What is Due Diligence in IPO Listing Process?

When a company becomes eligible for IPO by fulfilling the IPO eligibility criteria either for SME IPO or Mainboard IPO on stock exchanges of India. A prospective company has to initiate the due diligence process for getting public. Due Diligence is done to review a company’s standing on various parameters like financial, legal and its operations. 

Listing and Eligibility Requirements

 

What is Due Diligence?

Due Diligence is a term used in business which means a process undertaken to investigate and verify information about a company. It is the process of checking compliance under the provisions of various laws and rules/ regulations/ procedures applicable to organization.  It is essentially a mechanism to monitor compliance with the requirements of stated laws. Due diligence is the first and foremost step to enable business transactions like mergers, acquisitions, fund raise, private equity or any other investment opportunity. Due diligence is a systematic way to analyse and mitigate the risks from an investment decision. An adequate due diligence refers to independent verification of data points to assist in the following:

• Identify any hidden liabilities
• Understand the growth prospects through verifying future projections
• Assess the price claimed for proposed investment 
• To assure about the legal and statutory compliances
• To review company's various documents, verifying references and double-checking for financial stability, business practices, and transactions.

 

For carrying out the due diligence activity, an effective team comprising of IPO Advisors, consultants like chartered accountants, company secretary, lawyers and others with professional expertise might be required.

 

Why Due Diligence is done for fund raise through IPO?

Due Diligence is an important business technique to consider before making any key business decisions. It is the first and foremost step to be undertaken by the merchant bankers as a part of listing requirements and IPO. The Due diligence process reviews the business practices and financial stability of a company for the protection of investors in an Initial public offer. This activity of investigation ensures that all aspects of the Issuer are thoroughly examined and validated. It involves a detailed check and assessment of the company’s financial, legal, and operational aspects to provide investors with transparent and accurate information. If something of a material nature is discovered during the due diligence process, the business transaction like IPO, merger or acquisition may be delayed.

Due diligence in IPO means means looking into pending litigations, financial stability, ageing of debtors and creditors, labor relations, and sales.

The bigger and more complex the deal, the more extensive due diligence is needed.

Here are the factors which highlights the importance of due diligence in listing and IPO.

• Ensuring Compliance: It helps the company to comply with legal and regulatory requirements, reducing the risk of penalties or delays in the IPO process.
• Financial Stability Review- Financial due diligence reviews the sales, receivables, creditors position and projections and other statutory compliances. It ensures the long term financial stability of a business.
• Building Investor Confidence: By presenting verified information, due diligence establishes trust with potential investors, ensuring that they can make informed decisions.
• Identifying and Mitigating Risks: The process uncovers hidden liabilities or risks, such as financial discrepancies or legal disputes, allowing the company to address these issues proactively.
• Enhancing Valuation Accuracy: Thorough due diligence provides a clear picture of the company’s worth, ensuring that the IPO price accurately reflects its market value.
• Maintaining Transparency: By disclosing all material facts, the company avoids future litigations or claims of misrepresentation.

Due diligence involves coordination between various financial intermediaries like IPO advisors, legal advisors, auditors, and underwriters, ensuring smooth IPO process smoothly and alignment with investor and regulatory expectations. 

 

Types of DD

Various types of due diligence are conducted for IPO and listing to ensure that the Issuing company is prepared to enter the public market, is compliant with all regulatory requirements, and provides accurate and transparent information to potential investors. Each type of due diligence plays a critical role in verifying the company's readiness and mitigating risks for stakeholders. Below is the explanation of the key types of due diligence that take place when a company goes public:

 

• Financial Due Diligence – Financial due diligence is conducted to ensure the accuracy of a company’s financial records. Financial accounts, business forecasts, and inventory schedules are often investigated.

The process also involves analysis of profit margins, fixed and variable cost analysis, customer account verification, and analysis of internal control procedures. Moreover, the company’s debt position is checked, evaluating its ability to pay its outstanding debt.

 

• Legal Due Diligence – Legal due diligence includes secretarial and compliance due diligence which is conducted to highlight any pending litigations or any breached contracts. It involves evaluation of material contracts like
  • Loan and bank financing agreements
  • Licensing or franchise agreements
  • Partnership agreements
  • Guarantees
  • Copy of Memorandum and Articles of Association
  • Board meetings over the past three years

 

• Operational Due diligence – This type of due diligence assesses the company’s operating model to identify gaps and opportunities that require development or investment. It indicates identifying risks relating to company’s assets, products and services, technology, supply chain, sales, marketing, and any existing facilities. It also verifies whether the operational expenditures are declared in the financials. Administrative part entails the verification of any administrative-related elements, including business facilities, occupancy rates, and workstations.

• ESG Due diligence – Environmental, social and governance focuses on non-financial factors that might affect an enterprise’s reputation, financial performance, and regulatory standing. It investigates a company’s adherence to ethical, sustainable, and well-governed policies.

• Intellectual property due diligence- This kind of due diligence evaluates intangible assets that contribute to a company’s market position and competitive advantage. Following verifications are sought out for:
  • Patents for technologies or inventions developed by the company
  • Copyrights for business software and creative assets
  • Existing trademarks that could lead to legal disputes
  • Chain-of-ownership documentation

This type of due diligence is crucial for Information technology companies providing SaaS products and IT solutions.

 

• Human Resource Due Diligence- This type of due diligence is as extensive as financial due diligence, and involves investigation and review of the following:
  • Employee positions and vacancies
  • Current salaries of employees during the last three years
  • Employee Benefits and retirement packages
  • HR policies for annual and sick leaves
  • Any kind of Employee issues like alleged discrimination, harassment, or wrongful termination

                                                                                                                        

Who is responsible for Due Diligence?

The responsibility for conducting due diligence lies with multiple stakeholders, primarily the professionals engaged in the due diligence process, such as Company Secretaries, auditors, legal advisors, and financial experts. These professionals work collaboratively to ensure compliance, assess risks, and verify the accuracy of information provided by the entity.

However as per the ICDR Regulations, the ultimate responsibility of Due diligence lies upon the Merchant Banker. The Merchant Banker can appoint experts for Due Diligence activity.

SME Merchant Bankers Performance List

Mainbaord Merchant Banker Performance List

 

Due Diligence Team

1. Practicing Company Secretaries (PCS):

• Responsible for compliance-related due diligence, including corporate, legal, and regulatory compliance.
• Prepare detailed reports verifying adherence to applicable laws, such as the Companies Act and SEBI regulations.
• Often engaged for legal due diligence, corporate governance audits, and certifications.

2. Financial Auditors:

• Conduct financial due diligence to assess the accuracy of financial records, cash flow, profitability, and debt levels.
• Evaluate the financial risks and potential liabilities of the entity.
• Focus on areas such as historical performance, projections, and taxation issues.

3. Legal Advisors:

• Responsible for legal due diligence by examining contracts, litigation risks, intellectual property, and regulatory compliance.
• Verify the legal status of the company's assets, intellectual property, and potential disputes.

4. Environmental Experts:

• Conduct environmental due diligence to ensure compliance with applicable environmental laws and assess the risks related to environmental liabilities.
• Evaluate the impact of company operations on the environment and compliance with sustainability standards.

5. Human Resources Specialists:

• Responsible for HR due diligence during mergers, acquisitions, or IPOs.
• Evaluate employment agreements, workforce structure, compensation, and compliance with labour laws.

6. Management and Promoters of the Company:

• Must cooperate fully in providing accurate information and documentation to the professionals conducting due diligence.
• Have ultimate accountability for ensuring the organization meets its obligations under applicable laws and regulations.

Role of IPO Advisors in Due Diligence

• Play a crucial role in due diligence for IPOs, ensuring all disclosures are accurate, and regulatory requirements are met.
• Collaborate with various professionals to validate the company’s readiness for public listing.

What are the disclosures regarding DD in DRHP?

The lead manager(s) shall exercise due diligence and satisfy themselves about all aspects of the Issue including the veracity and adequacy of disclosure in the draft offer document and the offer document.

All the mandatory disclosure should be stated in the offer document (DRHP) after taking care of due diligence by various experts. The lead manager should provide the due diligence certificate at the time of filing DRHP with the relevant stock exchange, being the BSE SME or NSE Emerge.

 

What is the cost of Due Diligence process?

 Key Factors Influencing DD Costs:

• Scope of Due Diligence: Comprehensive due diligence (e.g., financial, legal, environmental) tends to be more expensive than a narrower focus.
• Nature of the Business: Businesses with complex structures, global operations, or regulatory-heavy industries incur higher costs.
• Type of Transaction: Mergers and acquisitions (M&A), IPOs, or strategic investments often involve detailed due diligence.

Process of Due Diligence

The process of due diligence involves systematic steps to evaluate and verify information related to a business transaction, compliance, or regulatory requirement. While the attached document does not detail the process explicitly, a typical due diligence process includes the following key stages:

1. Planning and Scoping:

• Define the purpose and scope of due diligence (e.g., financial, legal, environmental, or operational).
• Identify the type of transaction (IPO, M&A, or investment) and the areas requiring investigation.
• Create a checklist and timeline for the due diligence activities.

2. Information Gathering:

• Request relevant documents and records from the entity being assessed, such as financial statements, contracts, licenses, and compliance reports.
• Conduct interviews with key stakeholders, including management, legal teams, and auditors.
• Access public and regulatory information, including filings with authorities like SEBI or the Registrar of Companies (RoC).

3. Analysis and Verification:

• Review financial data to assess performance, cash flow, and liabilities.
• Evaluate legal contracts, intellectual property rights, and potential litigation risks.
• Assess compliance with applicable laws, including environmental, labor, and industry-specific regulations.
• Analyze operational aspects like supply chains, IT systems, and human resource policies.

4. Risk Assessment:

• Identify potential risks, including financial discrepancies, legal liabilities, and compliance gaps.
• Classify risks based on their impact (critical, high, medium, or low).
• Recommend risk mitigation strategies.

5. Reporting and Recommendations:

• Compile findings into a comprehensive due diligence report.
• Provide recommendations for addressing identified risks or liabilities.
• Highlight areas that require immediate attention or further investigation.

6. Decision-Making:

• Share the due diligence report with stakeholders, such as investors, acquirers, or the board of directors.
• Use findings to inform transaction terms, valuations, or compliance measures.
• Negotiate based on identified risks or liabilities.

 

What is the preparation of due diligence by the promoters?

Promoters of the Issuing company can proactively prepare for the due diligence process to streamline and simplify the procedure once initiated. Key preparatory steps include the following:

1. Engaging Professional Advisor

   • Ensure the appointment of experienced professionals, such as legal, financial, and compliance experts, to guide the due diligence process.

2. Data Collection

   • Gather all necessary documents and information relevant to the company's operations, financials, legal matters, and compliance.

3. Data Organization

   • Systematically arrange and structure the collected data for efficient review and assessment during the due diligence process.

4. Compliance Review

   • Conduct a thorough review of the company's compliance status. Identify any instances of non-compliance and take corrective measures to address them promptly.

These measures can help facilitate a smoother due diligence process and ensure readiness for scrutiny by relevant stakeholders.

 

What are the business transactions which require due diligence to be done?

Due diligence is a critical process undertaken to evaluate and verify various aspects of a company's operations, financials, legal compliance, and overall health. This process becomes especially crucial when a company is preparing to go public through an Initial Public Offering (IPO). It ensures transparency, entails confidence in investors, and complies with regulatory requirements.

In addition to the IPO stage, there are several key scenarios where due diligence becomes essential, including:

• Due Diligence at Pre IPO :

Some of the companies do a pre IPO round before going fir IPO. Due diligence is conducted at pre IPO stage also and involves a review of their operations, finances, and legal framework. This preparation helps identify and address any potential risks or gaps, ensuring readiness for the rigorous scrutiny of public markets. 

At the time of IPO, comprehensive due diligence is carried out as per the listing requirements of NSE and BSE or the SME platforms of the stock exchanges in India.

• Private Equity Fund Raise:

When a company seeks to raise funds through private equity, venture capital, or other forms of investment, due diligence is conducted to provide potential investors with a clear understanding of the company’s value, operational soundness, and growth potential.

• IPO and listing requirements :

During the IPO process itself, an extensive due diligence exercise is performed by underwriters, legal advisors, and auditors to ensure all disclosures are accurate, complete, and in compliance with regulatory standards. This includes reviewing financial statements, corporate governance practices, and risk factors.

• Post-IPO Compliance and Monitoring:

Even after going public, companies often engage in periodic due diligence to maintain compliance with stock exchange regulations and uphold investor confidence.

By thoroughly conducting due diligence at these critical junctures, companies can ensure smooth transactions, minimize risks, and maintain trust among stakeholders.

 

What is the time duration of Due Diligence process?

Due diligence is an extensive and systematic process critical for ensuring the success of an Initial Public Offering (IPO). It involves multiple phases, each designed to assess the company's readiness, compliance, and overall health. Due diligence aims to identify and address any issues that could pose risks to the IPO or investor confidence. While the duration of this process can vary depending on the company’s complexity and the types of due diligence required, it typically takes 1 to 1.5 months to complete. A longer timeline may lead to delays in the IPO process, negatively impacting market timing and investor interest. 

 

Factors that affect the time line of Due Diligence process 

Several factors can influence the timelines for conducting due diligence (DD), especially during processes like an Initial Public Offering (IPO) or mergers and acquisitions. These factors determine the speed and efficiency of the DD process and can significantly impact the overall schedule. Below is a detailed explanation of these factors:

 

1. Complexity of the Business
2. Scope of Due Diligence
3. Quality and Organization of Data
4. Responsiveness of the Company
5. Regulatory and Industry Requirements
6. Size of the Transaction
7. Risk Profile of the Company
8. Involvement of Multiple Stakeholders
9. Availability of Technology and Tools
10. Unexpected Findings
11. Language and Jurisdictional Barriers

 

What happens in case of any adverse due diligence opinion? How much time is taken to resolve it?

An adverse due diligence opinion arises when significant issues or risks are identified during the due diligence process. These issues can include financial irregularities, legal disputes, regulatory non-compliance, operational inefficiencies, or environmental liabilities. Such findings can delay the process of IPO or other transactions unless they are resolved effectively. Some points to address such adverse opinions are:

 

1. Immediate Actions After an Adverse Opinion
2. Resolution Process
3. assessment the Impact on the IPO or Transaction
4. Resolution Timeline
5. Preventive Measures

Time taken to resolve such matters depends on the triviality of the concerns raised thus timelines vary on a case to case basis.

 

Conclusion

In conclusion, due diligence is the cornerstone of a successful IPO process, ensuring transparency, compliance, and investor confidence. By meticulously evaluating a company’s financial, legal, and operational aspects, it identifies potential risks and mitigates liabilities. This thorough process not only enhances the company’s credibility but also ensures adherence to regulatory requirements, enabling smooth transactions. With the expertise of merchant bankers, legal advisors, and financial auditors, due diligence sets the stage for a seamless and successful IPO journey.