A Due Diligence Exercise is a careful and detailed check carried out by an investor or buyer before investing in or buying a company. It examines the company’s legal, financial, operational, and business position to understand whether the company is healthy and trustworthy. The main aim is to find out possible risks, hidden liabilities, legal non-compliance, and key strengths, so that informed decisions can be made and risks can be properly managed.
In India, due diligence has become especially important because of complex laws, strict regulatory enforcement, growing data protection requirements, and increasing startup investments. Indian courts and tribunals have repeatedly recognised due diligence as a sign of responsible and cautious business practice, particularly in mergers, acquisitions, and investment transactions.
Purpose and Importance of Due Diligence
The core purpose of due diligence is not merely fact-finding, but risk assessment and mitigation. It allows investors to:
- Confirm the legal existence and validity of the entity,
- Verify ownership of assets, including intellectual property,
- Examine enforceability of material contracts,
- Identify ongoing or potential litigation, and
- Assess compliance with statutory and regulatory obligations.
Practical Illustration
Consider an investor evaluating a pre-revenue technology startup claiming ownership over a proprietary software platform. A legal due diligence exercise would verify:
- Whether the software code was developed by employees or third-party contractors,
- Whether valid IP assignment agreements exist,
- Whether patents, if claimed, are actually filed or granted, and
- Whether confidentiality and non-disclosure agreements (NDAs) are enforceable.
Failure to verify these aspects may result in the investor acquiring a company without clear title to its core asset, severely impairing valuation.
Judicial Recognition
In Daiichi Sankyo Co. Ltd. v. Malvinder Mohan Singh (2018), the Supreme Court emphasised the importance of accurate disclosures and consequences of misrepresentation in high-value transactions. The case underscored how inadequate due diligence and false representations can expose parties to substantial liability and enforcement actions.
Standard Process Followed in a Due Diligence Exercise
A due diligence exercise follows a clear and organised process to help the investor understand the risks involved in a transaction.
Scoping and Planning: The process starts by deciding the scope of due diligence. This may include checking legal, financial, tax, intellectual property, regulatory, and industry-specific compliance matters. The scope depends on the type of investment, the deal structure (such as buying shares or only assets), and how much risk the investor is willing to take. For example, in a health-tech investment, special attention is given to medical laws and data protection rules, because failure to follow these laws can lead to penalties.
Due Diligence Questionnaire (DDQ): Next, a Due Diligence Questionnaire is sent to the target company. This questionnaire asks for detailed information and documents about the company, such as corporate records, shareholding details, major contracts, intellectual property, employee matters including ESOPs, and any ongoing or past legal or regulatory cases. If the company gives incomplete or unclear answers, it may indicate possible problems and raise early concerns.
Data Room Review: After that, the target company uploads all requested documents to a physical or virtual data room. The due diligence team carefully reviews these documents to check whether they are legally valid and consistent with the information provided earlier. During this review, the team looks for missing approvals, expired licences, or contracts that do not follow the law. Any mismatch between the disclosures and documents is flagged as a risk. The importance of closely examining transaction documents was also highlighted in Vodafone International Holdings v. Union of India (2012), which showed how underlying documents can reveal regulatory exposure.
Follow-up Queries and Clarifications: Based on the initial review, the investor’s legal team may ask further questions or request additional documents. These follow-up queries help clear doubts and explain inconsistencies. This stage is important to understand whether the issues found can be fixed easily or whether they are serious structural problems.
Internal Risk Assessment: Finally, all identified issues are assessed internally and grouped by their seriousness. High-risk issues may threaten the deal or create major liabilities, medium-risk issues can usually be managed through contractual protections, and low-risk issues generally involve minor or procedural non-compliance. This assessment helps the investor decide whether to proceed with the transaction and on what terms.
- Preparation of Due Diligence Report
A final Due Diligence Report is prepared for the investor to clearly explain the findings and turn legal issues into practical business advice that can be used while negotiating the deal.
What a Due Diligence Report Should Include?
A good due diligence report should clearly cover the following points:
- Executive Summary highlighting major risks that may affect the deal,
- Company and Shareholding Details, including checking the accuracy of the shareholding structure (cap table),
- Review of Important Contracts, especially whether a change in ownership affects them,
- Intellectual Property Ownership and Protection,
- Court Cases, Regulatory, and Legal Compliance Issues,
- Employment, Labour Laws, and ESOP-related Matters,
- Risk Classification (high, medium, or low), and
- Suggestions to Manage Risks, such as compensation clauses, money kept in escrow, or conditions that must be met before closing the deal.
Indian courts have recognised that investors can rely on due diligence reports while seeking legal protections. In Shriram EPC Ltd. v. Rioglass Solar SA (2018), the Supreme Court accepted the importance of assessing commercial risks and making proper disclosures in complex business transactions.
Investor’s Options After Receiving the Due Diligence Report
After reviewing the due diligence report, an investor can choose one or more of the following options:
- Go Ahead with the Investment
If the risks found are small or normal, the investor may proceed with the deal as planned.
- Renegotiate the Price or Deal Terms
If some risks are found, the investor may ask for a lower valuation, delayed payments, or changes in the deal terms.
- Ask for Legal Protections
The investor may demand:
- Stronger promises and disclosures from the company,
- Compensation clauses if problems arise later, or
- An escrow arrangement where part of the money is kept aside to cover future claims.
- Set Conditions Before Closing the Deal
The investor may require the company to fix certain issues—such as getting approvals or correcting ownership of intellectual property—before the deal is completed.
- Change the Structure of the Deal
To reduce risk, the investor may choose to buy only certain assets instead of buying shares of the entire company.
- Exit the Deal
If the risks are serious and cannot be fixed, or if there are signs of poor management, the investor may decide to withdraw from the deal. Courts generally see this as a reasonable and careful business decision.
Conclusion
A Due Diligence Exercise is not just a routine step; it is an important tool to manage risks before making an investment. By carefully checking legal, financial, and operational issues, it helps investors identify problems in advance and avoid unexpected losses. Indian courts have also recognised the importance of due diligence, treating it as a key part of responsible business behaviour. This shows that due diligence plays a vital role in today’s investment and acquisition deals.
