Nigeria: Importance Of Conducting A Due Diligence In A Transaction

Have you ever heard of the term due diligence in a transaction? Ever wondered why it is so popular amongst investors or corporations?

As the world continues to evolve with increase in complex businesses or products/services, business expansion strategies into new markets, increased competitions globally, growth in investments, increase in mergers & acquisitions etc. due diligence becomes prominent in these transactions.

Due Diligence is an integral phase of any transaction as it helps an investor make informed decisions regarding the right time to make an investment and at the appropriate price. Although a Target (the Company/Business to be invested in) may be a good buy due to the face value earnings, reputation or stock price, the timing may not be right considering the economic and industry conditions within a particular jurisdiction at a given time.

A due diligence is a detailed and thorough examination of a business mostly carried out by a potential investor in a company. Due Diligence is often carried out from two perspectives

• Sell Side Due Diligence: This is also known as a vendor due diligence and is done by the seller (i.e., a company/ business considering the sale of its company, shares or business divisions etc).
• Buy Side Due Diligence: As the name implies, this is carried out by a buyer (i.e., a potential investor in a business or company).

In this article, we discussed the importance, impact and various perspectives of carrying out due diligence in a transaction.

When to Conduct a Due Diligence

Although, due diligence is important, the timing for this phase of a transaction is equally important. It is imperative that a due diligence is carried out before any binding contract is made between a buyer and a seller. There are various scenarios in which a due diligence can be performed however, the common scenarios are:

• Merger and Acquisitions: In order to take over the operations of another business or company, the buyer/ investor must fully understand the business operations and ensure that there are little or no potential liabilities or risks from the transaction. The investor needs to carry out a thorough examination of various aspects of the business to ensure that risks are minimised and informed decisions are made.
• Investments: Due diligence is not limited to big sized transactions. For example, when investing in minority stocks of publicly quoted companies, an investor needs to carry out detailed examination of the business by understanding the historical performance of the company's stock, trends, future plans and opportunities which will enable the company thrive and appreciate in stock value
• Divestments: This is when a business decides to sell off one of its segments, mostly to eliminate loss making business segments, non-core business segments etc. This process may necessitate the need for a vendor (sell side) due diligence to enable the sellers determine an appropriate selling price for that business division.

What does a Due Diligence Entail

There are various aspects of a business and this would entail a due diligence from various perspectives depending on the investor's preference and nature of the transaction. Although, the areas to conduct a due diligence is at the preference of the investor, key areas that should be covered in most transactions have been discussed in subsequent paragraphs below:

1. Financial Due Diligence:
   This is one of the popular examinations carried out as most or every investor is concerned about the financial integrity of the Target Company. Every investor would want to know that they are paying the right price and ensure that appropriate value/returns is earned on money spent.
   
   In carrying out a financial due diligence, an investor needs to ensure that all financial aspects are covered and the following key areas are covered depending on the Target's business, industry or market.
   
   1. Quality of Earnings
      This would entail a detailed assessment of the Target's historical performance (for an existing company) or future plans (for a start-up business). There is a need to understand how revenue is earned, the normalized levels of earnings, key drivers of cost etc. This is usually done by considering questions such as what are the key drivers of revenue, what are the non-recurring earnings over the historical period etc
   2. Quality of Assets
      This entails a detailed assessment of the Target's assets and balance sheet. An investor wants to know and understand how the earnings for a business will be generated and sustained over the life of the investment. The reported balance sheet may include overstated assets or understated liabilities which may impact the valuation of the Target.
   3. Net Debt
      As an investor, it is key to understand the debt accrued to a Company upon investment or at the time of purchase as this debt may directly or indirectly be borne by the investor. The net debt may not be distinctly defined in a company's financials, hence there is a need for a consultant to carry out a detailed examination and identify all debts and debt like items which should be considered in the valuation of the Target.
   4. Working Capital
      This creates an understanding of the Target's normalized working capital requirements. As the name implies, this is the amount that a business requires to carry out its day-to-day operations. The working capital analysis gives the investor an idea of the Target's operational efficiency. This is also a key aspect as it aids the investors in its negotiation of the appropriate purchase price.
2. Commercial Due Diligence:
   An assessment of the Target's industry/market is also a key area to note. An investor needs to understand and consider the impact of industry and market trends on the business operations of the Target. For example, in the times of the global lockdown, whilst some industries such as telecommunication experienced a boom, other sectors such as aviation experienced a massive decline and needed sometime to recoup from the negative effect of Covid. A commercial due diligence will aid in determining the right time for an investment. An investor should note the following key areas:
   
   1. Business Overview
      This gives investors an in-depth understanding of the business operations of the Target. A commercial due diligence provides more descriptive information on how revenue is generated, the various business segments (if applicable), summary of sales and distribution channels if applicable etc.
   2. Market Attractiveness
      This will enable the investor assess the market or industry of the Target thereby giving the investor a perspective on the industry trends, forecast and any potential risk or opportunities within the industry
   3. Customer Assessment
      What is a business without its customer? The investor needs to fully understand who are the existing and Target customers of the business. This will help the investor understand if the products or services provided meet the customers' needs/ expectations.
   4. Competitors Analysis
      As much as a full understanding of the Target company is required, there is a need for an investor to have an idea and carry out a detailed assessment of the Target's competitors within the industry/market. Analysis such as porter's five forces, benchmarking analysis should be carried out. This will help the investor also further understand competitive advantage of the competitor's and also note key areas of improvement for the company.
3. Tax Due Diligence:
   A tax due diligence will aid the investor in ensuring that all tax areas are clean and there are no potential tax liabilities on the investors/buyer. This would involve a detailed assessment of tax payables in the Target's industry or jurisdiction to ensure the general tax compliance status of the Target. It is important to note that tax payable will differ in various countries however, a tax due diligence may cover the following key areas:
   1. Companies Income Tax
      This would involve ensuring that all corporate taxes have been paid by the company and that the tax compliance status of the company is in order.
   2. Withholding Tax
      The buyer/seller must ensure that all transactions applicable have been subject to withholding tax and the same has been remitted to the appropriate tax authority – federal or state as the case may be.
   3. Value Added Tax
      The involves the review of the company's VAT compliance status by ensuring that all income which are to be subject to VAT have been charged and remitted to the relevant tax authority. Other areas which can be covered such as capital gains tax, employee tax etc. to ensure that all statutory payments are made as this may be classified as debt like items if the company (seller) is not tax compliant.
4. Legal Due Diligence:
   This ensures that all legal risks associated with a transaction are identified and mitigating strategies are put in place prior to the execution of a sales and purchase agreement or any binding contract amongst both parties (the buyer and the seller). The legal adviser will ensure that all pending litigations are thoroughly examined and all potential liabilities are defined, there is also a check on the ownership structure of the company and its assets. Implication for Buyers and Sellers
   
   The importance and benefits of a due diligence cannot be overemphasized as it results in a beneficial transaction for both parties. The following are key outcomes of carrying out a due diligence for both parties of a transaction:
   
   • Industry Knowledge: For an investor, who has little or no knowledge about the industry of the Target, a due diligence provides a detailed assessment of the industry and market. For example, a commercial due diligence provides information on the Target's competitors, their competitive advantage. A financial due diligence gives an investor more understanding of relevant or required financial metrics within the Target's industry.
   • In-depth Understanding of the Business Operations: A detailed assessment of a company's financials or other company information will provide an in-depth understanding of a company's operations as several questions can be asked.
   • Make Informed Decision: This is inevitable as a detailed assessment unveils any risk or loopholes that may have been missed by making decisions without a due diligence.
   • Provides the Appropriate Purchase Price: From a financial perspective, the buyer may be able to note some adjustments which can be used during negotiations and will help reduce the purchase consideration as the adjustments revealed from a due diligence are considered when carrying out a valuation of the Target. For example, if EBITDA (Earnings before Interest, Tax and Depreciation) is the valuation multiple being used to value the price of a company, the EBITDA used should be a normalized EBITDA (i.e after all necessary adjustments such as non-recurring income, one-off expenses etc)

Conclusion

As mentioned earlier there are several aspects of a due diligence however, the type of due diligence carried out is peculiar to the transaction needs. Other areas are actuarial due diligence, integrity due diligence, operational due diligence, human resources due diligence etc.

In transactions such as a merger and acquisitions, it is appropriate for a buyer or seller to appoint a consultant and professional adviser who would advise on the best approach to a due diligence and the relevant aspects which need to be covered for the success of a transaction.

Having assessed all relevant areas of transaction, an investor alongside its consultants should have a list of key transaction considerations which are risks pertinent in a particular transaction and give an investor the opportunity to make decisions from an informed standpoint.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.