Signing major contracts is an important stage in the development of any business. This may be a cooperation agreement with a new supplier, a partnership with a strategic partner, or the acquisition of a new business. However, before signing such contracts, it is necessary to scrutinize all aspects related thereto.
Due Diligence is a systematic research and analysis of a potential counterparty before entering into a major contract. This process helps businesses mitigate risks, identify potential problems, and make a reasoned decision about entering into a contract.
In this article, Roman Gruba, Head of Accounting Advisory and Transaction Support at BDO in Ukraine, discusses the importance of conducting Due Diligence when entering into major contracts for business. We will consider the key stages of the Due Diligence process, as well as the role of specialists, such as lawyers and financial experts. In addition, we will discuss risk assessment and making reasoned decisions based on the results of Due Diligence.
The need for Due Diligence is stipulated by the fact that contracts can have serious consequences for the business, including financial losses, reputational damage and legal issues. Identification of potential risks and deficiencies in the counterparty and/or contract terms helps to avoid such problems and ensure the successful execution of transaction.
Therefore, before entering into a major transaction, businesses should prepare and conduct Due Diligence to properly assess the potential counterparty and the risks associated with the contract.
Prerequisites for conducting Due Diligence
Before starting the Due Diligence process, there are several important prerequisites to consider that will ensure its efficiency and effectiveness. Below are some key aspects to factor in before conducting Due Diligence (DD).
Planning and preparation
Before starting the Due Diligence process, goals and expectations should be defined. This means setting clear criteria and requirements for the potential counterparty and the contract. It should be understood what information needs to be collected and what documents will be required.
Internal resources
Evaluation of a potential counterparty and contract requires the involvement of internal resources, including employees from relevant departments experienced in conducting Due Diligence. It is important to ensure that they have the necessary knowledge and expertise to conduct a successful analysis.
External resources
In many cases, it may be necessary to engage external specialists or consultants, such as lawyers, financial experts, or auditors, to conduct a more detailed analysis of the counterparty and the contract. This will help to obtain an objective assessment and ensure the high quality of the DD.
Access to information
Effective Due Diligence requires proper access to the necessary information. It is important to ensure the confidentiality and security of this information.
Timing
Due Diligence can be a resource-intensive and time-consuming process. It is important to set realistic deadlines and allocate sufficient resources to conduct a quality analysis. The flexibility in timing should be factored in, as sometimes the collection and analysis of information may take longer than planned.
Proper consideration of these prerequisites before starting Due Diligence will help ensure its efficiency, accuracy and successful outcome.
Stages of Due Diligence
Conducting Due Diligence before entering into major contracts involves several important steps that help to collect and analyze the necessary information. Below, we will consider the main stages of the Due Diligence process.
1. Gathering information
The first step is to collect all the necessary information about the potential counterparty and the contract. The necessary information includes financial statements, legal documentation, contractual terms, details on business reputation, ownership structure, and other important aspects. It is important to ensure that the information collected is complete and accurate.
2. Legal analysis
At this stage, a legal analysis of the contract and related documents is performed. This includes checking the legal purity of the contract, identifying risks, legal restrictions and obligations. Checking for possible lawsuits, disputes, or other legal issues that may affect the contract execution is also required.
3. Financial analysis
This stage involves a detailed analysis of the counterparty's financial performance, including profit/loss, financial position, debt, cash flow, etc. The analysis of financial performance helps to determine the financial stability of the counterparty and assess its ability to fulfill contract terms.
4. Assessment of operating activity
During this stage, the efficiency of the counterparty's operations is analyzed. It is important to understand how they manage business processes, produce or provide services, what their competitive advantages and weaknesses are. This helps to assess the possibility of successful contract execution.
5. Risks assessment
The next step is to assess risks associated with entering into a contract. This may include financial risks, legal risks, risks related to the stability of the counterparty, reputational risks, and other important aspects. Risk assessment helps to understand potential threats and develop strategies to minimize thereof.
6. Report preparation and decision-making
The final stage involves preparing a detailed report on the results of Due Diligence and making an informed decision on whether to enter into a contract.
Legal aspect of Due Diligence
When conducting Due Diligence, the legal aspect plays a key role in ensuring legal security and identifying risks. The main aspects that should be factored in when conducting legal analysis during DD are considered below.
- Checking the legal purity: this aspect involves reviewing legal documentation, including articles of incorporation, charters, registration certificates, licenses, etc. It should be ensured that the counterparty has the right to conduct business and has no legal restrictions that may affect the contract execution.
- Analysis of contractual terms: includes a thorough analysis of the contract, agreement or arrangement to be entered into. The legal terms, rights and obligations of the parties, risks, guarantees and other legal aspects should be scrutinized. Furthermore, it is necessary to check whether the contract contains any unacceptable or insufficient terms that may lead to legal problems in the future.
- Ownership verification: includes verification of the ownership of the assets, including real estate, intellectual property, patents, trademarks, etc. The history of the assets should also be examined, including ownership transfers, restrictions or disputes that may affect the transfer of assets in the context of the contract.
- Identification of risks and obligations: during the Due Diligence, it is important to identify possible risks that may arise in connection with the contract. It is also necessary to find out if there are any obligations that the counterparty must fulfill before entering into the contract.
- Checking for legal actions and disputes: it is important to check for any legal actions, disputes or arbitration proceedings in which the counterparty is involved. This helps to identify potential legal issues that could affect contractual obligations and dispute resolution.
- Preparation of the report: the last stage of the legal aspect of Due Diligence is the evaluation of the collected documentation and preparation of the report. The report should contain an overview of the identified legal risks, advice on how to minimize the risks, conclusions on the legal admissibility of the contract and recommendations for further action.
Legal analysis within Due Diligence helps to identify potential legal issues, ensure compliance with the law and minimize risks when entering into large contracts.
Financial aspect of Due Diligence
The financial aspect is another key element of conducting Due Diligence before entering into large contracts. It contains an analysis of financial indicators and an assessment of the counterparty's financial stability. The main aspects that should be factored in when performing a financial analysis during Due Diligence are as follows:
- Analysis of financial statements: the first step in the financial aspect of Due Diligence is to analyze the counterparty's financial statements. It helps to understand the counterparty's financial situation, its profitability, liquidity and indebtedness.
- Assessment of financial stability: during Due Diligence, the financial stability of the counterparty should be assessed. This includes an assessment of the solvency and ability to meet financial obligations. The study of factors such as indebtedness, liquidity, profitability and credit rating enables to determine the financial stability of the counterparty.
- Analysis of key financial indicators: it is important to analyze key financial indicators of the counterparty. These can be indicators such as EBITDA, margin, net debt, and others. The analysis thereof helps to understand the efficiency of the counterparty's business.
- Identification of financial risks: during Due Diligence it is necessary to identify potential financial risks associated with the contract execution. These can be, for example, insufficient liquidity, high debt, insolvency, which can affect contractual obligations. Identifying these risks enables to make informed decisions and, if necessary, develop risk management strategies.
- Assessment of financial prospects: the final stage of the financial aspect of Due Diligence is the assessment of the counterparty's financial prospects. Potential factors of growth, profitability, opportunities for financial development and sustainability of the business should be considered. Assessing these prospects helps determine the counterparty's potential future profitability and stability, and thus the counterparty's ability to perform on the contract.
Analysis of the financial aspect of Due Diligence allows to identify the financial stability, risks and prospects of the counterparty. This helps to make informed decisions regarding the conclusion of large contracts and ensures the financial security of the business.
It is obvious that Due Diligence is a necessary stage before concluding large contracts, which allows to ensure financial and legal security of business, identify potential problems and risks, make informed decisions, and ensure the successful implementation of large contracts. Learn more about the Due Diligence service from BDO in Ukraine by following the link.