Due Diligence

Due Diligence is a check-up procedure of a planned investment deal to reveal potential risks for its participants.

The term Due Diligence appeared in the 1930s from the banking sphere. It meant collection of information on depositors and borrowers by banks in order to eliminate risks of payment defaults and other damages to their property.

Nowadays collection of objective evidence on the assets on sale and its evaluation by experts is an essential procedure during mergers and acquisitions, purchases of real estate and other assets that are prone to risks. Due diligence is efficient in the following cases: sales of one’s own business or purchase of an established one, foreign start-ups, establishment of joint ventures or mergers, submission of solvency confirmation to foreign partners or investors, reliability and financial solvency inspection of a counterparty, acquisition of real estate, and this list is yet to be continued.

In case due diligence is executed by a vendor, it serves the purpose of pre-sale preparation of its business or investment property (Vendor Due Diligence).

Due Diligence allows:

• To determine tax, corporate and legal risks that may reduce the asset cost.
• To eliminate or minimize these risks.
• To get prepared for negotiations, to learn advantages of the business (asset) on sale.
• To participate in drafting of the unified due diligence report, which in turn reduces costs of this procedure.

However, due diligence is in higher demand among buyers. The peculiarity of the buyer’s order may be expressed through a non-disclosure agreement with the vendor, as the vendor has no interest in premature disclosure of the information on potential business sale. Such information may threaten its relations with employees or suppliers.

Due diligence under the buyer’s order will confirm that:

• all acquired assets are real, owned by the vendor and are not encumbered by third party liabilities;
• rights to assets are executed in accordance with the current legislation and with no risk of unexpected loss of assets;
• company (group of companies) under consideration has all required licenses and permits to pursue claimed activities;
• the company keeps proper tax and accounts records and there are no risks of claims from tax authorities;
• company’s activities are void of other violations that may lead to administrative or criminal sanctions.

Due Diligence includes revision and analysis of:

• incorporation procedure of the company, incorporation and in-house documents of the company;
• corporate business structure, including branches and representative offices;
• real estate rights;
• rights to movable property essential to the company’s activities;
• rights to shares and/or interests in other business entities;
• rights to intangible assets of the company;
• international economic activities of the company;
• contractual work of the company;
• labour relations of the company;
• rights of the company to pursue certain activities;
• receivables and payables;
• claims filed against the company by third parties;
• financial, accounting and tax reports;
• legal proceedings involving the company.

The assessment subject of due diligence includes the following elements:

Inventory Count.

Assets for sale (equipment, buildings, current assets) undergo the procedure of accounting. It includes determination of the current state, date of acquisition, current market price, status of the equipment (ownership or lease), the amount of money invested in improvement, if leased.

All contracts and legal documents are subject to inspection. It involves leasing agreements, purchase agreements, distribution agreements, sale and purchase contracts and other legal documents, including registration of trademarks, copyright and patents.

Inspection of lease agreements aims to determine whether the rights are transferred or not. If a business under investment consideration possesses any intellectual property, a lawyer specializing in intellectual property shall be engaged in report preparation.

Incorporation

Analysis of corporate structure – incorporation of the company, inspection of incorporation and in-house documents, analysis of business structure, including branches and representative offices, labour relations, licenses, receivables and payables, legal cases.

Calculation of the company’s net value may require reading between the lines. Some business owners use their business for personal needs, e.g. acquisition of items, vacation at the company’s expense, expenses for spouses (Tax Due Diligence).

Finances (Financial Due Diligence)

The content of financial statements is subject to evaluation in order to determine business profitability. Analysis of the sales system and assessment of its efficiency through consultations with experts specializing in this type of business activities.

Liabilities (Legal Due Diligence)

Assessment of the liabilities list to determine potential expenses and legal consequences (subjects of claims, creditors’ asset pledges, or use of assets, such as capital equipment or receivables as a pledge for short-term credits).

One should keep an eye for unaccounted liabilities, including claims by pension funds, social insurance funds. The subject of the receivable analysis is its term (the longer the term, the lower is the level of repayment). Top-10 debtors are determined and checked for credibility. If clients are credible and account overdue exceeds the two-month account, tightening of the company’s credit policy may accelerate the collection of receivables.

Due diligence is summarized in a detailed report with information on the current business or subject position and a list of risks with recommendations for their minimization.

Due diligence methods:

• Interviewing company’s employees;
• Spot-check of certain type of documents;
• Document analysis to check their compliance with the current legal requirements and in-house standards;
• Expert opinion and recommendations.

Check-up procedure when acquiring an asset:

• Revision of minutes with the resolutions of members (founders) regarding all the issues of incorporation and activities of a legal entity (identification of their true will to avoid appeals), verification of members’ validity (including, registration with a lost or stolen passport).
• Revision and analysis of the memorandum and articles of association to determine legal status, legal capacity, compliance of incorporation and activities of a legal entity with the legislation.
• Analysis of accounting and other financial statements (balance sheets and profit and loss statements for the last 3 years, tax inspection data, audit opinions, tax audit reports, inner audit reports, etc.), analysis of its financial state, assets and liabilities, tax risks.
• Revision of documents that confirm intellectual property rights and rights to means of identification, documents that cover commercial secret details to analyze the risk of losing intangible assets.
• Analysis of data on valid current accounts, account balance and cash flows for the last 2 years, credit history, valid credit agreements.
• Analysis of documents of title to real estate to analyze the risk of losing fixed assets.
• Revision of documents that verify legal entity’s rights to real estate, including shares, bonds, other securities, interests in other legal entities.
• Revision of documents proving law violations by a legal entity or its employee, which may cause the risk of criminal sanctions, initiation and review of court cases. Risk assessment of adverse consequences.
• Analysis of all current and performed contracts with a valid limitation period, analysis of risks arising from contracts, e.g. recognition of transaction invalidity, taking interim measures against property, enforcing recovery of property, failure to fulfill obligations by debtors, and other consequences regarding property. Liabilities arising from surety agreements, pledge agreements and other secondary obligations entailing the risk of property loss.
• Revision of a collective labour agreement, employment agreements, other agreements between employees and the company, and other human resources documents.

In case of a favorable report and upon the client’s request, the company prepares a full set of documents to execute a sale and purchase transaction of a legal entity, provided that a vendor is not entitled to set up a similar business, work or entice clients of the company on sale. The company provides services of notary support for a transaction and legal support for state registration of changes with a certificate being issued.

Due diligence is summarized in a detailed report with information on the current business or subject position and a list of risks with recommendations for their minimization.