Due diligence is one of your first tasks as a lawyer working in the M&A or corporate transactions team, or even as an intern.
Due diligence is also undertaken for IP or technology acquisitions.
Performing due diligence well is an opportunity to prove yourself and get noticed, whether you are an intern or an associate.
The partner in the law firm eventually signs off on a due diligence report, though 90% of the work is done by associates and interns, and it is supervised by the senior associate.
Due diligence is the second step in any corporate transaction – the first step is to structure the deal.
Partners and bankers are involved in structuring – as a lawyer looking to break into the world of law firms, you need to understand how to perform due diligence once the structure is decided.
Most people do not understand why they are doing due diligence, and so they feel that they are doing highly paid clerical work.
In reality, due diligence has a bearing on millions of dollars, thousands of employees, and fortunes of several people and even nations.
You will never think of due diligence as a clerical exercise once you know this.
I will now show you how to perform due diligence.
At the end of today’s session, you will have much more understanding today than what I had after my first internship, and also more than what I had after my training session and first real due diligence as an associate.
What is due diligence and why is it done?
Think of what you do when you buy something that seems a bit expensive. You inspect it from every angle, to ensure there are no flaws, and that this is really what you want to buy, right?
This is because there is money involved, and you don’t want to end up discovering that you spent your money on something that was not worth it.
Or worse, something that results in creating additional expense and liability for you.
Investing in a company or acquiring its shares involves a lot of money.
Investors and acquirers do not want to end up making a non-viable investment or end up finding out that the company they have purchased had committed some violations for which they will now have to bear the cost.
This is why they dig deep into the information and records of the company to ensure that their money is being applied to a worthwhile place.
How much money do law firms charge for doing a due diligence
Anything between 3 lakhs and 60 lakhs depending on the law firm, scope and the transaction! In very big transactions it can be much more!
What are the different types of due diligence?
Due diligence can be divided on the basis of functions – such as financial due diligence, legal due diligence, IP due diligence, HR due diligence etc.
We are going to discuss legal due diligence as that is what a lawyer is engaged for in an M&A transaction.
Legal due diligence can be of 2 types:
- Limited due diligence – If the amount sought to be invested isn’t very high, it may not make sense to the investor to spend a huge amount on getting an extremely detailed due diligence conducted. They will only check very important things.
In limited due diligence, you should also know the scope of the diligence as well – sometimes, it is restricted to the last 3 years, or review of top 10 material contracts of each category.
You may review transactions above a certain value and ignore smaller transactions because they are too insignificant given the size of the deal – for example, anything below 5 lakhs value may not be considered for a multi-crore deal, because the impact is too low on the overall commercials.
- Comprehensive due diligence – Significant investments call for a thorough due diligence exercise. How much data do you need to review?
- For most aspects, a 3-year period is seen.
- Some clients may want 5 years data.
- For tax and environment, 7 years’ data is reviewed.
Who conducts due diligence?
Usually, it is conducted by an investor/acquirer who plans to invest or acquire a company.
This is called buy side due diligence.
As a company, how can I be prepared for it though? I will need to conduct a mock due diligence myself to know what issues could arise when a real one is conducted, right?
If I don’t do that, I could be in for surprises when the investor conducts a diligence. That could reduce my valuation and in serious cases it could even lead to deal cancellation.
In all cases, if I am unprepared, it will definitely lead to a delay in raising the money.
If the company arranges for a due diligence on itself, what will it be called?
Reverse due diligence. Because it is the reverse process.
If the normal due diligence was buy-side, then what will the reverse be?
Sell-side.
Hence, reverse due diligence is an example of sell-side due diligence or an investee company getting due diligence conducted on itself.
The work is the same in both cases.
As a lawyer or law student who wants to build his/her initial track record or credibility, it is a great idea to offer to perform “reverse due diligence” on startups and help them prepare.
We will show you how to use this skill to reach out to high potential startups.
Which kinds of corporate transactions require due diligence and how does due diligence vary based on the transactions?
M&A, venture capital, Private Equity investment transactions and IPOs require legal due diligence.
Debt finance transactions also require due diligence to be conducted, for example, many banks have employees engaged specifically in mortgage due diligence.
The due diligence being conducted for a share acquisition will be different from an asset purchase, or a loan agreement.
Right now, we will go through the standard process so that you are not confused.
How does the standard due diligence process work
1 – Preparation of Due Diligence Questionnaire
Usually, the investor will appoint the law firm or the lawyer conducting the due diligence. Sometimes, though rare, the investee entity may also appoint the law firm conducting due diligence.
The lawyer will then approach the target company and ask for the information required for the purpose of the due diligence.
This is called a due diligence questionnaire or a due diligence checklist.
We can go through this here.
This is the questionnaire that will be used for any structure where an investment or acquisition is being made.
To start with, this is the most important structure you should know.
Here are the most important sections of the questionnaire:
- Corporate information
- Contracts
- Intellectual Property
- Loans and Financial Documents
- Employment
- Tax
- Insurance
- Litigation
- Environment (where applicable)
- Miscellaneous
How is this prepared?
Here are some ways in which this is created:
A law firm may have a rough template from a previous transaction – but by no means is it reliable or exhaustive for your transaction – it is your job as an associate to create the right one.
You are expected to update it. They don’t give you exhaustive information on how to prepare such a checklist for a new transaction that you are working on.
Sometimes, lawyers look at documents of companies in the same sector which have conducted an ‘IPO’, because their ‘prospectus’ is publicly available.
However, you won’t find an example if an IPO of Flipkart or Zomato is underway – because they will be the first ones in this sector to IPO in India.
If the wrong list is prepared, or if something is missed out and realised later, expect to be blasted by the partner and the client.
You cannot do this accurately unless you have practiced this before.
What will you look for if there is an investment in Uber?
What will you look for if there is an investment in Pepperfry?
How will this list be different for a Burger King IPO?
Let us take an example of what you would ask for a couple of the sections.
Let me give you an example of some of the questions for the Corporate Section:
- Copy of the Certificate of Incorporation, the Memorandum and Articles of Association of the Company, all amendments, any agreements between shareholders.
These agreements will explain to you the rights of the shareholders vis-a-vis each other and the company.
- Composition of the board of directors of the Company,
- Copies of all statutory registers of the Company – This will have details of directors, shareholders, any assets against which loans are taken, any employees who have been given stock option plans, etc.
- Minutes of all meetings or written consents of the board of directors and the shareholders of the Company relating to the past 3 (three) year period
This will enable you to develop a perspective of what business was conducted by the company and join any gaps in your understanding
There are more entries, but I can’t take you through everything right now.
The associate may even check this with the stock exchange filings or the Ministry of Corporate Affairs website.
Let us Explore what you will ask for Intellectual Property – what will you ask?
- Details of and copies of any copyright, trademark or patent or other registrations.
- Copies of any contracts involving IP or IP licences
- Details of any infringement/passing off actions initiated by or against the Company.
This list is known as a due diligence checklist/questionnaire and is usually standard for certain sections such as corporate information, financial documents, employee agreements, litigation etc.
This is the most crucial part of the due diligence.
2 – Provision of information through a data room
What is a data room? Physical vs. virtual data rooms
So now you know that you need to gather information about a company from its records and you need to gather all of those records, you would need to have a place where all those records are gathered.
In a physical data room, you would possibly be sitting inside a room with a big table, inspecting the different huge files that would be brought to you.
In a virtual data room, which is not only efficient but also environmentally friendly, the different departments of the company on which the due diligence is being performed will simply be uploading the required information.
The heads of such departments or some key employees can be given access to the software and they will upload the required information and documents.
Many providers such as Intralinks, DealRoom, Fordata etc. provide such services – these are advanced versions of Google Drive
Virtual data rooms are also particularly helpful when there are multiple bidders interested in acquiring a company.
This is because these rooms make it possible for the target company to make the data selectively visible to different buyers based on their requests.
3 – Prepare a list of which documents you need from the company (Requisition list)
After reviewing the data provided, you will need to prepare a list of documents which you need to complete your due diligence.
If you already know how to conduct due diligence and what to look for, you will do a good job of this part.
Most unprepared lawyers will not know what to ask. They will need their senior to figure this out at the last moment, when the senior was expecting the final report.
Then they will work overtime.
This is what a requisition list looks like: https://drive.google.com/file/d/1BjVd4ZNtFSpPwfDbM1M8OyCrZLRrp9gD/view?usp=sharing
In a comprehensive due diligence, there could be approx. 100 entries.
Let me show you a real exercise where we teach how to do this in the course – here
When you get data, each cell will correspond to a folder.
Every folder can have anywhere between 5 to 100 contracts.
You can do the math to understand the volume of work.
This is a submission of a student who has done the exercise.
4 – Start reviewing the documents, send a list of clarifications based on what you have received
You need to know what to look for. You do not have the time to read them from cover-to-cover.
In a private equity deal, you will have access to very big investment documents.
Similarly, the company’s filings will be very voluminous. You cannot read every page.
As you start reviewing the documents, you will need clarifications from the company. You will need to draft questions through emails or schedule calls to obtain these.
Keep your seniors informed about these.
5 – Identify high-level issues
Even though your report is not ready, the client will keep asking you from time to time for a list of high-level issues, so that he/she understands what he is getting into and can be prepared for it.
What are these high-level issues?
Don’t jump at every irregularity that you find. A young associate has this joy from finding many things that are wrong with the company while conducting due diligence.
You need to know ‘high level’ issues – usually these are called ‘red flags’ or ‘deal breakers’.
Maybe there are some corporate non-compliances. They could be rectified.
Maybe there are some vendors of the company whose contracts have expired. Those could be renewed.
Some trademark may have expired and it needs a renewal.
These are not red flags nor deal breakers.
You can write about them in the report, but not in the list of high-level issues.
What is a high-level issue?
Imagine that the company is in the fintech sector and needs a crucial licence from RBI, which it is yet to obtain. This could be a high level issue. It could even be a deal breaker.
A tax litigation of 5 crores is pending and if the company loses, this amount may be payable. This may not be a deal breaker, but it is definitely a red-flag.
Your client is the investor, and you need to know which issues are important.
This comes with practice.
6 – Write your report
You can use a base format to write a report. Here is a sample that you can use for your clients:
What do you need to write in the report?
- You need to write down important legal points categorised into different heads so that an investor can read it smoothly
- You need to make observations on any other irregularities that exist
- You need to identify “action points” that can be taken to rectify these irregularities.
You have to be very meticulous here and make notes. From time to time you will share a list of comments and clarifications to the list.
The senior associate will keep compiling the report from time to time.
After the back-and-forth is over, your report will be complete.
Let me show you a real exercise where we teach how to do this in the course – you can download it and try to solve it on your own.
Now, let me show you the assignment of a student from Aligarh Muslim University (AMU) who has done this work:
Can you guess where the student has interned post pandemic?
Atlas Law Partners, CAM, Azure Power and Spice Route Legal, and Trilegal. 🙂
He has secured a job at Indus Law.
When you are writing the report, you need to know what are the important findings, and how they can influence the transaction.
Some of these are called red flags or deal-breakers.
Can you give me some circumstances where the deal could get cancelled?
Obviously there is a lot more to learn, which we will teach you in the course, such as:
- What is the role of a partner, senior associate, associate and intern while conducting due diligence
- How to prepare for your first due diligence
- What does a real due diligence report for a 100 million dollar transaction look like
- How to identify red flags and deal-breakers for your first due diligence
- How to obtain clarifications from the management
- What are the segments of a due diligence report
- How to write the due diligence report
- How to improve the presentation style and visual appeal of your due diligence report
- How to capture the findings of the due diligence in investment contracts?
- What happens after completion of the due diligence? What are the next steps in the transaction?
- How to get due diligence-related work from clients
- How to use due diligence in your CV to get responses to internship and job applications
- How to talk about due diligence in your interviews
- How to get work from your seniors in your internship
- How to get feedback from your seniors on your due diligence work
- How to use your due diligence-related skills to get a call back or an assessment internship
Here is a list of these items for you.