Due Diligence: Basics & Investment readiness!

Due diligence is one of the most important activity during the life cycle of the deal. So, what is this fabled due diligence, why is it so important, and why so many transactions collapse during or after due diligence is completed??

Due diligence can be understood as a fact finding and matching activity. Whether it is on the financial side of thing, legal side of things or technology side of things. We can define due diligence as an appraisal mission undertaken by a buyer who is looking to buy or invest in a business to assess the asset base, the liabilities and other commercial aspects of the proposed entity.

Let’s take an example, John wants to buy a car. He goes through a lot of potential vehicles that he feels are a good fit for him. He then takes a deeper dive into all the shortlisted cars and visit their dealerships, takes a test drive, look at different mortgage plans available on each etc. and create a composite of fact and experience driven heuristicwhich allows him to take a detailed and imperative decision. In the same manner while looking to make an investing decision an investor would go through the complete due diligence process to ensure that the venture that he is investing in is financially, legally, and technically sound.

Due diligence is a multi-focal exercise and is focused on unearthing the basis and facts behind a business and its viability. At early-stage transactions, due diligence is focused upon 3 major aspects:

A) Financial Due Diligence

B) Operational Due Diligence

C) Legal Due Diligence

D) Technical Due Diligence

FINANCIAL DUE DILIGENCE: Financial due diligence is one of the most important aspect in any kind of due diligence activity. Financial viability is the key pillar of business decision making and investors love clean and clear financials, accounting and other key aspects. The most important aspect of financial due diligence is:

· Accounting practices followed by the entity

· An investor’s perspective behind financial due diligence is very clear as accounting practices which are misleading can lead to potential legal troubles, penalties, and in general an overall negative rep around the company. This can affect the potential returns that an investor expects from an investment. The other key aspects that an investor has a keen eye in the financial due diligence process:

A) Sustainable income & earnings.

B) Historical sales & operating expenses trends.

C) Historical working capital needs.

D) Key assumptions used in management’s forecast and vetting of such assumptions.

E) Key personnel and accounting information systems.

One key aspect to keep an eye upon is that financial due diligence and audit are a completely separate activity with different scope and importance altogether. An audit does ensure that the reporting of the finances is true and fair, but it does not really identify significant issues that are to play an important role in the investor’s decision-making process.

OPERATIONAL DUE DILIGENCE: Operational due diligence focuses on verification of the operations of an investee company.

1. Whether the operations are their or not, whether they do the same thing that an entrepreneur is claiming. For e.g. a fast food chain is looking to raise funds, then an investor will like to visit the store, try your product, speak with your team and then utilize all this information in making the decision.

2. One of the key important aspects of the operational due diligence is the personnel due diligence. An investor will take a look at your management and operations personnel and try to understand their fit for the business and their involvement. The idea behind it is very simple, an investor will supply the capital but growth is driven by an organizations culture and practices, thus having a clear understanding of the culture and practices of an organization allows the investor more clarity on the potential growth capabilities of the organization and supplements the overall decision-making process for the investor.

3. A venture should always ensure utmost focus upon corporate and operational governance. Tracking of key operational KPI’s and set SOP’s to tackle any issue which occurs over the course of operations. Clear operations with smart policies will add a lot of value to an investors decision making.

LEGAL DUE DILIGENCE: An early-stage venture with legal troubles is a nightmare for an investor and can be a potential pitfall in the completion of the transaction.

The scope of legal due diligence is clear to analyze and understanding the legal risk associated with the venture. The major scope of legal due diligence is focused upon the following key aspects:

A) Corporate & legal structure of the company.

B) Commercial Contracts with different stakeholders

C) Intellectual Property

D) Employee Contracts

E) Environment Contracts

F) Regulatory Compliances

G) Environmental Aspects

H) Current Litigation Status

I) Health & Safety measures

Clear legal compliances with all the necessary regulators and clear IP classifications are desired. A healthy corporate governance system ensures that the venture veers away from the path of legal obscurity and issues while ensuring stability of the business.

TECHNICAL DUE DILIGENCE: Technology is a key aspect of businesses today and plays an important role in scaling up of the business. Investors like founder’s bank upon the technology to act as a catalyst in a venture’s growth and scale.

A venture, which claims that their tech is the differentiator or a key component of the overall value proposition should ensure that there are no glitches in it and the tech is capable of doing what it is intended for.

There are multiple other aspects to the due diligence process and it gets complex according to the intensity and stage of the transaction.

Due diligence is one of the most important activity and the most taxing as well. Investor’s always focus on due diligence as a key component to their decision-making heuristic when it comes to a transaction. For a venture it is very integral to ensure that ethics and regulations are always to be adhered, to ensure a smooth due diligenceprocess.

While the above is just an indicative list of processes and things to be kept in mind by the organizations for overall investment readiness.

To know more about Investment readiness and Due diligence, contact us at www.instarto.com or +919929527757 or info@instarto.com

Written by: Ayush Dadhich & Manas Vashisth

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