Material on Due Diligence

______, is shown on the website of ________, as the _______Director of the

_________________ Centre, where it states that he “has more than 10 years of
experience in _________________” and that he “received his _______ degree from
the University of __________, ___________School and has practiced
_____________for 15 years,” among other things.
+ No certain information found on other - There was no definitive information of
nay sort (positive or negative) found regarding ____________ (the proposed
CEO), or ________________ (the President), ___________ state corporation
records show Mr. _____________ as the only listed officer, holding positions of
President, Treasurer, and Secretary, and listing a _________________----
address from him. We likewise found nothing on the two or three largest present
shareholders; their last names are somewhat common, and only their first
initial is listed (a with no indication of where they reside), so it is not likely that
anything conclusive would be found on these names, even if it certainly exists.
We have no indication at this point if these shareholders are insiders or exert
any real control or influence.
+ Potential problem areas - There were several pieces of non-conclusive
information, which may well be coincidences that do not pertain to the
principals; however, if they did actually pertain, it would be of significance, and
troubling. These can be investigated further if desired. They includes two of the
companies listed in the experience portion of Mr. _____'s bio-data (where he was
alternately the _____ manager and the CEO) are not listed with complete names
(i.e. “ABCD” and “T.S.G.”); there is (or was) a company called “PMFG” of PQRS
City, California that has had troubles with the SEBI; likewise there is a “TSG”
that has also had troubles with the SEBI. It would be prudent to simply clarify
the complete names of the companies that Mr. ______________ worked for.
Additionally, there appears to be another, different, _____________ on the west
coast in the same field; there is _____________, Advanced _________ Care”
website, with a different educational and professional background; the site also
has a photo, at www. _____________. com. We did not call to check Mr.
_____________'s prior employment claims.
+ Corporate identity - The Company was incorporated Sept. ____200____. The
Company has a website domain name reserved at www. ____________--. com
(with no functioning website yet). There are at least two previously existing
organisations with similar names.: the _____________ at the University of
 Due Diligence for Mergers & Acquisitions 97

__________ is sometimes referred to as the _______________. There is a

_____________ in _____, _____________ (which may be near _________).
+ Officer's stock - The present officers appear to own no company stock at present,
although there are _____________ shares variously described as either
“reserved for management” or “owned by officers and directors” (although there
are only _____________ shares listed as having been issued to date, and none of
these shares are ascribed to any of the listed officers).
+ Company's Officers and Directors may beneficially own a significant portion of
the outstanding equity Shares of the Company.”
+ Officers' compensation - There is conflicting information regarding the
proposed compensation of the officers. The PPM states that “All compensation
to the Company's Executives will be in the form of stock and/or stock options for
the foreseeable future.” On the same page it also says “Officers and Directors
are expected to draw limited salaries after this Offering has been successful.”
Note that it is generally not common that directors would immediately receive
salaries in the initial stages of a start-up, and that the identities of the Directors
has not been provided, nor has anything been established with regard to
elections of Directors; so who then are the Directors loyal to? The shareholders,
or the people that pay (and determine) their salaries? The PPM further states,
“For the most part, these persons control, and will continue to control, their
levels of executive compensation in future years, which may be significantly
higher…” The spreadsheet attached to the other document (not the PPM),
shows Mr. ______ with a Rs. _____ per year salary, and a bonus (not necessarily
all to him) to be paid of another Rs.______. While talent should be paid well, and
if this is successful such compensation may not be at all out of line, this comes
across to us as being handled in a less than forthright manner. Nothing is shown
with regard to compensation plans for Mr. ______, who is the only officer listed
in ______ corporate records, and who is President and Treasurer, and is not
listed as a shareholder in the PPM. Mr. _____ is presumably not doing this for
charity, and the complete lack of any disclosure regarding his financial ties adds
to the overall problematic lone here.

5. Summary Conclusion
We believe that either this has been inadvertently poorly written and structured, or
else it is a rip-off. It is difficult to tell which, even if it is not inadvertent, it is likely
98 Background Material on Due Diligence

that some of the principals may be entirely innocent, such as Dr. _____ who may
have been talked into joining this, and may not be involved in or knowledgeable
about the structuring, financial, and business issues. In either case, we would not be
comfortable recommending it unless certain aspects of the Offering were changed,
and some additional disclosure was made. There are some important issues here (as
well as a number of possibly not so important ones). Some of the key ones may
largely be legalistic “technicalities,” but they could absolutely be deadly to an
investor, and they are in cumulative total, “out-of-line.” If they are not intended,
they should be changed.

The investor is, in effect, depending entirely upon the goodwill of the Board of
Directors in order to not be screwed, and the Board is neither identified nor is near-
term elections plainly provided-for. Important items to consider include:
+ This Company has been set-up to largely bypass the normal accountability and
checks-and-balances. Perhaps they do not intend to utilise that capability; are
you comfortable in counting on that?
+ It does not appear that they are bound to use any of the proceeds raised to
actually acquire the necessary real estate.
+ It appears that if the Offering is less than fully subscribed, then there is
significant possibility that the subscribers will lose their entire investment.
+ It appears that a huge portion of proceeds raised will be paid to people raising
the money, and very possibly to the founders.
+ Additionally, there are potentially significant documents not disclosed, and the
budgeting appears amateurish.
 Due Diligence for

4 Venture Capital
Investment

Background
Before making any investment, the goal as venture capitalist is to understand
virtually every aspect of the target company, the experience and capabilities of the
management team, the business plan, the nature of its operations, its products and/or
services, the methods by which sales are made, the market for the products and/or
services, the competitive landscape, and other factors that may affect the outcome of
the investment. While due diligence exercise is viewed by many as mundane and
irritating tasks, the process enables venture capitalist to address areas of concern and
is an important tool in determining a fair pre-investment valuation, and may help to
avoid significant and otherwise unexpected liability following the investment.

For venture capitalist, the due diligence process is a means of identifying and
becoming comfortable with the risks to which the capital would be exposed. The due
diligence process for venture capitalist involves an assessment of both the
microeconomic and macroeconomic factors that can affect the earnings growth of
the target company. The due diligence process also includes a review of the
corporate and legal records, including the documentation supporting any previous
issuances of the company's securities.
100 Background Material on Due Diligence

Microeconomic Analysis
These are the factors within management's control and include a careful
assessment of the management team, the business model, the value proposition,
the distribution strategy, the intellectual property, the financial strategy and
capital requirements, and the legal structure and records of the company.

Macroeconomic Analysis
These factors are generally outside of management's direct control and include a
review of such areas as market size and expected growth potential, the perception of
the company and its products by its suppliers and customers, the competitive
situation and product differentiation, and government and regulatory influences.

Over the years, an extensive due diligence questionnaire have been developed and
fine-tuned which is usually provided to prospective companies at the inception of
the due diligence process.

Due diligence, itself, is both a quantitative and qualitative process. The due
diligence process commences only after the venture capitalist has spent sufficient
time with a prospective company to become convinced that spending the additional
time and energy required will be a worthwhile endeavor.

Perhaps, the most critical aspect of the entire process is the close interaction between
the venture capitalist and the management team of the company being considered for
investing in throughout the due diligence process. In the process of getting better
acquainted with the management team, it is important to discern whether the
management team is appropriately experienced and committed to the business, as
measured through the team's behavior as well as their response to queries.

While some of the findings of the due diligence process do little other than to confirm
the initial “gut feelings” of the venture capitalist, there are some areas that are best
described as "show stoppers." Show stoppers include determining that the target
company has a flawed business plan, is managed by a group of convicted felons, has
technology that does not work, or products that cannot be sold. However, there are
other, less obvious issues that may arise in the due diligence process to cause a
 Due Diligence for Venture Capital Investment 101

venture capitalist to break off discussions with a company.

One such problem is the inadvertent violation of provisions of the regulations of

Securities Exchange Board of India (SEBI) that occurred when the target company
was raising prior rounds of capital. Unfortunately, this is a frequent faux pas
committed by many early-stage companies that raised their initial capital from
family, friends, and casual acquaintances without proper documentation. In this
instance, the company and an unsuspecting investor could find a significant portion
of the proceeds of new financing being used to fund the repurchase of securities from
disgruntled existing investors who may successfully sue for rescission of an earlier
and improperly documented securities offering.

For instance, it might be agreed on a preliminary term sheet, subject to the satisfactory
completion of due diligence. The due diligence exercise could establish a pre-investment
valuation of the company significantly lower than the two previous investment rounds.
Individual investors, many of whom were not accredited investors, might have funded
both of those financings. Additionally, it could be determined during the due diligence
process that there were numerous failures to fully comply with the provisions of SEBI
Regulations. Because the proposed financing could be extremely dilutive to the existing
common stockholders, there might be considerable consternation among the investors in
the prior rounds. Ultimately, it could be concluded that the only cure for the SEBI
violations would be for the company to initiate a rescission offer to repurchase any
securities that the earlier investors wanted to sell back to the company; the price of the
rescission offer would have to be at the price those investors paid for the stock they had
purchased. It would be possible that most, if not all, of those investors would tender their
shares and recover their original investment. The cost of completing the rescission offer
would have consumed a significant portion of the proposed investment and increasing
the proposed investment would have adversely affected the economics of an investment
in the company. Ultimately, it drives the decision not to proceed with an investment in
the company.

Pending litigation can be another issue that can bring the investment discussions to an
abrupt halt. Not being able to determine how a court or a jury may rule in a patent
infringement suit is generally not a risk that a venture capitalist is willing to assume.
102 Background Material on Due Diligence

To summarise, if the due diligence process confirms an investors' initial instincts,

nothing untoward arises during the review process, and the additional time spent
between the venture capitalist and the management team results in a positive
working relationship, the result is likely to be successful closure of an investment in
the company. Additionally, a detailed due diligence process usually results in a
more informed investor who can help management in the value-creation process
from inception rather than spending time following the initial investment trying to
understand the business and the challenges faced by the management team.

Due Diligence Check List

Typically, due diligence for venture capital financing covers examination of the following:

Corporate Books & Records

a) Charter and By-Laws
b) Minutes of Meetings
c) Recent Records of Officers and Directors
d) List of Shareholders
e) Company Registrations
f) Reports to Shareholders

Financial Information
a) Financial Statements
b) Taxation Matters
c) Indebtedness
d) Contingent Liabilities

Employee Matters
a) Organisational Information
b) Agreements
c) Benefit Plans

Legal Matters
a) Regulatory Compliance
 Due Diligence for Venture Capital Investment 103

b) Litigation

Contracts, Agreements and Other Arrangements

Proprietary Rights
a) Licences
b) Royalty Arrangement
c) Infringements, if any, on these rights

Plant, Property & Equipment

a) Real Property/Assets
b) Encumbrances, if any
c) Description of Facilities

Insurance
a) Assets
b) Employees
c) Directors
d) Loss of Profit
e) Transit Goods

Sales & Marketing

a) Description of Market and Share
b) Customer Identification and Profile
c) Potential Market
d) Sales Policy

Others
a) Company's Information Management System
b) Future Business Plan
c) Press Releases
 Due Diligence for

5 Franchisee
Arrangement

Franchising is a popular method of doing business and the chances for success are
greater than those of independent business owners. To ensure survival some basic
but vital steps should be followed. Essentially, conducting due diligence is essential.
The fundamental factors for this due diligence are:
+ Know the Market. Once the picture of what can be afforded and the type of
franchise concept is clear, investigate the demand for that particular product or
service in the proposed assigned area. Just because one type of business works
in one region does not mean it will work in the community where it is proposed to
open the franchise. Some things to consider are the level of competition in the
target market and whether a concept has only seasonal marketability.
+ Comparison Shop. Even if the heart is set on one company, it never hurts to look
at other opportunities to make sure the investor is signing on with the best
concept for the skills and interests. One way to do this is by attending a franchise
tradeshow and/or using a franchise consultant who will enter the criteria into a
database and then present companies that match the investor's parameters.
There are numerous web sites that allow to see a snapshot of several concepts at
once. It is a good strategy to talk to existing franchisees of the franchise company
in which the investor is interested.
 Due Diligence for Franchisee Arrangement 105

+ Study the Franchisor's Offering. No contract should be signed or any payment

made until the opportunity to investigate the franchisor's offering is obtained.
All earnings statements should be substantiated. The franchisor should be
requested to disclose important information about the franchise system such as
the past earnings, franchise agreement terminations, number of outlets are in
operation, etc. Because investing in a franchise involves a substantial
investment, it is imperative to consider having a legal review of all documents
and franchise agreement, as well as have a financial review of the franchisor's
earnings claims.
+ Find out the training and support (technical, administrative, training, etc.) that
the franchisor provides. One of the advantages of buying a franchise is that the
franchisor provides intensive training on how to run the business and offers
some kind of ongoing support.
+ Talking to existing franchisees. This is an important step because they can give
honest feedback and substantiation of what the franchisor tells. They can be
requested to share their experiences and advice, if any. Following is an
illustrative set of questions that can be used to gather useful information from
the franchisees:
+ Why did you select this particular franchise system over others in the same
type of business?
+ What line of work were you in prior to purchasing a franchise?
+ Were you content with the initial training and support you paid for and
were promised?
+ Did the training only cover the operating system or did the training prepare
you to compete with other businesses providing similar products or
services?
+ Did you encounter any problems with the franchisor, the site, or
establishing your business and how did the franchisor respond to problems?
+ How would you describe your overall franchisor/franchisee relationship?
+ What are your thoughts on this industry, the products and/or services
available, and what trends do you see happening for the future?
+ Do you have any issues or concerns with the franchise agreement? Were
there any clauses that stuck out over others that may impact your
relationship with the franchisor?
106 Background Material on Due Diligence

+ How has the franchisor responded to your calls for support about business
operations or any other general questions you may have had?
+ Are you pleased with the quality of ongoing support, mentorship, and
advertising campaigns provided by the franchisor?
+ Has the franchisor responded to any of your own ideas about improving
the franchise system?
+ Are there any other franchisees or former franchisees you recommend I
contact?

If the individual is a former franchisee:

+ Why did you leave the franchise system?
+ Did the franchisor cooperate in helping you sell your franchise?
+ If there was a termination or non-renewal, did the franchisor explain why and
provide a reasonable opportunity for you to cure the problem?
+ Would you consider buying a franchise from a different franchisor?

Further, the following guidelines help to make a diligent assessment of the

franchise system.

Popularity of the Franchise System

If investment is proposed in a new franchise system (one that has been in operation
for less than five years or has less than twenty outlets) it is important to consider
that the business that is being bought may not be that well known yet to give an the
edge over the competition. Buying into a new concept does not mean that it is
necessarily making a bad investment; it just means that at the onset, one may not
gain the same advantages as those built into a mature franchise concept such as
consumer brand awareness.

Franchisor's Management Team and History

It is important to know who the key players are in the franchisor's management
team. One may not get access to their resumes but their work experience should be
enquired into and more importantly, their franchising experience. Information
should also be gathered about aspects such as their membership in certain other
organisations, their past track record, any lawsuits or pending convictions against
them.
 Due Diligence for Franchisee Arrangement 107

Financial Strength of the Company

If the franchisor is growing the franchise system with the influx of new franchisees
and has no working capital or investment backing, this may be a sign of trouble. A
review of the financial statements of the company, the financial stability of the
franchiser's system can be assessed. Without this financial security, a franchisor
cannot sustain operations and worse yet, cannot possibly expand.

Growth of Demand for the Franchised Concept

An easy way to address this question is to do a concept search on many of the
franchise directories available online. Market research and review of trade
magazines or journals is also useful in this regard. If the concept has been in
operation for many years but it is one of few in the marketplace, this may be an
indication that it is not a fad. On the contrary, if the concept is extremely unique, it
might not have acceptability among public.

Trademark and Brand Protection

The franchisor's trademark is the most important level of protection that makes the
concept uniquely distinguished from others in the industry or marketplace. A
franchise system could have a number of “marks” such as logos, names, slogans,
products, designs or a combination of these.

Franchisor's System for Choosing Franchisees

The franchisor should have a proper system in place for selecting candidates. The
primary considerations in allotting/ granting frachiseeship should be examined.
The franchisor should not be motivated to sign on franchisees simply because they
are lining up to buy franchises. To be granted a franchise means a franchisor's
investment in the franchisee.

Operational Outlets and Stores

A schedule that lists the names and locations of franchises that have closed over a
certain time frame and the stores that have changed hands as well should be
prepared. The reasons for the closures should also be determined. A franchise
closure has more negative impact than one changing hands but both needs to be
explored. Too many closures and/or terminations can signify an underlying problem
or issue regarding the franchisor's reputation.
 Challenges and Risks

6 Covered in Due
Diligence Process

The Value of Due Diligence

Prior to engaging in any business relationship, knowledge of the respective
company and individuals must be based on facts, not perception. Due diligence
findings have to provide conclusive, documented legal information about the target
company's litigation history, credit history, business formation and a host of other
pertinent information. In this litigious society it is common to identify pending civil
litigation not previously revealed, including discrimination, monopolistic practices,
and intellectual property lawsuits.

Acquisition due diligence assesses the risks and opportunities of a proposed

transaction. It helps to reduce the risk of post-transaction unpleasant surprises. It
is vital that the results of any due diligence process are relevant to the transaction
including:
+ Valuation of the target and therefore the purchase price
+ Sale and purchase agreement (e.g. accounting definitions, accounting and tax
warranties and indemnities, etc)
+ Integration plan (e.g. deal synergies).
 Challenges and Risks Covered in Due Diligence Process 109

There are a range of circumstances in which companies can benefit from externally
provided acquisition due diligence, viz.,
+ Where any organisation is considering an acquisition, merger or joint venture.
+ Where the organisation or deal manager has limited experience in undertaking
due diligence.
+ Where existing advisers face a conflict of interest, or are not well placed to
undertake the necessary due diligence.
+ Where the required due diligence demands technical capabilities and
commercial experience beyond the organisation's internal resources.

Doing business in emerging markets requires an acute understanding of the unique

risks present and an ability to mitigate those risks. Without such an understanding
or ability, any business, is exposed to a variety of threats to their operations, assets
and profit line.

Having an effective risk management or security programme in place allows a

business to protect its bottom line and maintain competitive advantage. The
business environments in these markets are all very different, each having its own
unique characteristics.

Different Markets, Different Challenges

Each country and its market have different features and therefore different
challenges. For example:
+ Unfamiliar customs, cultures and languages make understanding and
controlling risk difficult.
+ Complex regulations, a different legal system and priorities create barriers to
enforcement.
+ Political and economic change, business closures, rising unemployment and
grey markets can create hostile environments.
+ Obscured conflicts of interest, intricate personal networks, all make forging
business relationships difficult.
110 Background Material on Due Diligence

Different Challenges, Different Risks

These challenges give rise to various risks that need to be searched and examined
during the due diligence process. The risks, generally, entail:
+ Revenue losses from counterfeit goods, trademark infringements and grey
market activity
+ Theft of proprietary information and industrial espionage
+ Collusion, corruption and fraud
+ Loss or damage to physical assets
+ Physical threats to employees and their families
+ Damage to business reputation from unethical business practices or local
contractors and business partners.
Effectively addressing these risks requires any business to possess an acute
understanding of the various ethnic, cultural, socio-political and economic factors
affecting the business environment.

Culture Aspect
During the due diligence process, especially in case of merger and acquisition, it is
equally important to pay attention to what is called call human due diligence. Under
“human due diligence,” understanding the culture of the organisation, the roles that
individuals play, and the capabilities and attitudes of the people are grouped.
During the due diligence process, focus requires to be given on identifying key
employees to be retained. The new organisation will need the right talent and an
integrated, consistent leadership voice to make the merger successful. But when it
comes to how to factor in the two cultures into a new organisation, leaders need to
identify something more substantive than “decision making styles” to better
understand the role of culture in making or breaking the merger. Therefore, a
critical element of the due diligence process is an assessment of how well each
company is doing in executing key management practices that have been proven to
be linked to bottom line results. One company may be stronger in some practices
than the other. When working with companies who are looking to merge or acquire
the other, it is important to know how the two companies measure up individually in
executing these management practices. This assessment tells where the gaps might
be that the leaders will need to address before, during, and after the merger.
Otherwise it may be merely looking at what is called “culture” and find out only later
 Challenges and Risks Covered in Due Diligence Process 111

that it was more window dressing than substantive business concerns.

This exercise can give both companies a clear picture of how well each of them is
doing in four critical areas that reflect both an external and internal focus:
+ Adaptability
+ Mission
+ Consistency
+ Involvement.

It is a matter of concern in a merger that indicates that neither organisation has a

particularly strong ability to adapt to market changes and customer needs
(Adaptability) than how similar are the dress codes or benefits packages. Not to say
that the merger should be abandoned but instead such an assessment will present
the post-merger challenges and risks more clearly and concretely to the decision
makers. This makes for a more robust due diligence, focused on the key
management practices that will ultimately determine the success of the merger
and, more importantly, bottom line business results. Otherwise, the two companies
run the risk of falling into the trap of assuming the acquiring company or larger
company's culture will be the culture of the new company. This could end up
perpetuating, or even exacerbating, the deficient management practices in the new
company. Better to find out where each company stands during the due diligence
process by asking up front the people who see the company's culture from the inside
looking out. No matter how challenging a merger or acquisition can be to the
executives in charge, it is that much more complicated in the trenches. All the more
reason to concentrate on assessing and understanding the culture from grass roots
perspective. Otherwise, leaders retained will squander their talent by assuming
culture means one thing when it really means another.

Employee Screening
Security risks to companies are both internal and external. Loss prevention begins
internally, with the employee or business partner, only following that, does it deal
with the non-employee and external factors. Hiring employees is one of the most
critical business decisions a company makes. Recruiting new staff members on the
basis of personal recommendations and appearance is not enough. Experience has
112 Background Material on Due Diligence

taught many businesses that if they had objectively and comprehensively screened
candidates prior to employment, many malpractices such as conflict of interest,
industrial espionage, theft of proprietary information, contravention of business
compliance issues, business fraud might have been avoided.

Employment screening is an essential process to safeguard any business from

hiring persons who are either unqualified or of questionable integrity. Screening
applicants through pre- and post-hire enquiries is loss prevention in its purest
sense. This should not be restricted to employees, as the future problems that
choosing an unsuitable business partner or vendor may create, should not be
underestimated. To address this issue is due diligence and companies are
encouraged to approach suitable professionals who specialise in this and related
services, with wide network. This places them in an excellent position to screen
emerging market-based applicants who may have studied or resided overseas or
worked at companies that are incorporated or headquartered outside of India.

The extent of screening is determined by the seniority or sensitivity of the position to

be filled; this also applies to joint venture partners or vendors when checking
companies. Screening both existing and new employees at all levels is important.
Even the lowest level of employee might have access to proprietary information and
processes that are critical to the efficient running of the company. Companies
should also consider screening personnel being either relocated to or promoted into
areas where they will have additional responsibilities.

The overall objective of employee screening is to “protect” a company against hiring

personnel who exaggerate or make false claims about their qualifications, work
experience and personal background or, identify weaknesses or withheld
information that is relevant to employment such as previous criminal convictions or
misconduct.

There should, however, be a balance between the risks involved vis-a-vis cost of
employee screening. Further, though complexity and budget will vary from
company to company, initial outlay can assist in reducing potential for large losses.
It is a recognised fact that the soul of any organisation is its people and the
 Challenges and Risks Covered in Due Diligence Process 113

company's performance improves by providing care and attention to personnel

selection. It is recommended that with any programme embarked upon, screening
or background checks must be adapted to job level or size of company to be checked.
Selection of an individual or company must be on an objective basis, not a subjective
criteria and uniformity of processing is vital if the programme is to succeed,
otherwise the programme will be piecemeal and vulnerabilities exist.

For the purpose of due diligence, it is strongly encouraged to contact industry

leaders in security who can also be consulted on risk management, commercial
enquiries, information security, personal protective services, and many other
specialist fields offering premier security consultancy services for a systematic
approach to asset protection.

Environment Risk Coverage

Environmental, health and safety (EHS) due diligence is the best way to avoid
unforeseen environmental liabilities with new acquisitions.

When carrying out real estate acquisitions, divestitures or stock transactions

getting clarity on the environmental, occupational, public health and safety
regulations that could influence the investment can be an ordeal. That is why it is
imperative to conduct a thorough EHS due diligence assessment before buying a
facility or property. EHS due diligence assessment includes the necessary on-site
and desk studies for identifying potential environmental liabilities associated with
the acquisition, leasing and/or divestiture of real properties. Typically, EHS due
diligence is used to determine whether:
+ The facility has or will be able to obtain the right permits to do what it is doing or
planning to do
+ The permits will remain valid
+ There are any constraints on permit renewal
+ The facility has implemented the proper systems to ensure compliance
+ The equipment used on site is safe
+ The facility has a proper safety track record, etc.
114 Background Material on Due Diligence

EHS due diligence assessment analyses and outlines the legal ramifications to help
ensure the acquisitioning company or the investor will not be exposed to liability.

Site Contamination, Liabilities and Hidden Costs

Investing in a new business overseas is always a challenge. Focusing on limiting the
risk of acquiring contaminated site liabilities may sometimes overshadow the main
purpose of the investment - running a viable and sustainable business that meets high
environmental and occupational health and safety standards. Therefore, this part of
due diligence combines EHS risk assessment and regulatory compliance verification.

Following are just a few examples of issues that companies frequently overlook
during a transaction:
+ The absence of an air emission permit.
+ The upcoming expiration of a fire safety certificate.
+ The obsolescence or non-compliance of electrical installations or working
equipment.
+ The lack of emergency exits or restrictions on the import or use of an essential
raw material.

Further, inspections and analysis, include:

+ Subsurface sampling and analysis to confirm the presence or absence of
contamination or other problems from soil, surface water and groundwater.
+ Building integrity.
+ Machinery conformity.

In many countries, these issues can result in significant delays in the start-up of
operations. They may also require extensive additional investments to limit the risk
of prosecution and other employer liabilities.

Information Technology Security

Majority of the organisations today utilise computer systems for delivery and
support of their business. Rapid advances in technology have resulted in
 Challenges and Risks Covered in Due Diligence Process 115

deployment of new information technology (IT) systems. Adequate controls are not
typically enforced in these systems resulting in higher risks and vulnerabilities.
Concern over security, availability and integrity of IT systems is receiving
increased attention.

Reviewing key IT components to help ensure the integrity and accuracy of

information contained therein is of paramount importance to all areas of business
and industry. A comprehensive technical review of the computing environment
includes:
+ Operating systems
+ Network & Connectivity
+ Vulnerability reviews of business applications
+ Databases
+ Change Management
+ Governance
+ Risk management
+ Helpdesk services
+ Disaster Recovery Plan & Business Continuity Planning.

The assessment methodology should cover the following aspects:

+ Aligning business and local statutory requirements/mandates
+ Performing risk assessment and identify potential risk areas
+ Prioritising and categorise these issues
+ Possible Action plan to remediate potential risk areas.

Conclusion
In sum, in addition to the traditional financial, legal and technical matters, the
challenges cited above emerging with change in business environment and
globalisation are significant factors that a comprehensive due diligence is required
address.
 Work Approach

7 to
Due Diligence

Work Approach to Due Diligence

The purchase of a business in many instances is the largest and most expensive
asset purchase in life time and therefore some caution should be exercised through
the due diligence process. Therefore, assessing the businesses fair value passes
through:
+ Reviewing and reporting on the financials submitted by the target company.
+ Assessing the business first hand by a site visit (if applicable).
+ Working through the due diligence process with the acquisitioning company or
investor by defining the key areas.
+ Helping prepare an offer based on completion of due diligence.

Discovering the correct strategy is always challenging, and even more so during
challenging economic circumstances. Each situation is unique. The variables are
numerous, including factors such as company age, markets, geography, price levels,
competitive dynamics, to name but a few. But when a company and its products are
tuned to match market needs and expectations - that is, the decision makers and
influencers involved in purchase decision - exceptional changes in performance can
occur. However, a comprehensive model that describes this approach to the work is
 Work Approach to Due Diligence 117

illustrated in the figure below:

Diagnose

Discover Delivery
Define Defend

Design

Six Dimensional Process Framework

The approach as illustrated in the figure above is further expanded below to clarify
the work stages.

Controlled by company
Decision Decision Decision
Controlled by client
team(s) process metrics
Uncontrollable factors

Sales/
Company Products/ distribution Client Service
Services channel(s)

Industry Substitute
Rivals
forces Products

Value Chain Framework

118 Background Material on Due Diligence

It needs to make sure that no hidden time bombs are ticking away in the business
proposed to be acquired. The process kicks off when both the buyer and the seller
sign a letter of intent, or term sheet, which sets the starting purchase price for a
deal. By signing the letter, the seller agrees to open up the target company to a top-
to-bottom examination by the buyer and adjust the sale price based on the findings
of due diligence. Here is what to keep in mind:
a. It is about managing risk. Double-check financials, tax returns, patents, and
customer lists, and make sure the company does not face a lawsuit or criminal
investigation. Extra caution needs to be exercised if the company has never
undergone an audit from an outside accounting firm. The company's customers can
also be quite informative. The seller can be requested for a list of the most favoured
clients and these customers can be called up.
b. Prioritise the people. Background checks on the company's key officers
should be undertaken.
c. Carry out the checks as listed in Annexure 'A' of Chapter 3 with reference to
documents and third part verification, as appropriate.
d. Prepare to fix the price. The investor can and should use any flaws that the
due diligence uncovers to negotiate down the sale price. Due diligence is "a
chance to get a better deal."

How to Conduct Due Diligence

a. Start with an open mind. Do not assume that anything wrong will be found and
look for it. What needs to be done is to identify trouble spots and ask for
explanations.
b. Get the best team of people. If you do not have a group of people inside your
firm that can do the task (e.g. lack of staff, lack of people who know the new
business because you are acquiring a business in an unrelated areas, etc.),
there are due diligence experts that you can hire. When hiring such
professionals look for their experience record in the industry.
c. Get help in all areas: finance, tax, accounting, legal, marketing, technology, and
any others relevant to the assignment so that you get a 36-degree view of the
acquisition candidate.
d. Talk to customers, suppliers, business partners, and employees are great resources.
e. Take a risk management approach. So while you want to do your research, you
 Work Approach to Due Diligence 119

also want to make sure that you do not antagonise the team of people of the
target company by bogging them down with loads of questions.
f. Prepare a comprehensive report detailing the compliances and substantive
risks/issues.

Examples of Different Approaches

By and large, approach to due diligence exercise follows a common line. However,
there are methodologies which different practitioners have developed to adequately
cover the salient aspects of due diligence for various types of transactions. A
vignette of these different approaches is provided in Annexure 'E' of this Chapter.

Valuation
Business valuation is another important task in the due diligence exercise. There
are many reasons to know the value of the business -- if it is considered to buy a
business, a merger or outright sale. Whatever the reason for needing to know this
information, trying to come up with a valid figure can be a major effort and
challenge.

A realistic business valuation requires more then merely looking at last year's
financial statement. A valuation requires a thorough analysis of several years of the
business operation and an opinion about the future outlook of the industry, the
economy and how the subject company will compete.

There are many hard-to-measure intangibles that are a factor in the value of a
business. It is not simply a process of adding up the numbers from a variety of
reports. Business valuation has been called an art, rather than a science. Estimates
of a business' value by various experts can vary as much as 30 percent.

Not only is there no consistency in methods used, but also there is also no
consistency in naming the methods. Each method has a variety of names. The
important factor in any valuation is that the method used is relevant to your type of
business, providing a valid and supportable value.
120 Background Material on Due Diligence

This wide variety of methods available can be a confusing array to choose from. That
is why a professional is often helpful. There are plenty of pros and cons for each
method - and there seem to always be new valuation methods being touted.

Make certain a clear explanation of the valuation method is provided and justified.
The current business owner needs to understand the possible valuation methods to
be able to clearly defend the price of their business. For a buyer or investor, the
reasoning behind the pricing is critical for evaluating the personal risk involved. Of
critical importance to all parties is a sense of honesty in the method used.

While there is no such thing as absolute truth in business valuation, confidence in

the eventual number is based on the integrity of the underlying process. To assure
that integrity, many valuation professionals use more than one method, computing
a weighted average to arrive at their final number.

Following are some common valuation methods.

Adjusted Book Value

It is one of the least controversial valuation methods. It is based on the assets and
liabilities of the business.

Asset Valuation
This method is often used for retail and manufacturing businesses because they
have a lot of physical assets in inventory. Usually it is based on inventory and
improvements that have been made to the physical space used by the business.
Discretionary cash from the adjusted income statement can also be included in the
valuation.

Capitalisation of Income Valuation

This approach is frequently used by service organisations because it places the
greatest value on intangibles while giving no credit for physical assets. Capitalisation
is defined as the Return on Investment that is expected. In nutshell, one ranks a lists of
variables with a score of 0-5 based on how strong the business is in each of those
 Work Approach to Due Diligence 121

variables. The scores are averaged for a capitalisation rate, which is used as
multiplication factor of the discretionary income to arrive at the business' value.

Capitalised Earning Approach

This method is based on the rate of return in earnings that the investor expects. For
no risk investments, an investor would expect eight percent. Small businesses
usually are expected to have a rate of return of 25 percent. Consequently, if the
business has expected earnings of say, Rs.50, 000, its value might be estimated at
Rs.200, 000 (200,000 * 0.25 = 50,000).

Cash Flow Method

This approach is based on how much of a loan one could get based on the cash flow of
the business. The cash flow is adjusted for amortization, depreciation, and
equipment replacement, then the loan amount calculated with traditional loan
business calculations. The amount of the loan is the value of the business.

Cost to Create Approach (Leapfrog Start Up)

This approach is used when the buyer wants to buy an already functioning
business to save start up time and costs. The buyer estimates what it would have
cost to do the startup less what is missing in this business plus a premium for the
saved time.

Debt Assumption Method

This method usually gives the highest price. It is based on how much debt a
business could have and still operate; using cash flow to pay the debt.

Discounted Cash Flow

This method is based on the assumption that a rupee received today is worth more
than one received in the future. It discounts the business's projected earnings to
adjust for real growth, inflation and risk.

Excess Earning Method

This method is similar to the Capitalised Earning Approach, but return on assets is
122 Background Material on Due Diligence

separated from other earnings, which are interpreted as the "excess" earnings you
generate. Usually return on assets is estimated from an industry average.

Multiple of Earnings
One of the most common methods used for valuing a business, in this method a
multiple of the cash flow of the business is used to calculate its value.

Multiplier or Market Valuation

This method uses an industry average sales figure from recent business sales in
comparable businesses as a multiplier. For instance, the industry multiplier for an
ad agency might be 75, which is multiplied by annual gross sales to arrive at the
value of the business.

Owner Benefit Valuation

Under this method value of business is computed by multiplying 2.2727 times the
owner benefit.

Rule of Thumb Methods

This is quick and dirty methods based on industry averages that help give a
starting point for the valuation. While not popular with financial analysts, this is
an easy way to get a ballpark on what your business might be worth. Many
industry organizations provide rule of thumb methods for businesses in their
industry.

Tangible Assets (Balance Sheet) Method

This method is often used for businesses that are losing money. The value of the
business is based essentially on what the current assets of the business are worth.

Value of Specific Intangible Assets

This method is useful when there are specific intangible assets that come with a
business that are highly valuable to the buyer. For example, a customer base would
be valuable to an insurance or advertising agency. The value of the business is based
 Work Approach to Due Diligence 123

on how much it would have cost the buyer to generate this intangible asset
themselves.

Sales Agreement
The sales agreement is the key document in buying the business assets or the stock
of a corporation. It is important to make sure the agreement is accurate and
contains all of the terms of the purchase. It would be a good idea to have a lawyer
review this document. It is in this agreement that everything should be defined that
the buyer intent to purchase of the business, assets, customer lists, intellectual
property and goodwill.

The following is a checklist of items that should be addressed in the agreement:

+ Names of Seller, Buyer and Business
+ Background information
+ Assets being sold
+ Purchase price and Allocation of Assets
+ Covenant Not to Compete
+ Any adjustments to be made
+ The Terms of the Agreement and payment terms
+ List of inventory included in the sale
+ Any representation and warranties of the seller
+ Any representation and warranties of the buyer
+ Determination as to the access to any business information
+ Determination as to the running of the business prior to closing
+ Contingencies
+ Possibilities of having the seller continue as a consultant
+ Fee - including brokers fees
+ Date of closing.

Due Diligence Team

A due diligence team needs multi-discipline expertise. Finance and accounts and
124 Background Material on Due Diligence

legal specialists are the core to be adequately supported by market analyst,

environmental expert, human resource specialist and the requisite technology
specialist. Hence, it is an association or consortium approach that fits the bill for
this exercise. Accordingly, the lead manager for the due diligence exercise has to
arrange and organise this team. However, it may be mentioned that the description
of the team given should not be taken as sacrosanct as this depends on the type and
nature of due diligence. For example, in case of franchisee, finance and legal experts
together with a market analyst may be sufficient.
 Work Approach to Due Diligence 125

ANNEXURE - E
OUTLINE OF APPROACHES FOLLOWED BY
DIFFERENT DUE DILIGENCE PRACTITIONERS
FOR VARIOUS NEEDS OF THEIR CLIENTS

I. Approach to Acquisition of Overseas Company

XYZ was engaged by two investment firms (“Client Firms”) to perform financial and
operational due diligence on a Chinese manufacturer based in Zhejiang Province,
China. The Client Firms were in negotiations to acquire a company to which the
Chinese manufacturer was a key exclusive supplier. The Client Firms wanted to
better understand the Chinese manufacturer's financial controls, performance, and
operations in order to decide whether to make the investment and at what
valuation. XYZ immediately deployed a team to meet with senior management of
the Chinese company and to assess the company's operations and manufacturing
capabilities. It carried out

Financial Due Diligence - XYZ addressed issues relating to the company's

accounting system, financial performance, transfer pricing, payables to suppliers,
royalty payments to the current owner, etc.

Operational Due Diligence - XYZ assessed the effects of changes in raw

materials pricing on the business, existing equipment and capital expenditure
requirements, worker satisfaction, management quality, potential effects of sales
increase on operations, etc.

XYZ's due diligence addressed the key questions and concerns of the Client Firms
and gave them the confidence to move forward and close the transaction on the best
terms.

(Source: AuBridge Partners, LLC, USA)

II. Approach to Enter a New Market

XYZ advised a leading industrial chains manufacturer on selling its products into
126 Background Material on Due Diligence

the China market. The following steps were taken in helping the Client enter the
China market:
+ Market Research: XYZ conducted an in-depth research on the China market for
the Client's products and identified the largest buyer of these specialty chains in
China.
+ Relationship Building: XYZ visited the potential customer to better understand
its product specifications and to establish confidence and interest in cooperating
with the Client. XYZ then hosted a meeting in China between the Client and
Chinese customer to further build a good relationship between the two parties.
+ Production Due Diligence: XYZ arranged a visit by the Chinese customer to the
Client's factory to assess its products and production capabilities.
+ Contract Negotiations: XYZ negotiated and finalized the sales contract between
the Client and the Chinese customer.

XYZ helped the Client develop a distribution channel in the fastest growing market
in the world for its products, despite a relatively late start as compared to its
competitors. By selling to one of the largest accounts in China, the Client moved to
greatly strengthen its global competitive position.

(Source: AuBridge Partners, LLC, USA)

III. Approach to Identify Manufacturing Partners

The XYZ team was engaged by a major building products and services company to
identify potential Chinese manufacturing partners to serve in an OEM capacity.
The Client has over 30 years of flooring experience and installations in over 30,000
new housing starts per year. The Client is one of the leading experts in the field of
wood flooring and wants to leverage that knowledge into developing and marketing
a "best of breed" wood-flooring offering. In January 2005, the XYZ team was
retained to develop and implement the Client's product development strategy in
China. The methodology followed was:

Phase 1
The XYZ team first conducted an in-depth analysis of the China wood flooring
 Work Approach to Due Diligence 127

industry by attending trade shows, visiting domestic point of sales, and speaking
with current distributors of Chinese flooring products. Then pre-qualified potential
partners were based on the Client's requirements for management style and
capabilities and then conducted on-site due diligence and inspections of machinery,
materials, production process, QA, and above all, people.

Phase 2
After working with the Client to identify the top manufacturer, XYZ team
facilitated all discussions and negotiations between the Client and the Chinese
manufacturer throughout the product development stage. This was the first
experience working with a foreign company for both the Client and the
manufacturer; thus, it was crucial that differences in language, customs, and
business practices were properly managed. Over the course of 6 months, 8 new
wood flooring lines were developed and approved to the satisfaction of the Client.

Phase 3
(Actually initiated in the middle of Phase 2) The XYZ team negotiated, on behalf of
the Client, an Exclusive Supply Agreement for the Northern Regional territory
valued at over Rs.500 million over the next 6 years. The XYZ team was able to
balance the manufacturer's immediate needs for cash flow with the Client's goal of
investing gradually.

The XYZ team has developed a cross-border supply chain for products within the
fastest growing wood flooring category by bridging an up-and-coming Chinese wood
manufacturer with the right skills and technologies with a leading wood flooring
expert who has established distribution channels and marketing know-how.

(Source: AuBridge Partners, LLC, USA)

IV. Approach to Acquisition of Competitor's Retail Network

The Issue
The client company was considering the acquisition of a competitor's network of 10
depots and 350 petrol retail stations, spread across five countries in East Africa.
128 Background Material on Due Diligence

ABC was engaged to provide the financial due diligence when it was realised that no
one was overseeing environmental, health and safety issues.

The Approach
From the project base in New Delhi, ABC:
+ Managed an environmental, health and safety and physical asset due diligence
of the network. This began with visits to five data rooms, one in each of the
target's operating territories, to review available HSE-related information.
+ Worked with the client company to modify one of its network site risk
assessment tools, making it relevant to the deal context.
+ Then applied this tool to the target network.
+ Mobilised, during a four-week period, five teams to undertake site visits to over
100 destinations.
+ Simultaneously managed the sub-contracting and delivery of intrusive
investigations at 20 of the sites to investigate the presence of suspected
contamination. This work formed the basis of statistically robust estimates of
the level of contamination-related financial liability likely to be associated with
the target's network.

The Outcome
The results included the following:
+ Identification of a likely Rs.100 million of contamination-related liability in a
report produced in time for price negotiations between the client and the target;
+ Providing further client support with direct visual evidence of site
contamination to counter the target's claims that its sites were essentially clean.
ABC understood that these contributions materially affected the sale price in
favour of the client company.

The work also equipped the client company with an action plan to effect early
improvements to the network, by identifying sites where contamination clean-up
was necessary and where early asset replacement, principally underground storage
tanks, would avoid future contamination and product loss.

(Source: PwC, UK)

 Work Approach to Due Diligence 129

V. Approach to Due Diligence

When PQR handles the detailed analysis and, if necessary, management of difficult
situations, credit issues are resolved before they threaten the survival of a company.
Increasingly, stakeholders seek the help to ensure their own analysis is
comprehensive and validated by an independent source and to build consensus for
strategies that maximise value.

PQR's approach is disciplined, predictable, proven and effective. Once PQR has a
clear understanding of the engagement and the desired outcome, the issues behind
severe business problems are identified and financial models are used to integrate
income statement, balance sheet and cash flow projections.

Using the experience, analysis and expertise, PQR developed a realistic plan of
action that includes restructuring debt and identification of opportunities to
rationalise operations or refocus the business. PQR gains the confidence of company
management, which increases their willingness to modify their plan and its
implementation. Throughout the process, PQR maintains an active and open
dialogue with creditors and company management to build consensus and make
sure all parties have a clear understanding of the facts.

When a company is in crisis, the one asset almost as scarce as cash is time. And a
response that respects the value of both - in the form of knowledge, experience and a
proven methodology - makes the difference between failure and recovery.

With each engagement, PQR works quickly to identify problems, then Analyse,
Stabilise, Advocate, Implement and Improve - each process laying the foundation
for the next. Using this focused approach as a tool, PQR is able to weigh the
variables and make difficult and time-sensitive decisions with confidence.

Analyse
PQR constructs a detailed, comprehensive analysis that examines fixed and
variable costs, product line and operating unit performance, operating expense
structure, asset performance and operational and financial restructuring options.
130 Background Material on Due Diligence

Stabilise
Establishing trust and confidence, PQR works with management, lenders and other
creditors to prevent any actions that could threaten stability and endanger the
recovery process.

Advocate
PQR is the catalyst for understanding and accepting the course of action embodied
in the recovery plan. Good communication and cooperation among all constituencies
are vital for moving the plan forward.

Implement
Marshaling the internal and external resources required to solve operating and
financial problems, PQR motivates all levels of management, labour, creditors and
shareholders to work toward successful recovery.

Improve
PQR develops and institutes process and performance improvements that increase
profits, enhance corporate value and bring the enterprise to a new level of
competitiveness - even excellence. Based on the overall approach described above,
PQR undertakes financial and operational review and assesses business/
turnaround strategy as indicated below.

Financial and Operational Review

PQR reviews a company's historical financial performance against its financial
projections to develop an assessment of the business plan and its risks. The
operations are reviewed to assess potential areas for improvement and capabilities
to achieve the projected financial performance. PQR assesses potential cash needs
and profitability, at the level of detail that provides the clearest support for the
desired results.

Business/Turnaround Strategy Assessment

Drawing on the knowledge of the needs of lenders, creditors and investors, PQR
uses a straightforward, predictable process to deliver results.
 Work Approach to Due Diligence 131

PQR determines the outcome through examination of how achievable the proposed
turnaround strategy or business plan is in relation to current market conditions
and other operational issues.

PQR evaluates management's ability to implement the proposed strategy and plan.

PQR investigates into the interests and the position of other stakeholders
(creditors, suppliers, minority shareholders, key employees and customers) to
determine potential risks in achieving the proposed plan.

Also, PQR identifies changes to the strategy and its implementation, as well as its
proposed capital structure that would minimise execution risks in achieving the
desired outcome.

(Source: Corporate Revitalization Partners, LLC, and USA).

8 Summary

Due diligence is the process of obtaining sufficient reliable information about the
proposed acquisition to help to uncover any fact, circumstance or set of conditions
that would have a reasonable likelihood of influencing the offer or decision to
acquire the business.

The internally-generated information obtained during the due diligence process

will help to:
+ Verify seller representations
+ Assist in the determination of value (assets and liabilities)
+ Uncover problems, issues and concerns (current and future)
+ Gain a better understanding of the business and industry, key customers,
trends and regulatory requirements
+ Evaluate management and key employees.

The externally generated information will focus on:

+ Public information regarding the company, its principals and key employees,
key customers
 Summary 133

+ Market research to gain a better understanding of the dynamics of the

marketplace.

Many buyers of small businesses do not conduct any due diligence or conduct an
insufficient amount of this examination because they feel the amount of the
purchase price does not justify their time and effort, as well as, the cost of the
professionals they might engage. Some buyers feel they lack the knowledge of how
to conduct a due diligence investigation. They are not sure about what to look for or
where to look.

If the buyer is not sure how to effectively conduct a due diligence investigation, it is
advisable that he seeks help of experts in the field. The cost of the investigation
should be balanced against the total risk exposure, both now and in the future. Just
because the purchase price is small or the seller is offering lucrative terms does not
mean that the risk exposure cannot be large. An undiscovered contingent or
pending liability could wipe out the total investment not to mention the
psychological suffering it can cause. A legal remedy could be costly and time-
consuming.

The nature, scope and timing of the due diligence investigation will depend on many
factors. Among the more prominent factors are the price of the deal, the perceived
risk, the urgency of consummating the deal (buyer or seller) and the cooperation of
the seller.

Before getting bogged down in the detail of the due diligence investigation a
preliminary investigation should be conducted that would focus on:
+ Getting a comfort feeling about those significant factors that make the
opportunity attractive to the buyer or investor
+ The business practices, values and reputation of the company to be acquired are
consistent with the acquisitioning company's approach to doing business
+ Changing a company's way of doing business or trying to improve its reputation
can be time consuming and costly
+ An indication of price and terms (the following can all be used as a preliminary
guideline before engaging in a more sophisticated valuation)
134 Background Material on Due Diligence

+ Industry "rule of thumb" - basic return on investment calculations

(price/earnings)
+ Cash flow.

Once this preliminary investigation is completed the next step will be to decide
whether or not the deal is worth pursuing.
Final tips for conducting a successful due diligence investigation are:
+ Professional judgment and experience is critical.
+ If you are lacking in certain areas get help.
+ Use a questionnaire to help guide the investigation .
+ Document the findings of the investigation.
+ Be aware of how the nature of the information impacts - its reliability, internal
versus external, how and from whom it is obtained, is it independently verifiable
+ Be on the lookout for inconsistencies in verbal representations or information
that are either individually or cumulatively material.
+ Ask open-ended questions rather than asking for the confirmation of a fact, and
ask a question that leads you to the same answer.
+ Remember that in many instances past behavior can be a good predictor of
future performance; this can be crucial in evaluating management's and
employee's values, practices and performance.

Due diligence may not and probably will not uncover fraud or a conspiracy to commit
fraud. The seller should always be required to sign a representation letter prior to
closing the deal.

POSITIVE - confirming all the representations the seller has made

NEGATIVE - no known facts or circumstances that would affect the decision to buy
the company under the terms and conditions agreed upon.

Also, it is important to note that from the seller's side, it is necessary to enquire into
the buyer's financial strength, business practices, and market reputation and over
and above the sincerity of intention to acquire or invest. This is called for so as to
 Summary 135

ensure that the efforts for the deal do not go in vain for any deficiencies of the buyer
that was not known earlier. Moreover, it provides the seller an idea of whether the
business that is build up does not go to hands of those that are not competent to
carry on the business or the intention for acquisition is totally different. Besides,
from the employees' perspective, it facilitates to assess the change contemplated
following the acquisition or merger.
 Appendices

Appendix - I
Open House Discussion with
Sample Questions and Answers

Appendix - II
Group Exercise

Appendix - III
Glossary of Salient Terms
 Appendices 137

Appendix - I

Open House Discussion

with Sample Questions
and Answers

Introduction
The analysis of financial statements is important for many reasons, and for
those people who routinely check the pulse of their companies; many of
these reasons are obvious. But when the analysis relates to the acquisition
of, or investment in, a new business, most investors will agree that numbers
alone are entirely inadequate.

Financial statements provide thumbnail sketches of a business and its

history, supplying a few clues and insights into the company's present, and
may possibly offer a reasonable guess about its near-term future. But general
and specific conditions and events relating to the business's future, and
the ramifications of past events and conditions, will determine its eventual
success or failure. Using only past results to forecast the future is folly.

Financial statements do not tell about some of the most critical factors
that impact businesses, such as management competence and continuity,
market trends, production capability, quality, potential litigation, employee
turnover, the status of supplier contracts and a host of other items. These
138 Background Material on Due Diligence

"non-financial" factors, more often than not, determine the future structure
and viability of a company. For this reason, potential investors must care
fully study these factors during the due diligence phase, before a final agreement
is reached.

Planning Due Diligence

Due diligence is one of the procedures that is used to study, investigate and
evaluate a business opportunity. It normally occurs after the parties to a
deal have decided the deal is financially feasible and after a preliminary
understanding has been reached (or appears reachable), but before a binding
contract is signed. The term came into common business usage during
the 1980s. While the term is new, the activity itself is not. Studying and
investigating before buying and investing is as old as trading itself. While
the term was originally used in the context of studying a potential acquisition
or merger, it has been broadened to cover the study of almost all
business transactions, including the issuance of securities and private placements,
real estate sales, appraisals and commercial lending.

Due diligence can be accomplished successfully if it is preceded by careful

planning. Such planning includes the assessment of available resources,
theestimation of risk, selection of management, the recognition of the
consequences of failure, the identification of possible obstacles to the deal, the
definition of the deal's scope--all of which lead to the crucial decisions essential to
produce the results one wants to achieve. All of these major planning elements
are essential and must be included in the planning process. Establishing clear
objectives is of highest priority. To proceed without them would be like setting out
on a trip to an unknown destination.

The objectives and results one hopes to attain must be equated with the
number of people and the amount of money one has. The scope of the due
diligence is also influenced by other resources one has and by the level of
risk one will accept. There will always be some risk, but how much there
actually is should be carefully assessed.
 Appendices 139

Conducting Due Diligence

Investors must be objective, able to maintain an open mind and avoid premature
conclusions and yet react quickly to significant adverse information.
There is no point in continuing a due diligence programme once defects of a
"deal killer" magnitude arise. The most common evidence of a biased
mind-set at one extreme is to be awed by a management that seems all
virtuous, rarely makes bad decisions, is highly efficient and has total concern
for the employees and shareholders. If prominent people or celebrities
are involved in the business or promoting the transaction, due diligence
investigators should be even more wary and not attribute to the business
virtues that do not exist.

An opportunity to acquire a long-coveted business can place blinders on

the potential investor. It can be equally erroneous to start with an assumption
that the management is evil, solely-concerned with short-term personal
enrichment and has survived in spite of itself. A Pollyanna view of looking
only at the positive aspects of a business is as much indicative of a closed
mind as exclusively concentrating on defects, characterised by the attitude
of, "We are going to find out what is wrong with it."

An objective approach free from ill-conceived prejudices, one that quantifies

defects, can result in a rational evaluation of the business. Those involved
in due diligence soon learn that more often than not what first
appears to be a major problem or defect can be explained. Or there may
be solutions under way and the problem is of lesser magnitude than first
believed. An alarming first impression should only dictate that more study
is necessary before conclusions are drawn. However, when critical problems
arise, or the full dimensions of others known or suspected are revealed,
the investor should reassess his/her position and might even want to suspend
further due diligence.

Constructing the Checklist

Once an investor decides to seriously consider a business opportunity, a
list of information and documents that eventually may be required should
140 Background Material on Due Diligence

be compiled. It should contain all essential data yet avoid the superfluous.
Such a large quantity of information on so many subjects is needed that
an effort must be made to circumvent matters of little importance or those
that are irrelevant. Superfluous data will overburden, confuse, delay and
distract analysts already confronted with a voluminous amount of data.

Overly burdensome demands for information could jeopardise the potential

transaction by antagonizing a seller or whoever provides the data. As a
result, the belief that the more information one has about a business, the
more likely a shrewd investment decision will result, is not always true. The
objective of data collection is to obtain enough information to make
an informed business decision. No precise definition exists as to what is
"sufficient," but the following questions can help develop the questionnaire:
+ Is the information necessary to understand the business?
+ Is it necessary for negotiations and to write the contracts to conclude the deal?
+ If the information is not requested now, will it be needed at a later date?
+ Could mistakes be avoided by obtaining the information?
+ Is the information necessary to affect a smooth transition and for those
managing the investment to be effective?
+ Since it's impossible to predict which subject or document will prove to be of
great importance, it is better to include a subject than to delete it.

A due diligence checklist is a memory crutch on a grand scale; it records

answers and identifies what is missing.

Due Diligence from a Legal Perspective

"Due diligence" will be involved in almost every type of business transaction
and all business persons, including the professionals representing them
or otherwise involved in the transaction, should be interested and concerned
about conducting proper due diligence. Proper due diligence rewards
a cautious person and increases the opportunity to avoid a problem situation.
Failure to conduct proper due diligence could lead to other implications,
such as liability to third parties or criminal liability. Attorneys,
 Appendices 141

accountants, broker/dealers, appraisers and other professionals may also

find themselves being sued by their clients or by third parties asserting the
failure to have conducted proper due diligence.

By being alert to the need for due diligence and focusing on the proper
issues at the beginning of any transaction, a person can avoid a bad business
transaction or unwanted liability. For example, early due diligence
in a business acquisition may alert the purchaser to the need to structure
the transaction in such a way as to avoid unassumed liabilities. Proper
due diligence may also serve as a legal defence to third-party claims after
a transaction closes. Finally, part of the due diligence process in many
transactions includes the drafting of contracts and other documents (such
as acquisition agreements and loan documents) that contain appropriate
representations and warranties that elicit information and identify and
address the transaction's risks. The information obtained from proper
due diligence will also be critical to negotiating the terms of a business
deal.

Business Description and Basic Information

The business description and basic information enumerated in the checklist
constitutes the core reports, documents and data necessary to commence due
diligence investigations. Financial reports are important, but at this stage
additional information on the organisation's structure and the participants is
essential. A primary objective of due diligence is to verify, analyse and distill basic
information initially accepted at face value. After all, it was this temporary
acceptance that spurred some interest or type of agreement to justify the cost of
proceeding. It should be an adequate framework within which to plan the due
diligence programme.

An overview of the business gained from the basic information enables an investor
to plan the due diligence. Planning will be impossible without some general
knowledge of the business, its structure and names and responsibilities of the
participants. Without this information, the programme's scope cannot be
estimated, assignments made or realistic time schedules developed. Requests for
data will be misdirected or irrelevant and result in excessive expense, and
142 Background Material on Due Diligence

needlessly antagonise those interrogated. An objective always should be

expeditious completion, something that can only be achieved with intelligent
preparation. At this stage, the majority of the basic information for planning the
entire due diligence process is probably in the investor's possession.

During the analysis, one should record the time period of the study and the dates
and source of documents and information received. Since any business is a
moving target, the study is little more than a photograph of a specific time in its
history. Business investments usually take considerable time, even when all goes
well. The parties may also find agreement impossible or may agree to delay
negotiations.

Critical Early Questions

The responses to questions or topics in the checklist and the initial questions the
checklist should provide an investor with a comprehensive but not complete
understanding of the business.

The ramifications and costs of due diligence require that priority be given to
questions, data and analysis most likely to affect an investor's final decision. The
answers and analysis may inspire greater interest in the investment's potential,
trigger in-depth studies of problem areas or constitute "deal killers" that cause the
investor to back out.

Top priority must be given to a dispassionate evaluation of management,

since the success or failure of any business is primarily a function of management.
The evaluation should include key executives who have managed or had a major
influence on the business during the past five years. They are responsible for the
business's current condition. However, the most important executives requiring
intense evaluation are those responsible today and in the future. The investor
should devote the time necessary and use whatever proven techniques are available
to reach valid conclusions. Simultaneously, replacements for existing or anticipated
management vacancies must be identified and evaluated.

Management evaluations are both objective and subjective. Announced

 Appendices 143

terminations to retire or take other positions, serious health problems, education

and the performance of the business managed are objective factors. Actual results
and identifiable accomplishments are of paramount importance. Personality
characteristics, management skills, creativity, leadership ability and a myriad of
other traits involve subjective evaluations.

Capital Structure and Ownership

A basic part of any due diligence programme is to determine how the business is
legally and financially structured and who owns each unit. An investor must know
what he is buying, whom he is buying it from and who makes the key decisions. This
should be confirmed for each legal entity under consideration, including subsidiaries,
joint ventures, partnerships and other business entities. The legal structures may be
simple and uncomplicated or complex with multiple classes of securities and debt
instruments, each of which has its own rights and obligations. Ownership may be
obvious or intricate, difficult to determine and in some cases mysterious
.
There are two appropriate, revealing follow-up questions relative to structure and
ownership issues: why and/or how. Insight can be gained by probing to learn the
factors, rationale or chance events that led to current conditions. For example, why is
this a corporation rather than a limited partnership? Why are 20 million equity shares
of stock authorised and only 1 million issued? Why were preferential rights granted to
the share holders? How many shares were acquired for the employee stock ownership
plan (ESOP) and why not more or less? By asking such "how" or "why" follow-up
questions, the investigator will pursue information in greater depth.

Questions on the legal structure, ownership and control should come early in the
due diligence process, since serious issues may emerge requiring resolutions before
a deal can proceed. A buy-sell agreement may emerge. A major shareholder may not
be committed to the deal. Conversion rights could exist that make the transaction
impractical.

For every business, documents describing the legal structure should exist
and must be located and reviewed.
144 Background Material on Due Diligence

Management
Management built the business, operates the business today, and will manage the
business in the future. These simple truths should be foremost in the mind of any
investor. Due diligence activity relative to management consists primarily of
identification of executives and professionals in positions of substantial
responsibility, determining their total compensation and associated expenses and,
most importantly, evaluating their competence and potential. Current and
anticipated vacancies must also be identified.

Management is usually viewed as a group or team, but any study will focus on
individual members and team vacancies. The future role for each member of the
current team will require decisions after review of their responsibilities, estimates
of potential and, not to be overlooked, and the individual's wishes. No due diligence
should be considered complete or adequate without personal interviews.

Identification of key management members is a critical first step, but not always a
simple one. Officers may not be key employees and key employees may not be
officers, because job titles can be misleading. Some companies have both a chairman
of the board and a president with either one Chief Executive Officer or the other's job
poorly defined. Some businesses have few officers, while in others, such as financial
institutions; there may be a large number. Key employees who are not officers, such
as managers of important divisions, may have greater responsibility than all
officers other than the president. There may be executives with officers' titles who
are not formally elected officers, such as division presidents. Compensation may not
always indicate importance to the business, since shareholdings, age, former
positions and relationships influence compensation. Formal job descriptions cannot
be relied upon to learn the true nature of an executive's job. The diversity is
so great among businesses that all factors must be considered to sort out
the management team.

Products and Services

Comprehensive due diligence requires gauging the importance of products and
services to the business. Public perceptions and initial impressions often deviate
from reality because many businesses are best known for activity representing only
 Appendices 145

a small fraction of their total business. Extensive promotion of new products

thought to have great potential catches the public eye but today may have minimal
revenues or serious quality problems. A business may have a famous name, but the
products or services that brought the name into prominence may have long since
been replaced. Use of trade names and private label manufacturing contributes to
misconceptions. Actual amounts and proportions of sales revenues and operating
profits for each product line within a business may prove to be a surprise.

Product line operating income is rarely in direct proportion to sales revenues. What
constitutes a product line or category of service will be defined by
the business, its organisational structure and its accounting system. The
more detailed the breakdown by product segment, the more valuable the
information to an investor. However, the existing accounting system that
tends to track the organisational structure will largely determine the product
breakdown possible. In many businesses this is sales revenue without
calculation of separate operating profits. At some point the cost of calculating
profits for each small segment of a business, plus the uncertainty
caused by the subjective nature of overhead allocations, discourages detailed
accounting. The result can be highly profitable or very unprofitable
product lines or product line segments concealed in a broad financial report. An
investor will likely have to accept whatever product or service break
downs are contained in the financial statement.

R&D and Technology

Research and Development (R&D) is usually defined as:
“Research and development arising from laboratory or experimental procedures. It
includes the cost of developing, or improving a product, a formula, an invention,
a plant process, an experimental or pilot model, or something similar. It also
includes the cost of any research or experimental work carried on for the
organisation by someone else (such as research institute, foundation, engineering
company or similar contractor).”

However, the terms R&D, research, development and design may have working
definitions that vary from business to business. An understanding of how
146 Background Material on Due Diligence

management defines the terms will avoid confusion during the due diligence study.
To evaluate the R&D effort, the historical and forecast costs should be equated with
results, both actual and anticipated. "Results" are commercially profitable products
or services. Projected costs to complete R&D projects in progress and the quantity
and quality of proposals for new R&D projects should be part of the study.
Evaluation may be difficult and require a team of technical, marketing and financial
people to ask pertinent questions and comprehend the responses.

R&D, by its very nature, represents the hopes and commitments of individuals and
the business with the stakes very high. Since success or failure of R&D projects can
easily influence careers, it is understandable that overly optimistic comments may
abound from those involved. Identify early the accounts in the financial statements
recording R&D expenses.

Real Estate and Facilities

There are four general categories of real estate due diligence subjects: description
and location, environmental, financial issues relative to costs and values and
operational involving adequacy and continued availability. Unfortunately,
opportunities for erroneous, misleading or withheld information, often totally
unintentional, regularly occur to confuse or mislead an investor. Book values may
have little relationship to true market value, which may in turn have little
correlation with appraised values, whether tax, contemporary or anecdotal
estimates. Known or unknown title defects may exist. Old photographs or
descriptions may describe younger days rather than present conditions.

Facilities may be underutilised, creating unwanted expenses, or be inefficiently

crowded, necessitating a costly relocation or expansion. Additionally, leases may
expire, forcing an unwanted move, or long-term leases may be a burden or of
debatable value.

A visit to each facility and review of ownership or lease documents is highly

desirable. Visits confirm prior information; provide information on maintenance
upkeep, general condition of facilities, housekeeping, safety, type of neighborhood,
appearance of employees and level of utilisation. Leases, deeds, title insurance,
 Appendices 147

contracts for leasehold improvements and other documents relating to real estate
must be located and reviewed for defects and unusual provisions, and to verify basic
information.

One business's real estate activity may be static with few past changes and none
anticipated. But for others, there are constant requirements to sell existing and/or
lease or build new space. Due diligence should not only identify the activity but
evaluate the causes or need for each sale or new facility. The causes may reveal or
confirm information about the business previously unknown or only suspected. The
importance of any real estate for sale is a function of the size of the sale in relation to
the business's size.

Markets, Competition and Customers

Due diligence must define markets, competition and customers. They are typical of
many nebulous and imprecise terms brandished about in business that create
confusion and misunderstanding. The "market" for a specific business may be
proscribed by geographical, pricing, service or other limiting factors. "Competitors"
include not only today's competition but also those who could enter the market in
the future. Pricing changes, influenced by transportation costs or other forms of
overhead, could generate new competitors. Investors also must determine how
many "customers" are one time, not repeat, buyers and decide whether potential
customers, those with a need but no financial resources, should be defined in the
market.

Gauging the size of a business's potential market should not be hard. Management
will have some facts, estimates, opinions and possibly even detailed information.
Trade publications are an excellent source of data for only the cost of a subscription,
and various government agencies, security analysts, industry associations,
utilities, chambers of commerce, Yellow Pages, economic development agencies and
private research groups can produce market studies. Many of the publications and
studies will identify both competitors and customers, and the quantity of such
reports available usually makes it unnecessary to commission expensive market
studies. Reviewing customer lists and identifying individuals and businesses
similar to those being served can ascertain exactly who the market's customers are.
For some businesses it is possible to identify all existing and potential customers
148 Background Material on Due Diligence

and accurately determine the total market.

Census and demographic data will be helpful in identifying trends and market size.
It is absolutely essential for investors to understand markets, both their size and
their customers, to understand a business. Without such information an investor
cannot evaluate the present marketing scheme or estimate the business's potential.

Marketing
Marketing is a term used to describe a broad range of activities associated with the
sale of a business's products and services. Sales planning and strategy, pricing,
staffing, distribution, financing and advertising are all major functions that fall
under the general category of marketing. A financial review of marketing in which
marketing or selling expense is solely equated to results in the form of sales will be
inadequate. However, an overall review of marketing activity without equating cost
to results will be equally frivolous.

Understanding and evaluating a marketing programme is both an objective and

subjective task in which all factors need to be considered to produce a balanced
judgment. Since marketing is an activity for which there may be more than one
approach, differences of opinion are common and they complicate evaluations. It is
easy to be enthusiastic or critical of what has or has not been accomplished, but no
one knows with certainty what sales might have resulted with a different approach.

The level of marketing expense is a fundamental management decision. Whether

the programme is adequately, under- or over funded are questions managements
continually ponder and are basic to due diligence. There are other important
questions: If the business sold more, could it finance, produce and deliver more?
How can marketing be improved? Is the present programme adequate or merely a
good foundation upon which to build? A business must establish a system for
customers or clients to obtain information and enter into contracts or place orders.
This may be as simple as a customer talking with a sole proprietor or as complex as
an international sales programme involving multiple methods of distribution and
hundreds of individuals. The investor should learn how the selling of the
business's products or services is accomplished.
 Appendices 149

Pricing
Due diligence objectives are to analyse all factors affecting pricing, the existence of
improprieties and hidden liabilities and, most important, to gather sufficient
information to decide if pricing is maximising profits. Pricing directly affects
profitability; so pricing improvements may be one of the quickest ways to increase
profits.

An investor should understand the pricing philosophy, the method of setting prices
and the factors influencing prices. Pricing improprieties and errors are an
unpleasant reality that occurs with sufficient frequency that their possible
existence cannot be ignored. For each product or service line, pricing should be
reviewed separately, because variations can occur regardless of broad corporate
policies. Formal pricing policies may clearly set forth the overall pricing philosophy
used in setting prices. Such policies tend to be guidelines from which deviations are
not permitted without the approval of a senior executive. If written policies exist,
copies should be requested. While policies typically are unwritten, they usually are
understood within the business. Whether written or unwritten, the pricing
approach and policies are as basic information as the business's name and address.

Regardless of pricing philosophy, policies and management statements, it is

important to understand and verify precisely how prices are established. There may
be large variations between policy and reality. Understanding the nuances can be
achieved by obtaining current price lists, recently accepted quotations, or prices
marked on merchandise, and then questioning in detail how the prices originated.
Were they a fixed percent over cost or based on competition? What was believed to
be the most a customer would pay? Were prices simply pulled out of the air? After
determining how actual prices are established, a comparison can be made between
prices received and those on price lists or quotations.

Advertising and Public Relations

Except for businesses with substantial advertising and public relations
expenditures, most investors limit the due diligence efforts on these activities.
Dealkilling problems and perils are improbable, but knowledge of the functions will
be useful in planning a transition if acquisition occurs. Since the functions are not
150 Background Material on Due Diligence

precisely defined and do overlap, it is usually wise to study both simultaneously.

Wide variances exist between industries and businesses within industries in the
extent and use of advertising and public relations. For smaller businesses,
expenditures are minimal, but as businesses grow or try to grow, advertising and
public relations become more prevalent. In medium-sized businesses, both
advertising and public relations often are combined. In larger businesses,
advertising and public relations tend to eventually separate into independent
functions.

Advertising is primarily concerned with promoting the sale of products and

services, preparing literature, brochures, advertisements and buying media time or
space, while public relations seeks publicity through news releases, lobbying and
events. Public relations are more concerned with promoting the overall image of the
business, government relations, its securities and often its key executives. Public
relations informs the public of what the business wants the public to know and tries
to cast in the best light whatever it wishes the public to know.

Budgets for the current year and actual expenditures for the last fiscal year indicate
the extent of the advertising and public relations programmes and may identify
projects and programmes. Information on specific activities and programmes can
then be requested for evaluation. Any measures that the business may have of its
advertising effectiveness should also be requested. A list of employees and their
specific functions will clarify responsibilities.

Purchasing
Purchasing decisions spur broad due diligence questions. Is the function well
managed with adequate controls? Does it have the authority and status to be
effective? Does it contribute to business success with aggressive buying and by
providing a source of intelligence for the entire business? Or is it simply a neglected
arm and possibly a centre of conflict of interest and corruption? The importance and
stature of purchasing may be evident in the existence of procedural controls and the
placement of purchasing executives at senior levels. Regardless of its status,
purchasing should be closely reviewed during due diligence, as every rupees saved
 Appendices 151

in purchasing becomes a rupee of pretax income.

The role and impact of purchasing may be large and not limited to selection and
evaluation of suppliers, negotiations, placing and expediting orders. It can be a
conduit of information to the organisation on what is available from suppliers. It
also can identify supply alternatives and be a valuable source of intelligence on
competitors, industry trends and practices. Purchasing establishes controls so
orders are precisely written and entered into the financial reporting system.
Purchasing monitors and, when necessary, pressures suppliers to meet delivery
dates and grant price concessions.

Purchasing does have a dark side because of the opportunities and temptations for
personal enrichment. Few employees are entrusted with the business's money like
those in purchasing and no other function has the breadth of opportunity for
dishonesty. It ranges from the secretary buying personal items from the petty cash
fund, to a clerk typing fictitious invoices, to the chief executive officer receiving
kickbacks. Entertainment, gifts, kickbacks, conflicts of interest and fictitious
purchases can and do happen. Due diligence investigators should be alert to any
indication of misplaced trust.

Human Resources
A thorough knowledge of employees, employee costs, employee relations and
commitments to current and former employees is an essential part of any due
diligence programme.

An investor should know the total number of employees as well as the number in
each category and at each location. This information provides another measure of
the size and importance of each segment of the business. Careful attention should
be given to defining the employment relationship for all individuals providing
regular services to the business, including those on a contractual basis. Seasonal
factors must also be considered when applicable.

The number of job openings, the length of time each has been open and the
circumstances creating the vacancies and any recruiting problems should be
152 Background Material on Due Diligence

reviewed. It might be that no one is available to fill the positions, that compensation
is too low, working conditions unsatisfactory, the job specifications unreasonably
high, or the business is ineffective at recruiting. Basic questions for an investor are
whether a shortage of employees at any level is adversely affecting the business and
what corrective measures are possible. If personnel are not available locally, could
they be recruited from other areas? Is subcontracting a partial solution? If the
condition does not improve, must relocation be considered? Is the shortage
temporary or has it been a chronic problem? Is it possible to quantify how seriously
the business has been hurt by the shortages?

Management vacancies and the recruiting and selection methods deserve special
attention. The philosophy and attitude of the board of directors and chief executive
officer may be reflected in the selection procedures.

Employee Compensation and Benefits

Employee compensation and benefits, for most businesses, constitute a substantial
expense that is burdensome but not crushing. However, for some the costs are so
great they cannot remain viable without change. In others, unless wages and
benefits are increased to attract and hold employees, the business cannot grow or
survive. Due diligence should review actual compensation and benefits and
causative factors such as competition, affordability, government regulations,
customs, employee demands, levels necessary to recruit and retain employees and
industry standards. Knowledge of these key factors is particularly important if the
investment results in a merger necessitating the integration of operations and work
forces. Care should be given to understand and evaluate both current and future
costs, because present benefits and commitments for future benefits may not be
reflected in financial statements. The lack of disclosure and understanding of future
benefit costs is one of the most important areas for due diligence investigation.
While reviewing the financial implications, investigators should be alert for
compliance with central and state laws and regulations governing benefit plans.

If retirement plans exist, what are their costs and the method and adequacy of
funding? What current contributions are required under the plans and are these
being made on a timely basis? There is a strong trend away from defined benefit
pension plans, but thousands exist with large liabilities. "Unfunded past service
 Appendices 153

liability" is the amount not paid into a fund actuarially adequate to pay for promised
future benefits. The unfunded past service liability can be of such magnitude that a
business's ability to ever fund the benefits may be in question. Investigate to learn if
these liabilities are fully disclosed in the financial statements and whether
practical measures can be taken to fund or reduce the liability.

Corporate Culture
Business deals all too frequently fail because differences in corporate cultures
prevent the parties from understanding, accepting, reconciling or compromising.
Unfortunately, cultural clashes are usually less a barrier to completing a deal than
to success after the deal closes, because investors tend to minimise or ignore
differences during due diligence.

Cultural factors may exist because of chance but more likely because individuals in
power are convinced they are the right things for the business. The factors become
deeply ingrained and difficult to modify. Naive beliefs that cultural differences are
interesting but insignificant or can easily be changed have caused many investors
to regret the day of their involvement. Cultural clashes are most severe when a
business is acquired with a very different culture from the investor, who promptly
attempts to revise practices to conform to his convictions or methods. However, if
cultural practices have been clearly detrimental to the business, such as oppressive
management styles, dishonest or rapacious marketing, excessive political activity
and discriminatory employee selection practices, their elimination may have a
liberation effect highly beneficial to the business.

Business culture is composed of numerous factors, both obvious and subtle, that
have varying degrees of importance. Importance is partially a function of how long a
practice has been in existence and if entrenched, fully accepted and expected to
continue. Practices and conditions are far more significant when carried to
extremes, as would be an authoritarian structure where all decisions are made by
the chief executive officer, or a work force that is nearly all one religion or race.
Common components of business culture are level of centralisation of authority;
relative independence of business units; management approach to employee
relations including paternalism, fads, compensation and dress codes; community
involvement and the likes.
154 Background Material on Due Diligence

Legal
Most due diligence issues could conceivably be categorised under the heading "legal"
because they directly relate to the compliance or non-compliance with laws. Of
particular concern to any investor is whether the business is involved in litigation, and
whether as a defendant or as a plaintiff. Similarly, an investor will need to know if the
business is under investigation by any governmental agency, if it is subject to fines or
penalties, or whether the government, has prohibited it by court order, or by
agreement, from engaging in any activities. In addition, the investor will want to probe
whether the business's operations meet all legal and regulatory requirements.

An investor does not want to invest in a company that, shortly after closing, will be
fined millions of rupees by a government agency or subject to a court verdict. In
fashioning legal questions, the investor will find helpful the assistance of a lawyer to
ensure that all aspects of the business's operations are adequately investigated. As
with other due diligence questions, legal questions should be coordinated with the
representations and warranties in the transaction document. In addition, although
these questions may be termed "legal" in nature, the investor's financial and
operational people, as well as the lawyers, should carefully review the results.

At the heart of the legal due diligence is a review of pending or prospective litigation.
The investor will want to review any lawsuits involving the business. Not only
might the business be liable for the underlying claim, but also even if the claim is
without merit, the business will incur litigation costs. The lawsuits or claims may
also indicate a foreboding trend in the business or its industry. The investor should,
at a minimum, request the name of the case; the court where the suit is filed; a
description of the general nature of the case; the amount sought; the status of the
case; and the likely outcome.

Information Systems
Most information obtained during a due diligence review of a business's information
systems will be utilised after the investment is completed rather than to decide
whether to invest. This will be particularly true if integration of the business's and
the investor's systems is contemplated.
 Appendices 155

Knowledge of the present state of the systems is essential to decide what further
additions or improvements are needed and economically justified. However, there
are a few broad questions that could affect the investment decision. Are the systems
compatible with the investor's? Can the software licences be readily transferred to a
new owner? Are the present systems inadequate or obsolete and in need of large
capital expenditures? Specific questions regarding the nature, effectiveness, costs
of systems, compatibility of systems, proper licensing and future programmes
should help answer the broad questions for an investor.

Information systems include communications of all types. While computer

technology changes at a rapid rate, the entire field of communications is changing
equally fast. Whatever is the state of the art in both technologies, all agree today's
technology will soon be obsolete and therefore will complicate any due diligence
evaluation.

The first step is to find out what hardware and software is used, what systems they
support and what information are provided. An inventory of all systems, records and
reports provided through the use of computers and associated electronic equipment
will indicate the end product. A second inventory of all hardware, computers,
peripherals and software will indicate the type of equipment and software used to
provide the systems and reports in the first inventory. The inventories should indicate
which systems are being revised or scheduled to be replaced and if any hardware is
considered to be surplus either now or in the near future.

Budgeting and Planning

Planning consists of studies, recommendations and decisions as to what products,
services and industries the business should be in and what direction it should take.
Planning involves establishing an overall philosophy, plan and objectives for the
business, while in budgeting, pro forma financial statements are created to
forecast, monitor and control existing business units. The financial statements
normally reflect anticipated revenues, expense levels and approved capital
expenditures. Most budgets have monthly financial statements for the first year
and then quarterly or longer periods for future years.
156 Background Material on Due Diligence

In large corporations, planning and budgeting tend to be segregated into two

distinct functions. In medium-size businesses, planning and budgeting often merge,
with the chief executive officer or chief finance officer assuming more of the
planning function with budgeting folded into the responsibility of the controller or
some other financial executive. In small businesses, neither function may formally
exist, with planning remaining in the head of an owner consumed with day-to-day
operations, and budgeting considered unnecessary.

A primary due diligence should target copies of existing budgets and plans. No
documents other than financial statements will be more informative. A comparison
of prior years to actual results will provide insight into management's competence,
failures, successes and changes in direction. The latest budgets and plans will
indicate current thinking and management's views of the prospects for the
business. There is little uniformity among businesses and great variation exists in
both format and content of plans and budgets. Both become molded to the needs of a
business and the preferences or whims of those in charge. They tend to increase in
size and scope each year as executives not only see areas to improve and new
subjects to cover, but learn from prior failures or overlooked problem areas.

Insurance
Professional assistance is usually necessary to adequately evaluate a business's
insurance coverage. For most investors, the professional will be the insurance
broker providing their existing insurance, but other consultants free of conflicts of
interest can be employed. It is a relatively simple matter to gather the policies,
secure premium and other related information, but to fully understand the policies'
terms, coverage and common risks not covered is another matter. Most
businessmen have a general knowledge of the policies and costs but very limited
information on specific terms, at least until a disputed claim occurs.

Evaluation of the adequacy of any insurance coverage is no longer complete with

just a study comparing probable risks to the terms of the contracts. The practices of
the carriers and their financial capability to pay must also be considered. Carriers
are private companies and, as in any industry, there are a few who are disreputable,
engage in sharp practice and have limited or no financial ability to pay losses. Even
some of the larger, better-known carriers have experienced substantial losses from
 Appendices 157

poor investments, underwriting or both. The well-publicised financial problems of

Lloyds of London, the large number of carriers that have failed, and the
shortcomings of regulatory agencies should be a warning, in every due diligence
evaluation, that review of the contracts is not enough. There are several companies
involved in rating insurance companies that can be a quick reference and starting
point. If the business has a significant outstanding but unpaid claim, carrier
evaluation will take on immediate importance.

All insurance in effect is described in a contract between the carrier and the insured,
and one should assume that if there is no contract or policy, there is likely to be no
insurance.

Environmental Issues
A public awareness of environmental hazards has resulted in broad, complex
legislation, vigorous enforcement, endless litigation and horror stories in which
investors found themselves owners of environmental liabilities that often exceeded
their original investment. Today, few investments involving real estate or
manufacturing are completed without an extensive review of environmental risks
and negotiations to establish responsibility for remedial costs of any hazards that
may exist--known or unknown. While no statistics are available, anecdotal evidence
indicates that more deals upon which preliminary agreements were reached were
eventually terminated over environmental issues than any other. An even larger
category is failed deals that never reached the preliminary agreement stage
because investors learned of environmental problems.

Due diligence of environmental issues is difficult because of their complexity,

nebulous and untested legislation, unreasonable and ill-considered regulations,
conflicting and changing regulations, changing technology, difficulty in securing
estimates of the cost of remedial measures, difficulty of proving what does not exist.

When environmental issues arise, expert opinions may be necessary to evaluate the
risks. Environmental engineers evaluate the nature and extent of the problem. A
lawyer specialising in environmental law may be needed. Direct meetings with
regulatory agencies may be advisable. All of these activities can become time-
158 Background Material on Due Diligence

consuming, expensive and often discouraging because of the difficulty of securing

precise answers, and differing opinions from the experts.

Debt and Banking

Debt is an extraordinarily broad term that describes financial obligations that must
be identified and fully understood during the due diligence study. Debt and all its
conditions have variations limited only by human imagination. Timing and terms of
repayment, collateral, penalties for default, guarantees and various covenants can
result in debt obligations that are extremely onerous or impossible to repay and
others in which the debtor can largely repay at his discretion. Due diligence of debt
requires studyingthe details of the actual financial instruments. The tedious fine
print cannot be ignored.

An initial step is to identify all indebtedness of the business. Debts may be owed to
banks and other financial institutions, shareholders, officers, security holders,
individuals, a government and anything or anyone who can be defined as a legal
entity. Supporting each debt should be documentation describing the terms and
conditions of the indebtedness. Since such documents are often revised or amended,
care must be taken to have the complete and latest documentation.

An investor will find it helpful to develop a list summarising all debt, its terms and
conditions for use in evaluating the business and planning the programme. At a
minimum, the list should include the amount owed, name of lender, repayment
schedule, rate of interest, restrictions on use of funds, borrowing base, collateral,
prepayment provisions and guarantees. A summary list does not reduce the need to
study the individual loan documents. For most businessmen, the detailed study will
be a task for their attorneys and accountants.

Any bank or financial institution with which there has been or is a business
relationship will have an opinion regarding the business and its management. The
nature of the relationship and the opinion of the institution will largely determine
the future relationship.
 Appendices 159

Investments and Cash Management

Investments are extremely variable in their nature and require separate study. An
investment may have a market value higher or lower than that recorded or its
original cost. Restrictions on liquidity either by contract terms, government
regulations or the market's ability to absorb the investment can affect the value.
The value of an investment may be instantly discernible, as would be the case with
government securities, or extremely difficult to determine, as would be the case
with unregistered securities in a private company that was losing money. Some
investments have no present market value and cannot be sold, but there remains
the possibility that value would return at some future date and under the right
circumstances. The due diligence objectives for each investment are to determine
present value, quality and liquidity.

Businesses invest surplus cash in nearly every manner imaginable. Each

investment should be reviewed, along with the decisions and policies that led to the
investment. The investor should understand the rationale for the policies, how they
were developed, and how investments were selected. Also to be determined is who
makes the investment decisions and what have been the results. Investors should
review the business's plans for using the invested funds and determine whether any
investments were improper or insider deals. Additionally, the investor will want to
review the financial instruments and documentation to confirm each investment.

Loans to shareholders and executives are usually insider transactions for the
benefit of the borrower and as such those investments need careful review early in
the due diligence process. Their most common purposes are a means of extra
compensation, a method of financing stock purchases, financing for personal
residences or other executive perquisites.

Taxes
Taxes may be an unpleasant cost of doing business. They contribute nothing
directly to the success of a business but indirectly make the business possible, since
only the most primitive of trading could occur in the absence of government. The
task during due diligence is to identify tax obligations, evaluate how well they are
being met, review their impact upon competitiveness and learn the status of any
160 Background Material on Due Diligence

disputes. Sufficient information should be gathered to determine if excessive taxes

have been paid and what steps may be taken to reduce the overall tax burden
without violating any laws. Businessmen can readily gather the basic information
on taxes and identify obvious problem areas and subjects for further study.
However, taxes may be complex, and a professional tax expert may be required to
evaluate a business's tax situation. If tax savings are a possibility, an expert usually
will be required. Possibly several experts will be needed because of their
tendency to specialise. An expert on income tax may know little of local ad valorem
taxes or state taxes and their administration, and the reverse can definitely be true.
Foreign taxes require experts on a country-by-country basis and the best will most
likely reside in the country involved.

The first step in the due diligence study of taxes is to identify the tax reports
required. Some will be of much greater importance (such as income tax returns)
than others, but any of the taxing authorities has the power to take legal action
against the business for failure to file required reports and pay taxes. The legal
action may be slow in coming but one can assume it will eventually happen.

A summary of activity relative to each taxing authority will help to understand the
effect of taxes upon the business. Identifying the actual amounts paid or due enables
a rational determination of the taxes' impact upon profits and the business's
competitive position.

General Accounting Questions

There are a number of subjects, questions and issues that apply to the accounting
functions and systems in an overall or general way that are not specific to a
particular account such as receivables or payables. Since a major part of the due
diligence process consists of understanding the financial statements, background
and supplemental information are essential to comprehend and verify the
statements or determine the facts.

The reliability of the financial statements should be repeatedly questioned during

the due diligence investigation. Few mistakes in investing are more common than to
automatically assume the financial statements are accurate in all respects. There
 Appendices 161

are at least three categories of financial statements: monthly or interim reports,

annual reports and reports that are part of tax returns. Public companies must
submit reports containing financial statements to SEBI. Interim monthly or
quarterly reports are not audited except in public companies, where auditors prior
to publication may review quarterly reports.

Monthly reports are the least reliable and tend to be used more for internal
operating purposes than as a basis for investment decisions. Annual reports may or
may not be audited and if audited still may not be adequate. Certainly, the audited
accounts have a high degree of reliability.

Accounting Policies
A business's accounting policies and practices can have an extreme effect on the
profit or loss recorded in the financial statements. In many cases a recorded profit
could just as easily have been a loss with different accounting policies, or the reverse
could be true. What appears to be a remarkable turnaround from losses to
profitability may be due to accounting policy changes rather than brilliant
management. Frequently, large one-time losses are better explained as reversions
to more conservative accounting policies or recognition of losses more properly
attributed to prior years. A business's accounting policies may be precisely written
and elucidated by management, but some tests are always necessary to confirm
that actual practices are consistent with policies. Not all executives are willing to
admit their practice is to inflate or depress income. In the due diligence process, it is
important to determine the accounting approach, policies applied and if a pattern of
accounting practices is used to accomplish an objective. If any practice is discovered
to either inflate or deflate income, it is highly probable a pattern of similar practices
exist. An example is that a business slow to write down obsolete inventory will also
be likely to delay recognition of bad debts.

Cash
The cash account is first on the balance sheet and first in concealed characteristics.
Many investors' enthusiasm for a business has been enhanced by the presence of a
large cash balance only to discover later that much of the cash is gone or
inaccessible. Conversely, investors have disparaged businesses because of a low or
162 Background Material on Due Diligence

negative cash position only to belatedly learn the condition was temporary. Large
cash balances can reflect a very temporary condition, bad management or failure to
make short-term investments or funds the business is obligated to keep in cash
form. A balance sheet is a financial snapshot of the business that captures the cash
position on a particular day. Few accounts are subject to change so rapidly and they
should be viewed accordingly during due diligence. The cash account is something of
a way station for cash after it is received and before it is sent to pay creditors and
investors or to be invested. When reviewing cash, there are three other accounts
that should be looked at simultaneously:
+ Short-term investments, where surplus cash is temporarily placed
+ Receivables, from which cash is received
+ And current liabilities, where cash goes.

The amounts in these accounts have to be considered and trends identified to fully
understand the overall cash account .The business may have cash in bank accounts
but all or part may be restricted and cannot be spent. Compensating balances are
funds required by a bank to be left in a non-interest-bearing account as part of the
price the bank charges for a loan.

Accounts Receivable
A broad study of receivables provides an insight into numerous aspects of a
business. Not only is the value of this major asset quantified, but from receivables
customers can be identified, the proportion of revenues coming from geographical
areas or customers can be determined, knowledge of customer relations can be
gained and business problems identified through the existence of disputes.

Certain critical areas of accounting (receivables, inventory, accrued liabilities and

income recognition) require intense scrutiny during due diligence because of the
possibility of highly discretionary management polices, controversial entries,
improprieties and disputes over value. Of these, receivables are easiest to verify and
evaluate. Asking the questions in the checklist, coupled with direct confirmation of
individual receivables, may give an investor comfort to proceed, information to
negotiate adequate guarantees or convincing evidence to forget the entire investment.
Trade receivables are amounts owed to the business from the sale of products or
 Appendices 163

services. Other receivables that may be included in one all-encompassing

receivables account could be from the sale of patents, assets, licensing or royalty
fees and other non-trade transactions. Notes receivable can be for anything but
most commonly are slow-pay receivables converted into long-term loans to key
shareholders and executives who may or may not repay on schedule.

An overview of receivables is possible by classifying the individual receivables into

categories defined by the length of time a receivable has been outstanding or
unpaid. This practice is called "aging" and an important internal accounting report
for most businesses compiled at least monthly are a receivables aging report. An
aging report can identify the overdue amounts and individual receivables overdue
but it will not identify new receivable that may become overdue.

Inventory
Inventory presents a difficult due diligence challenge because it may be under- or
overvalued and the chances of knowing its precise value are remote. The final value
will be based on information prepared by accountants and used by the parties to
reach an agreement incorporating a value they can accept. Even when management
strives for realistic inventory values, the actual values may remain unknown until
future sales occur. Management's intent upon manipulating financial statements
find inventory an area of extreme opportunity, and it is one of the most frequently
used means to inflate or reduce income.

Questioning management and reviewing reports and financial statements are

important but should only supplement actual counts and physical inspection of the
inventory and inventory records. Verification of the inventory both in count and
price is essential and preferably observed by independent auditors. The overall
statistics, trends and other information are vital to the study but will not provide
sufficient data for comfort in the absence of on-site inspections. Inventory may
conveniently be in one location, numerous locations, in transit or on consignment
and so complicate the task of verification. Knowledge of its location is not only
essential for verification but for studies conducted as to the cost of maintaining
inventory at specific locations and the impact of the inventory level on sales. A
business's total inventory is important to know, but the information of greatest
value is the inventory by product line. The amount of capital committed to
164 Background Material on Due Diligence

maintaining an inventory for a product line is a key element in evaluating

profitability or lack thereof.

The number of inventory turns is a measure of how well a business is being managed
in relation to others in the industry.

Fixed and Other Assets

Assets other than current assets may be the business's most important and valuable
property. Facilities, production equipment, office and systems equipment are all
critical components without which the business could not function. Major tangible
assets should be identified along with their value as reported on the financial
statements, their estimated market value and importance to the business.
Intangible assets are those primarily visible only on the balance sheet, such as
goodwill, capitalised expense, customer lists and trademarks. Intangible assets
may have great value or even be undervalued, but many are worthless. Determining
the origin of each intangible asset is helpful to estimate current value.

Fixed assets may appear on a balance sheet as several line items or an all-in-one
general category of "property, plant and equipment" (PP&E). Regardless of how
broadly described, this is a reasonable starting place. Using the balance sheet
summary, the due diligence investigator can request the records supporting the
individual components. They should disclose the original cost as well as the amount
of depreciation taken and that remaining. A review of the financial records coupled
with visual inspection of the assets is an essential part of due diligence.

A perfectly managed business will have accurate, up-to-date records identifying

each fixed asset, its original cost and the depreciation taken to date. However, fixed-
asset records often are poorly maintained, dated and do not accurately reflect the
actual assets. Significant assets may have been acquired but not recorded and
others sold, scrapped or discarded and not removed from the records. If physical
inventories of assets are infrequent or never made, that permits the perpetuation of
recording errors.
 Appendices 165

Liabilities
Due diligence requires verification of liabilities both listed and not listed on the
balance sheet. To achieve a level of comfort the investor must gain adequate
knowledge of the business's liabilities. Since unknown liabilities can emerge after
the investment is consummated, the due diligence investigation should reduce this
concern to a reasonable and acceptable business risk. It is virtually impossible to
prove there are no other liabilities, but it is possible to reach a point where further
concern or fears would border on the irrational. Just as identification of liabilities is
important, investors should be wary of overemphasis on liabilities and what is
wrong with a business rather than its attributes.

Unrecorded liabilities are those that should have been recorded or those in which a
probable, undetermined liability exists. Inability to determine the precise amount of a
liability is sometimes used as an unacceptable excuse to record no liability at all. A list
of all unrecorded liabilities, actual and probable, should be developed for the investor
to gain a complete picture. Common areas to search for unrecorded liabilities are
litigation, non-capitalised leases, product guarantees, loan guarantees, service
guarantees, self-insurance, purchase contracts, employment contracts, severance
benefits, pensions and health insurance. These areas are by no means inclusive and
each industry may have its own special types of liabilities. Once identified, investors
need to determine whether liabilities are valid, estimate when cash outlays will be
required and determine probable best or worst case exposure.

Backlog and Income Recognition

Making sales, recording orders and maintaining a backlog are basic activities that
commence a sequence eventually resulting in a profit or loss reported on the business's
income statement. The level of reported income largely determines the tenure of
executives and so produces pressures to perform that should continually be kept in
mind during due diligence. Lack of profits will eventually cause failure, the loss of the
owner's investment and jobs. A profitability influence the market price of shares,
spurs hopes to sell more shares and creates opportunities to exercise options and enjoy
bonuses. Budgeted profits, earnings projection, growth targets and unbroken records
of increased earnings have often caused managements to engage in dubious practices.
The demands for performance are so strong that executives may take regrettable
actions that should be ferreted out during due diligence.
166 Background Material on Due Diligence

Many businesses receive orders for products or services to be shipped or provided at

a later date. The cumulative total of all unfilled orders is the "backlog" and is an
important indicator of near-term business activity. In manufacturing, construction,
contract services and hundreds of other types of businesses, executives watch the
backlog closely to plan business activities. Comparisons of the present backlog to
prior years and current trends in the backlog will give an investor the single best
indication of what is happening to the business and the level of business to expect in
the near future.

The amount of gross profit in the backlog is a far better indicator of future pre-tax
income than the total level of backlog. In fact, total backlog and trends can be
extremely misleading without gross profit data. Low-profit work may have been
taken to make the backlog appear good or in the belief that increased pre-tax profits
could result from a larger volume of business with a lower margin of profit.

Cost of Sales, Selling and Administrative Expenses

Due diligence should involve gathering sufficient data to analyse and understand
the costs and expenses incurred by the business. While the term "costs" usually
applies to production-related activities and "expense" to so-called non-production
activities such as selling and administrative charges, there is no difference.
Hundred rupees of wage cost paid to a production machine operator eventually has
the same effect upon the business's income statement as ten rupees of expense paid
as part of the chairperson's compensation. Executives who are zealous in “cost”
cutting but largely oblivious of “expenses” often ignore this obvious fact.

Financial income statements will provide basic information in summary form and
are the proper starting points to evaluate overall costs. Most contain separate
information on costs of sales, selling expense and general and administrative
expense. From the summary information trends should be discernible, but more
specific information must be sought on the composition of each category and any
significant shifts in the percentage of the components within a category. As an
example in cost of sales, wage costs may be declining and material costs increasing
with no net effect. In selling expenses, a large increase in support staff or a shift to
telemarketing may be occurring, but selling costs as a percent of total sales may be
declining. Trends are of great importance to identify the favourable
 Appendices 167

accomplishments of the business as well as alert an investor to emerging problems.

Gross profit is the profit calculated by subtracting cost of sales from revenues. They
are profits before selling, general overhead charges and administrative expense
(SG&A) and are primarily determined by two factors--prices received and cost of
sales. Higher prices will increase gross profit and lowering of cost of sales will have
the same effect.

Inter-company Transactions
Multiple business units with common ownership or control have evolved to
accommodate diversity and growth, spread risk, facilitate management and
maintain financial controls. Unfortunately, inter-company transactions can be a
source of controversy, complex or misleading financial reports and, in extreme
cases, an opportunity for deception. Inter-company transactions have been a
favourite playground for those wishing to manipulate the books.

Whenever there are multiple business units controlled, owned or influenced by a

common entity, the relationships must be clearly defined from both an operational
and a financial perspective. Is the relationship with the parent one of tight or loose
control? Do the individual units conduct business between themselves and how are
such transactions recorded in the financial statements? Do policies, methods and
approach to recording inter-company transactions reflect a desire to accurately
record income or losses by each business unit? Are policies designed to benefit the
business as a whole rather than individual unit? If statements are audited,
consolidating income and balance sheets should indicate inter-company
transactions.

Inter-company sales are the sales of products and services from one business unit to
another. Some businesses negotiate inter-company sales between units on an arm's
length basis without influence of the parent. Products and services purchased may
be paid for by cheque. The other extreme is when all inter-company transactions are
controlled by detailed policies and only accounting entries are made to record the
transactions without cash changing hands.

The investor should identify inter-company sales and learn the policies and
168 Background Material on Due Diligence

practices influencing pricing and accounting for the transactions. Each line item on
the financial statements involved must be identified.

Investment Questions and Issues

There still remain due diligence questions relative to participants in the proposed
transaction and the business's value. All professionals, organisations and
government agencies that may influence or can affect the investment decisions
should be identified. Data useful in estimating the relative value of the business
should be reviewed. Information on the business that may have been previously
overlooked should be sought, even if it involves locating third parties whose
approval must be secured before the investment can close.

Third-party approvals are those required from individuals, businesses, institutions

and government agencies that are neither the buyer, seller nor investor. In some
cases the third party must approve the entire transaction and in others only one
segment. A search for such parties and an evaluation of the time, procedures,
difficulty and strategy for securing their approvals should commence early in the
due diligence process. The type and structure of an investment will affect the
approvals required. If the investment is a purchase of selected assets and liabilities
of a going business, approval may be required of lenders and creditors, and to
transfer all contracts in effect and government permits. Contracts include leases,
customer orders, purchase orders and licenses. In stock acquisitions approvals may
be required from lenders, government anti-trust regulators and licensors.

Consultants provide highly specialised skills for projects of relatively short duration
where it will be impossible or impractical to employ full time employees. They
provide businesses with knowledge and skills often unavailable by any other
means. Consultants are not employees and are considerably more expensive, often
commanding large fees. The investor should identify the problems for which
consultants were hired to solve and compare their costs with the results.
 Appendices 169

Appendix - II

Group Exercise

Q. How to start the due diligence exercise?

Q. What to read in the Sales/Purchase Agreement?
+ Is this a purchase of stock or net assets?
+ What is the approximate value of the transaction?
+ Will the seller provide indemnification to the buyer for self-insured or
uninsured liabilities?

Hint
Before getting started, the due diligence investigator should gain an understanding
of the overall situation and the time-line. For example, if the proposed transaction
is being conducted as an auction, you may have to get by with the documents in the
data room. After the buyer has signed a letter of intent, you should insist on getting
whatever reasonable information you think you will need.

Five Process-Planning Items

1. Sign a confidentiality agreement.
2. Obtain the index of the documents in the data room
170 Background Material on Due Diligence

3. Make sure you know what your scope will be. (Who is doing the Employee
benefits, environmental compliance, etc?)
4. Compile the names and contact information of those with who you will be
Dealing (buy-out firm partners and associates, heads of risk management and
employee benefits at the company, and your client's lawyer, etc.
5. Decide if you will need to visit the business to be acquired to observe
operations and conduct interviews.

Q. What to learn from the Information Memorandum and other

available information about the company?
+ In what business (es) is the company?
+ What are its products/services?
+ Where are its plants and offices located?
+ How many does it employ and what are the occupational classifications?
+ What were the revenues and EBITDA over the past three years?
+ What is projected for the rest of this and next year?
+ What are the approximate values of the raw materials, inventory, plant
and equipment on the balance sheet?
+ Who are the company's major customers and suppliers?
+ Are there any disclosures in regarding to legal compliance, enforcement or
tort litigation?

Hint
Look for potential deal-breakers, such as businesses claim and product liability
legacy issues. If necessary, search the internet for information about the company,
its competitors and the industry. Other red flags to look for are unique exposures
that may require special types of examination.

If a purchase of assets and the seller will be retaining the liabilities for workers
compensation and other liability claims incurred prior to the sale, carefully read the
indemnification provision in the purchase agreement to see if there are any rupees
amount or time limits.
 Appendices 171

Appendix - III

Glossary of Salient Terms

1. Acquisition
Assuming ownership of another business. The acquisition can be made through a
direct purchase or through a merger agreement that involves the exchange of
assets.

2. Merger
A full joining together of two previously separate corporations. A true merger
in the legal sense occurs when both businesses dissolve and fold their assets
and liabilities into a newly created third entity. This entails the creation of a
new corporation.

3. Joint Venture
Two or more businesses joining together under a contractual agreement to
conduct a specific business enterprise with both parties sharing profits and
losses. The venture is for one specific project only, rather than for a continuing
business relationship as in a strategic alliance.
172 Background Material on Due Diligence

4. Strategic Alliance
A Strategic Alliance is a partnership between businesses in which you combine
efforts in a business effort. The joint effort can involve anything from getting a
better price for goods by buying in bulk together to seeking business together
with each of you providing part of the product. The basic idea behind strategic
alliances is to minimise risk while maximizing your leverage in the
marketplace.

5. Appraisal
An estimate of the worth or value of something on the open market. The term is
also used for the report that describes how the estimation and conclusion of
value was made.

6. Business Valuation
An estimate of the worth of a business entity and its assets.

7. Buying a Business
For many entrepreneurs the idea of starting a business from scratch may seem
overwhelming. For them, buying an existing business or a franchise is often a
viable alternative.

8. Adjust Purchase Price

This will take care of prorated items such as rent, utilities and inventory up to
the time of closing.

Review documents required to be provided by the seller. This will provide a

corporate resolution approving the sale, evidence that a corporation is in good
standing, any tax releases that may be been promised by the seller. Check with
the department of corporate affairs.

9. Security Agreements
These documents may be necessary if the purchase is going to be self financed.
 Appendices 173

A Security Agreement lists the assets that will be used for security as a
promise for payment of the loan.

10. Lease
If it is agreed to assume an existing lease, it is required to execute the
assumption. Make sure that the landlords' concurrence to assumption of the
lease. Instead there may be a new negotiated lease with the landlord instead of
assuming the existing lease.

11. Patents, Trademarks and Copyrights

May need to execute the necessary forms of part of the transaction.

12. Franchise
May have to execute franchise documents if the purchase of the business is a
franchise.

13. Closing or Settlement Sheet

The closing or settlement sheet will list all financial aspects of the transaction.
Everything listed on the settlement should have been negotiated prior to the
closing so there should be no surprises.

14. Covenant Not to Compete

It is a good idea to have the seller execute this agreement. This will help add to
the success of the operation of the business without any interference from the
previous owner.
 Answers to Questions
in Chapter One

Response 1.1
The legal side of due diligence is not as exciting and interesting necessarily as the
financial end, and how well the buyers can actually model where the business is
headed. It is a lot more important than making sure the contracts say what you
think they do, although that is an important part what is asked for to be done. It is
one aspect.

In simple terms, due diligence is doing the homework on a deal. Of course, it can
create reasons not to do the deal, or it can show some hair on the deal, potentially
influencing the deal terms. Generally speaking, it is doing the homework,
whether it is on the legal side, on personal, on financial, on software, on
technology and others. It runs the gamut of doing the homework on the deal
before it is closed.

Due diligence could be finding something wrong that does not make the deal or
that makes to renegotiate a price, but for someone who does it well, it may be
finding value that allows to outbid someone else who has not done the proper
homework.
 Answers to Questions in Chapter One 175

Response 1.2
Normally, Due diligence requires the following:
(a) Examination of documentation and litigation issues, preliminary and in the
review of the financial books, operations and technology to assess the way
business is run, possibility of cost savings in operations and means to improve
the working capital structure.
(b) Due diligence also involves background checks on people and it is usually based
on bad experiences in the past.
(c) Due diligence entails the buyer's core competency in judging the business
targeted and critically important is judging the management.
(d) Due diligence should endeavor to find out “what else?” It is not sufficient to stop
at such as that it is possible to fill in the product line or to say it is possible to
move into the plant. The upside comes on the operating company's standpoint.

Response 1.3
The parties conducting due diligence generally create a checklist of needed
information. Management of the target company prepares some of the information.
Financial statements, business plans and other documents are reviewed. In
addition, interviews and site visits are conducted. Finally, thorough research is
conducted with external sources including customers, suppliers, industry experts,
trade organisations, market research firms, and others.

Response 1.4
There is no correct answer to this question. The amount of due diligence conducted
is based on many factors, including prior experiences, the size of the transaction,
the likelihood of closing a transaction, tolerance for risk, time constraints, cost
factors, and resource availability. It is impossible to learn everything about a
business but it is important to learn enough such that could lower the risks to the
appropriate level and make good, informed business decisions.

Response 1.5
Yes. Too much due diligence can offend a target company to the point where it could
walk away from a deal. It can also result in “analysis paralysis” that prevents from
176 Background Material on Due Diligence

completing a transaction or provides time for a better competing offer to emerge.

Accordingly, it is important that due diligence be prioritised and executed
expeditiously. A sensible level of trust concerning lesser issues must balance
appropriate investigation and verification into the most important issues.

Response 1.6
Time allocated for completion can vary widely with each situation. Many
preliminary agreements define the time frames in which due diligence would be
conducted. Time schedules through the closing of a transaction are typically tight
parties should ensure that adequate time is allocated to due diligence.

Response 1.7
Every transaction would have different due diligence priorities. For example, if the
main reason for acquiring a company is to get access to a new product it is
developing to accelerate buyer's own time to market, then the highest priority task
is to ensure that the product is near completion, that there are no major obstacles to
completion, and that the end product would meet the buyer's business objectives. In
another transaction, the highest priority might be to ensure that a major lawsuit is
going to be resolved to the buyer's satisfaction.

Response 1.8
Certain activities conducted during due diligence could breach confidentiality that
a transaction is being contemplated. For example, contacting a customer to assess
the satisfaction with the target company's products might result in a rumor
spreading that the company is up for sale. Accordingly, to maintain confidentiality,
often customers may be contacted under the guise of being a prospective customer,
journalist, or industry analyst.

Response 1.9
A well run due diligence programme could not guarantee that a business
transaction would be successful. It can only improve the odds. Risk could not be
totally eliminated through due diligence and success could never be guaranteed.
 ISBN No. 978-81-8441-015-0

The Institute of
Chartered Accountants of India
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