Due Diligence

Due Diligence is the procedure of forming objective picture about object of investment, ranging from investment risks, independent estimation of investment object to a great number of other factors. First of all, due diligence is aimed at comprehensive verification of legality and commercial attractiveness of the planned transaction or investment project. Important factor in this regard is completeness of information, which is provided in the course of such examination, enabling investors or business partners to identify all advantages and disadvantages of possible cooperation.

Originally the term Due Diligence came in consulting business from a bank sphere, implying a complex system of collection and analysis of information about potential or existing clients and partners, and was intended for protection of property from possible harm. At present, however, this concept does not belong exceptionally to banking sector, suggesting performance of thorough analysis of company’s activity from the point of view of financial analysts, auditors, lawyers, appraisers and experts, whereby each group of specialists prepares detailed report on company’s position for the Customer.

Why Due Diligence is important

Estimation of profits and liabilities of the planned transaction is carried out by analyzing all past, present and future aspects of business being acquired and detecting all possible risks. Non-performance of due examination may be the reason of poor financial results after change of the owner, the reason of court claims, tax or financial examinations, as well as other unfavorable consequences.

Due Diligence begins from the moment when a buyer just starts planning acquisition (merger) of investment object. Afterwards, there starts an investigation of company’s activity, search for any information about the company, generally through official resources (internet web-sites, publications in press publications). Monitoring, collection and analysis of information is aimed at determining company’s value and interest in its acquisition.

Reasons for
Due Diligence:

  • sale/acquisition of a company

  • evaluation of investment attractiveness of a company

  • public offering of securities on a stock exchange

  • merger and acquisition

  • setting up of joint venture

  • commercial crediting

  • verification of reliability of a contractor

Due Diligence procedure may take from three days to four weeks depending on business structure and volumeits size.

The objective of Due Diligence
is to avoid or minimize existing business risks (economic, legal, tax, marketing), particularly:

  • Risk of acquiring the company (stock of shares) at overstated price

  • Risk of non-fulfillment of liabilities by debtor enterprise

  • Risk of loss of property, money

  • Risk of harm (losses), also relating to intangible assets, for example, business reputation

  • Risk of initiating litigations and unfavorable consequences thereof

  • Risk of seizure of property or application of other protective measures

  • Risk of transaction invalidation

  • Risk of foreclosure with regard to property, securities (shares)

  • Risk of bringing to tax, administrative or criminal liability

  • Risk of corporate conflicts (seizure, takeover, litigation)

  • Risk of loss of intellectual property (trade mark, industrial design, invention, know-how, commercial idea, business-plan, etc.)

  • Risk of unfair practices of competitors (collusion with contractors, initiation of examinations ordered by or in the interest of your competitors, price policy, lobbying, etc.)

  • Risk of denial non-obtaining of permissions or loss of necessary relevant permissions, licenses, agreements, etc., which are decisive for a project, transaction)

Objective and competent performance of these procedures is important for both sides: an investor (buyer) and a party attracting investments (seller).

Independent estimation of the situation is a necessary procedure when change of ownership, since it helps to establish trust between the parties of the transaction based on opinions and recommendations of experts, and search of compromise solutions for overcoming potential conflicts of interest.

In the course of Due Diligence there are taken into account quantitative indexes and financial data, as well as qualitative indexes: evaluation of existing management, internal processes and procedures, cost of licenses, location and rights to real estate objects.

Due Diligence implies performance of works in three usually inter-related stages:

  • Estimation of shares stock value (value of property complex, business).

  • Estimation of financial accounting system, reliability of statements, financial analysis, evaluation of tax risks.

  • Legal estimation of risks arising from liabilities and transactions performed.

Herewith, appraisers, auditors and lawyers collaborate closely with each other, since full information regarding transaction can sometimes be obtained only through joint efforts. Below is presented more detailed description of these three groups of experts, whose activities jointly constitute the concept of Due Diligence.

The first group of professionals is the appraisers. They are tasked with determination of fair value of investment object, the range of values of a company in accordance with different scenarios of its mission in the future.

There can be determined market, investment or liquidation value depending on the fact whether the company is purchased as existing business, for the purpose of full reorientation or merger with the customer’s business.

The result of work of this expert group is a report on business estimation.

The second group of professionals is the auditors. They are tasked with financial examination, examination of company’s activity, as well as distinguishing tax benefits and risks.

This stage foresees performance of analysis of structure of revenues and expenses of the company, evaluation of internal control system, analysis of fixed assets, financial investments, accounts receivable and payable, inventories; there is also performed analysis of credit agreements and liabilities, analysis of contingent liabilities, completeness and reliability of accounting of assets and liabilities. Final stage provides for determination of potential tax risks and benefits, as well as identification and numeric expression of potential tax liabilities the company may face.

Structure of data provided by the auditors is generally as follows:

  • Analysis of structure of company’s revenues and costs for analyzed period, analysis of major indexes of company’s activity.

  • Evaluation of internal control system with regard to document workflow related to company’s expenses. Selective Sample analysis of quality and completeness of documents confirming company’s expenses.

  • Analysis of fixed assets: general structure, accrued depreciation, results of revaluation.

  • Analysis of financial investments of the company.

  • Analysis of accounts receivable.

  • Analysis of company’s inventories: structure, cost, dynamics, non-liquid assets.

  • Analysis of accounts payable.

  • Analysis of credit agreements and liabilities: structure of creditors/lenders and the amount of borrowed funds, borrowing terms.

  • Analysis of contingent liabilities (fines; penalties; guarantees issued for security of debts of the third parties; endorsed bills; claims made against the company; collaterals and other material and legal charges over company’s property).

  • Analysis of completeness and reliability of accounting of assets and liabilities reflected as per the Balance Sheet of the company.

  • Consideration and comments on below stated issues with determination of any potential tax risks and benefits. Identification, generalization and, if applicable, numeric expression of all existing tax risks, unaccounted and (or) potential tax liabilities for the company.

The result of work of auditors’ group is a report on financial expertise.

The third group of professionals is the lawyers. They are tasked with performance of legal expertise regarding company’s activity in order to identify most accurately the risks associated with its acquisition.

Lawyers review founding documents, legal status, documents on corporate governance, decisions of collective management bodies and basic powers of attorney. Subject to analysis are major transactions with shares, data about shareholders, their proprietary and non-proprietary rights. State regulation of company’s activity is analyzed, as well as major contracts and proprietary rights of the company, labor relations and litigation.

In general, the scope of lawyers’ analysis during Due Diligence covers the following issues:

1. Corporate governance, which includes:

1.1. Company’s founding documents;

1.2. Company’s legal status;

1.3. Major documents defining corporate governance;

1.4. Copies of minutes of management board meetings, meetings of shareholders, all working groups and committees of a Company;

1.5. List of basic powers of attorney of a Company

2. Company’s shares and shareholders, including:

2.1. Major transactions with company’s shares and data on change of owners;

2.2. List of company’s shareholders;

2.3. Proprietary and non-proprietary rights of company’s shareholders;

3. Regulatory aspects of company’s activity, which include:

3.1. Company’s licenses and permissions

4. Major contracts and other transactions, including:

4.1. Contracts with main suppliers and buyers;

4.2. Loans, guarantees, persons having guarantees, different types of bills of credit and liabilities;

4.3. Analysis of agreements on rent/leasing of premises and other assets: types, amounts, validity periods, mechanism of formation of prices, possibility of termination and/or re-conclusion under different terms.

5. Documents confirming proprietary rights of a company, including:

5.1. Rights to real estate and other company’s assets;

5.2. Shares and other securities owned by a company;

5.3. Other significant tangible and intangible assets of a company;

5.4. Pledge agreements, mortgages and other liabilities under company’s assets.

6. Personnel and labor relations, including:

6.1. Collective and other agreements between the personnel and a company.

7. Lawsuits and other claims, including:

7.1. Lawsuits against the company (major cases);

7.2. Major existing claims/lawsuits;

7.3. Major unsettled claims/lawsuits.

The result of lawyers’ work is a report on legal expertise of the company.

Presently, participants of investment market become increasingly aware of the necessity of risk management related to their activity, improved financial management, development of prudent investment policy. Establishment of new relations between companies, necessity of production modernization, development of relations with investors, as well as the possibility of entering international capital markets have contributed to the fact that transparency of activity is no longer a mere trend but an obligatory requirement for companies competing for leading positions, but also for smaller growing companies.

Therefore, there is rising demand for Due Diligence services in Ukraine, which is attributed, first of all, to the fact of entering international capital markets, as well as rising demands of investors towards amount information of disclosures about the object of financing.