DUE DILIGENCE

Today’s competitive forces have brought a paradigm shift in the mindsets of the investor community, that focuses more on business ground rules than ever before. Profitability is not the only parameter which plays a role. Preferably, the product/business must also exhibit a trend of sustainable development in revenues along with good corporate governance.

To ensure good corporate governance, what is required is an intensive and thorough Due Diligence (“DD”). In the private equity scenario, it can make or break a deal. More often than not, this being a condition precedent, it is an onus on the entrepreneur to support the DD process. The DD process essentially intends to ensure compliance to all applicable laws, identify gaps, ascertain risks and take a final decision.

DD Vs Audit:

Now, the DD process is somewhat different from an Audit process. Audit aims at bringing to the fore; a true and fair picture of the current status, however, DD aims at negative assurances i.e. identifying risks, if any. Moreover, the Audit process is generally defined and scoped out on the basis of the ‘laws of the land’, but DD is somewhat more scoped out to ‘deal-specific and limited issues’.

The Process:

DD usually starts at the inception of a deal. It has become a legal yardstick which enables prospective investors to enter into a transaction.

Recently there have been many instances where concerns were raised, both privately and publicly, about the intensity; quality and timelines of due diligence carried out by professionals around the world. Especially in India, which has witnessed major corporate scams over the last decade or so, it is critical to deploy a structured methodology for carrying out effective Due Diligence.

Due diligence usually involves looking into the various aspects/divisions of a company, subject to the ticket size of the investment. Depending on the industry, a high net worth deal would probably involve an intensive DD process covering all aspects – Legal, Financial, Secretarial, IT, HR and others. The process covers – reviewing documents; seeking more information; identifying gaps and providing a solution to all identified issues. All this is clubbed into one document – commonly referred to as the DD Report.

Takeaway for Entrepreneurs

The investment community is very highly networked and it becomes imperative for the entrepreneur to ensure that he times his pitch accordingly.

The best trick to succeed in this game is to ‘anticipate’. An entrepreneur, who can anticipate Due Diligence, will ensure the compliances are in place even before he starts to pitch the investors.

Technology can play a vital part in ensuring that documentation is in order. Online data rooms like Dropbox, Box and other cloud services are excellent platforms to record and keep – all executed contracts; originals of the licenses procured and other related documents – in one place.

An entrepreneur today, needs to and must think ahead, making sure that his company proactively responds to any Due Diligence that the investor may wish to undertake. This will substantially reduce the turnaround time for closing the deal with his investor. It is critical for the entrepreneur to close the deal, expedite the transaction and get the money in the bank.

Another simple, yet effective tool for an entrepreneur is to be painfully honest and share their concerns (if any), for a long and effective relationship with their investor. Early stage investors definitely like to follow this cardinal principle – ‘the bet is on the jockey and not the horse’, therefore, it is highly recommended that the entrepreneur be open and expressive with the investor.

Experts Required:

Contrary to the general belief, that professionals like lawyers and company secretaries should be hired when the business relays substantial growth, we strongly suggest that they be hired BEFORE any legal contracts and agreements are signed!! Simply put – prevention is better than cure. Most entrepreneurs enter into multiple contracts, agreements and understandings with their employees, customers, clients and shareholders in the initial stages, which usually haunt and hurt their businesses in the future.

The most common and vulnerable areas of concern are –The Founder’s Agreement, Intellectual property protection, promises made to certain employees etc. Hence, it is always advisable to know on what you are riding on and to make sure you have control over it.

Conclusion –

A study conducted by Standard & Poor’s has revealed that in India, there is a direct relationship between corporate governance and market value. The takeaway here being that – investors definitely take DD into account when deciding where to put their money. It also states that “only companies above a certain threshold of governance level, trade at a premium”. Hence, Due Diligence plays an important role in the investment scenario. A ‘clean’ company is a huge attraction to a potential investor.

Disclaimer:  This is not a legal opinion and should not be construed as one.  Please speak with your attorney for any advice.

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