Due Diligence in M&A, PE, and VC Transactions

The private equity/venture capital investments and mergers and acquisition transactions are experiencing phenomenal growth in the Indian landscape. However, navigating this dynamic ecosystem requires meticulous planning and execution. A prospective investor or acquirer may require conducting a thorough examination of the target entity, also referred to as ‘due diligence’ to evaluate the target entity's operational, financial, and legal standing. It entails a thorough examination of the documentation and records in addition to uncovering plausible risks, liabilities, and opportunities related to it’s business. Due diligence ensures the identification and mitigation of risks and liabilities, contractual obligations, and potential legal disputes which can further assist the acquirer/investor in safeguarding it’s investments.

Legal due diligence emerges as a critical first step in laying the foundation for informed investment decisions and successful transactions. By facilitating well-informed decision-making, legal due diligence empowers acquirers/investors to strategically negotiate terms and reduce transactional risks.

Therefore, the due diligence process shields their investments and raises the possibility of a profitable post-acquisition integration. This article explores the process of due diligence which is pivotal in any mergers and acquisitions and private equity/venture capital investment. It provides a clear picture of the target entity’s financial and legal health, operations, and growth prospects, allowing for well-informed investment or acquisition decisions as the acquirer/investor receives a comprehensive overview of the target entity before the proposed transaction.

Due Diligence

1. Corporate Structure: Firstly, while conducting the due diligence on the target entity, the corporate details may be reviewed from the incorporation of such entity or for a specific period, as the case may be, till the cut-off date. Apart from the documents received from the target entity, public inspection may also be conducted on such entity for a holistic due diligence on it’s corporate structure. It is imperative to note that the corporate structure of the target entity, which includes the shareholding pattern of the entity, the authorized share capital and any change thereof, issued and paid-up share capital, the details of the directors and their appointments or removals, the shareholders of the entity and subsidiary companies (if any), is analyzed to ascertain if the same is properly maintained in the records of the relevant authorities.

The secretarial due diligence may also be conducted as a part of the due diligence process, wherein the summary of the minutes of the board and shareholder meetings of the target entity may be analyzed for the relevant financial years, financial statements under e-form AOC-4, annual returns under e-form MGT-7, allotment/issuance and/or transfer of shares, as the case may be, and in case of any discrepancy or non-compliance, the risks associated and the sanctions imposed are highlighted during the due diligence process.

2. Charter Documents: The memorandum of association (“MOA”) and the articles of association (“AOA”) form the charter documents of a company, wherein the MOA defines the core aspects of the company’s business including it’s main and incidental objectives which outlines the permissible scope of activities and businesses which can be undertaken by such company. The AOA on the other hand defines the internal governance of a company which includes but is not limited to the share capital structure, conduct of the shareholder meetings, meeting of the board of directors, the transfer/transmission of shares, winding up, and other management of the target entity. During the due diligence process, an analysis of the charter documents is undertaken in order to ascertain whether the transactions contemplated between the principals can be consummated and if necessary, adequate alterations/amendments to the MOA and/or AOA can be carried out in accordance with the applicable laws including the Companies Act, 2013.

3. Material Contracts: The material contracts and agreements executed by the target entity can include various supply agreements, service agreements, vendor agreements, non-disclosure agreements to conduct it’s business affairs. During the due diligence process, the material contracts are reviewed and perused in order to ascertain the implications of the same on the business of the acquirer/investor and/or the target entity in light of the proposed transaction and may also include review of such agreements to check the legal aspects such as execution and the delivery, expiration, term and termination, consideration, payment of stamp duty, and/or dispute resolution mechanism under the said agreement.

4. Human Resources and Employment: The target entity’s organizational structure, the policies and manuals adopted by such entity to administer and govern the operations and management and smooth functioning of the entity may be examined to check and take note of the compliances under the relevant labour legislations which may include Equal Remuneration Act, 1976, respective shops and establishment legislation, the Maternity Benefit Act, 1961,the Factories Act, 1948, the Sexual Harassment of Women at Workplace (Prevention, Prohibition and Redressal) Act, 2013, the Payment of Bonus Act, 1965, Payment of Gratuity Act, 1972, the Employees’ Provident Funds and Miscellaneous Provisions Act, 1952, the Employees State Insurance Act, 1948 and the rules made thereunder, as amended from time to time.

5. Licenses and Registrations: For the purpose of carrying out it’s business operations, a target entity must have requisite licenses, registrations, approvals, and permits essential, such as the tax deduction and collection account number, permanent account number, registration under the Central Goods and Services Tax Act, 2017, certificate of registration under the relevant shops and establishment statute, or business-specific registrations including but not limited to importer exporter code, MSME registration certificate, the FSSAI license in compliance with applicable laws, from the relevant authorities. The due diligence exercise helps the investor/acquirer to ascertain if the target entity has procured and maintained the aforesaid registrations and licenses required for carrying out it’s business operations in accordance with the applicable laws.

6. Data Protection: An analysis of the data protection infrastructure implemented by the target entity, including the privacy policy, and/or terms of use are perused and reviewed, to ascertain if the services being provided to the users of the entity’s website, the collection of user information and sensitive personal data or information, disclosure of such information, security and storage of information by the entity, are in compliance and in accordance with the applicable laws of India including the Information Technology Act, 2000 and rules made thereunder.

7. Assets including Intellectual Property: Assets of an entity, whether tangible or intangible, form an integral part of the business operations. Firstly, while conducting the due diligence on the target entity, tangible and intangible assets are identified including the plant and machinery, land, vehicles, inventory of stock, and intellectual property, and a review of the executed documents/agreements is conducted to analyze the title and rights attached in relation to such assets. The extent and complexity of due diligence with respect to the assets of an entity will be dependent upon the nature of the proposed transaction. Intellectual Property Rights of an entity also form an integral part of it’s business identity along with it’s goodwill. An analysis of the registrations of the intellectual property as part of a comprehensive due diligence process allows evaluation of the target entity's intellectual property, the registration/filing details, classification of such intellectual property, and the current status and validity of such intellectual property.

Therefore, the due diligence on the requisite assets of the target entity including intellectual property may thereby safeguard the investor’s/acquirer’s interests by mitigating potential risks associated with the entity’s assets including the intellectual property, and thus minimize the exposure to losses and/claims as a result of the deal.

8. Loans and Debts: Reviewing the secured and unsecured debt obligations of the target entity during the due diligence process, provides knowledge pertaining to the overall financial health of such entity. In the event the acquirer/investor intends to undertake an investment in a target entity, the due diligence of the documents on the loans and debts including but not limited to sanction letters, loan facility agreement, convertible loan agreement, compulsorily convertible debt subscription agreement, provides a thorough reflection of the target entity’s financial architecture, which helps to ascertain any restrictions and whether such entity can manage it’s current debts, repay loans, partake future debt obligations and ensures an informed decision making while making investments in the said target entity.

9. Insurance: It is imperative to note that insurance policies with adequate coverage must be obtained by an entity in line with it’s business requirements for it’s smooth operations. While conducting the due diligence on a target entity, the potential financial risks associated with the investments may be highlighted upon assessment of the adequacy of the coverage and costs of insurance. An analysis of the kinds of insurance undertaken by an entity enables evaluation of the target entity’s risk management capacities leading to informed investment decision-making while also mitigating potential risks affecting the investor/acquirer.

10. Disputes and Litigations: An acquirer/investor would intend to invest in entities with good repute and high standing. Gaining knowledge of the past and/or existing litigations strengthens the negotiation capacity of the investor and also prevents them from going ahead with the deal to prevent losses of any kind. Therefore, the legal due diligence process focused on litigations and disputes with respect to the target entity or any of it’s directors, disclosed by the target entity itself, and/or obtained through independent research for records on the portals/websites of the Indian courts, ensures that proper measures or steps can be taken by the investor/acquirer for safeguarding it’s position.

Practical Aspects of the Due Diligence

Upon successful completion of the due diligence process, the findings of the due diligence may be incorporated as action items in the form of conditions precedent, closing action items and conditions subsequent that the investor/acquirer may require the target entity and/or it’s promoters to fulfil.

Further, the findings of the due diligence may also be incorporated as specific representations and warranties to the contemplated transaction from the target entity and/or it’s promoters which can be incorporated under the definitive documentation. Furthermore, specific indemnity protection provisions may be incorporated under the definitive documents to mitigate the losses, claims and/or non-compliances under the applicable laws of India.

Conclusion

A holistic analysis of the target entity’s financial and legal facets thereby addresses areas of concerns and/or threats with respect to the proposed investment while also providing observations and viable recommendations. In order to identify the potential liabilities and legal and/or financial risks involved in an investment, an end-to-end examination and inspection of the corporate structure of the entity, the borrowing capacity, loans/debts, intellectual property and other tangible assets, ongoing and/or past litigations, if any, compliances, permits and registrations in compliance with applicable laws, is paramount.

The upcoming articles in the ‘Series’ will further explore the relevant transaction documents, including the key terms and conditions, rights, liabilities, obligations, and restrictions of the investors, promoters, and other shareholders captured therein.