Due Diligence Report

A due diligence report is a comprehensive report to understand better a company's financials and overall standing in the marketplace. There are two types of reports - verbal and written. 

The verbal report consists of con calls, Formal/informal discussions, and client meetings. The written reports are in the form of a Databook or a Final report. Databook is always issued with the final report.

Reports contain valuation concerns, relevant decision-making information, and data analysis and financial information. The frequency of dissemination of information depends on the type of information. 

Information like ongoing client discussions, meetings, and informal chats are reported continuously. However, information like preliminary issue reports, interim reports, draft reports, and final reports are issued periodically.

Reasons to use Due diligence in various sectors

1. Real Estate
2. Business Valuation
3. Sales, Acquisitions, and Mergers

Why is there a need?

This report benefits both parties involved in the transaction - the buyer and the seller. In the case of buyers, it is pretty straightforward. 

It assures buyers that they are getting the best bargain possible and have all the facts at hand to make a wise purchase decision. In addition, it gives an idea of all the possible obstacles or downsides in business before purchase. 

It also contains details that help us understand the company's current clients and partner relationships.

From the seller's point of view, due diligence is also necessary as it briefs the business owners about the soundness of their organization's finances and in determining the fair market value of their enterprise. 

The valuations and acquisition prices always increase; hence, investing in the DD report is rational. 

Here are some of the following details that are a must for a comprehensive DD report. It should begin with an introductory section specifying these items:

• Are we looking for funding?
• Is this for a real estate investment opportunity?
• Is it for sale or M&A?

After answering all these questions, we can move on to the other section and identify the types of information required for each DD report.

Sections of the due diligence report

A few of the sections are:

Real Estate

1. Property taxes: Property taxes are paid to the government by the property owner. It needs to be paid annually. The property includes all tangible real estate property.
   During due diligence, it is important to ensure that the previous owner has paid all the taxes until he owns the property.
2. Comps - comparable sales: This technique calculates a value for real estate by comparing it with properties of similar characteristics.
   This section helps to find a roughly fair value of real estate property for both the buyer and seller.
3. Inspection reports: This report presents issues in the property that might hamper its value or safety. A qualified property inspector is required to complete this section. 
   The inspection process includes assessing electrical wiring, plumbing, sewage, fire, and safety issues. 
4. Potential zoning issues: The land is divided into various zones according to the preservation principles of the government. Zoning is required to optimize land use by classifying the type of use of a particular region. Generally, the land has three zones - commercial, residential, Industrial, and Environmental. This section of the report clarifies the following issues - Property boundaries, Overlapping issues, Setback issues, and Pollution guidelines. 
5. Opportunities for further development: To evaluate all possible opportunities for property development, you need to know all the specific zoning regulations in the nearby areas. 

Business Valuations

1. Financial statements
2. Financial projections: Using financial statements, we can estimate future projections and find a fair value for the transaction. E.g., DCF Model
3. Capital structure: Capital Structure elaborates on financing a company's operations and growth. It states the amount of debt and equity funding used to run the firm's overall operations. 
   Debt can be in the form of bonds, where bonds are issued, and interest payments are made to the investor. Equity funding means giving up fractional ownership of the company. 
   The debt-to-equity ratio is used to understand the possibility of the firm defaulting on the loan.
4. SWOT Analysis: SWOT stands for Strength, Weakness, Opportunity, and Threat. 
   The SWOT analysis is done as part of the DD process, focusing on assessing the organization's motivation, current capabilities, and potential use of the capacity building to achieve its goals.
   Internal factors determine strengths and Weaknesses, and Opportunities and Threats are determined using external factors. 

Sales, Merger, and Acquisitions

1. Corporate Records: Companies may also have agreements among the owners (such as a stockholders' agreement or a voting agreement) that give the owners extra rights in addition to the bylaws and operating agreements (or transaction restrictions).
   Together, these corporate documents will contain crucial details about the target company, including its formal legal name, the rights of current equity owners, and any limitations on its operations or capacity to complete the proposed deal.
   You can establish whether the permission of the company's owners is necessary by reviewing these documents along with the state's statutes of incorporation (and the requisite approval threshold). 

2. In addition to fundamental approvals, the proposed transaction may also be subject to the first refusal or pre-emption rights.

3. Financial information: This section is crucial to evaluate the fairness of the business deal. Financial due diligence also has two types - the Buy-side DD and the Sell-side DD. Both of these DD reports are similar. The only difference is the perspective behind report creation.
4. Debt: Getting complete information on the debt and equity financing helps in finalizing the finances of the deal
5. Employment and Labor: Employment and labor, or human capital, is an intangible asset of a company that the buyer acquires. Any issues or negligence can prove to be very costly for the buyer. Hence it is advisable to hire an employment lawyer to look into this section of the DD report. 
6. Real Estate: The real estate section is expected to contain information on specific zonal regulations, opportunities for further development, property taxes, etc. For further details, we can look at the Real estate due diligence mentioned in this section.
7. Agreements: During any sale, a contract must contain details of all the terms and conditions. These agreements help defend the rights of the involved parties.
8. Supplier and customer information: Supplier and customer information being a part of the business itself, needs to be passed on to the buyer during any sale or M&A.
9. Legal: Legal, due diligence is the process of gathering and overlooking all of the legal records and data related to the acquired company. 
   Before finalizing the transaction, this report is important as it offers both the buyer and the seller the option to carefully review any legal issues, such as lawsuits or intellectual property specifics. 
   Both parties may make an informed choice in the M&A transaction by having a thorough grasp of the target firm and potential liabilities.

Steps

The steps are as follows:

Laying Plan of Action

1. Deciding on the usage - It is important to define the use of due diligence and the need of concerned parties. As we saw in SWOT Analysis, Due diligence is required to present the possibilities of various opportunities and threats in any transaction. Due diligence focuses on compliance, litigations, uncovered risks, and future investments to include all of these details. 
2. Focus areas in DD - Let us understand the areas of focus in the DD report. Here are some of the most commonly looked for areas in the DD report:
   1. Finances: Financial statements and reporting are a key part of making sense of the transaction.
   2. Management: Management or C-level executives decide the company's fate; their vision and qualifications matter a lot to get an idea of business operations.
   3. Economics: It is necessary to note down the macroeconomic conditions of the place and how they can affect the target company. 
   4. Liabilities: Reports on liabilities can go a long way in deciding optimal finances for business operations.
   5. Technology: Technology not only decides the edge over other competitors but also lays out a map for the business cycle. Hence, it is necessary to understand the technology used for business operations.
3. Deciding the structure of the team: There are various changes to the team structure when companies merge with different verticals to improve the team's efficiency. 
4. Responsibilities and work Delegation: There are some structural changes to the team. Defining their responsibilities would optimize the working of the firm. 
5. Managing time schedules: When we look at the Mergers and Acquisitions Synergies, we get to know how timing can be vital in deciding the quality of results that are obtained. 
   Hence it is necessary to plan out the schedule of all the activities related to the business deal or M&A transaction.
6. Efficient Communication among teams: During the planning phase, it is important to factor in time, as in most business activities, and results are highly time-sensitive. 

Data collection

As the name suggests, this stage involves collecting existing data from business operations, key products, and critical quality services. 

Data Analysis

This step analyzes the data to reach a decision based on critical criteria such as business importance, functional complexity, technological difficulty, infrastructure needs, etc.

To decide whether the team should provide a good recommendation, the study of due diligence data typically involves balancing several variables to make a choice. The organization must weigh all the relevant variables.

Finalizing Report

The next step is to formalize the findings into a final presentation and final deliverables once the due diligence team has finished all the interviews, site visits, and related studies.

The due diligence team puts together a report and delivers its findings, which becomes a crucial part of the negotiation and decision-making processes.

Issues

Following are a few challenges faced during report writing:

1. Questions unearthing critical matters and possible issues: It is important to understand the deal and business activities properly before diving into the DD process. 
   This way, it prepares you with the right questions to understand the possible issues and litigations in the deal and lay out a map to tackle them.
2. Lack of Communication: Many different teams are involved in the DD process. Hence there is a high chance of lack of Communication between one team with the other. This lack of Communication can withhold an important piece of information.  
3. Incomplete information: Accessing the information is difficult because only IRP has access and authority to manage the corporate debtor's affairs. 
   This has to do with the IRP, who frequently relies on the promoters and other executives of the corporate debtor for such information because they typically lack industry understanding (apart from the fact that they have very little visibility of the target company). 
   The promoters are typically not very much available as they have already been fired, leaving the IRPs with many unanswered questions. 
   Although the IBC requires the promoter or any other person to cooperate with the IRP, it also gives the IRP the power to apply to the NCLAT for the required instructions in the event of a default.
   Apart from this, even if the seller communicates complete information, record mismanagement is possible. Therefore, overcoming these incorrect information pieces is important as they might lead to catastrophic results. 
4. Time: In a distressed purchase, there may be interactions with third parties who have an interest in the sale assets but over whom the seller has no control.
   However, if we look at a normal M&A situation, the stakeholders have time to negotiate with third parties to obtain consent or negotiate changes to allow the sale to proceed. Hence, the completion of a transaction may lead to significant delays due to this. 
   The other challenge of the time factor is that if the schedule is not made properly, there is a significant chance of missing the possible synergies from M&A or any other transaction.

Researched and Authored by Punit Manjani | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Trailing P/E Ratio
• Transaction Multiples
• Types of Synergies
• Unlevered Beta / Asset Beta
• Valuation Drivers