As the startups continue to raise funds through private equity (PE), conducting due diligence is vital to safeguard investments and ensure compliance with Indian laws. Due diligence helps identify potential risks, financial irregularities, and legal non-compliance before finalizing an investment.

This article provides a detailed understanding of the legal and compliance checklist for due diligence in private equity transactions in India, covering relevant legal provisions and sections under Indian law.

Due Diligence in Private Equity

Due diligence in private equity involves thoroughly investigating a target company's financials, legal status, compliance frameworks, assets, and liabilities. The objective is to ensure that the investment is secure and aligns with regulatory norms. Indian laws governing such diligence include the Companies Act, 2013, Income Tax Act, 1961, Foreign Exchange Management Act (FEMA), 1999, SEBI Regulations, and Labour Laws.

Key Legal and Compliance Areas for Due Diligence

- Corporate and Legal Structure Due Diligence

This process examines the foundational legal aspects of the target company.

• Incorporation Documents: Verify the Certificate of Incorporation, Memorandum of Association (MoA), and Articles of Association (AoA).

• Legal Status: Ensure the company is legally registered under the Companies Act, 2013.

• Director and Shareholder Details: Review details filed under Section 92 of the Companies Act and ensure all changes are updated with the Registrar of Companies (ROC).

• Statutory Registers: Verify the maintenance of statutory registers as per Section 88 of the Companies Act.

• Corporate Filings: Check for timely filings of Annual Returns (MGT-7) and Financial Statements (AOC-4) with the ROC.

- Financial Due Diligence

Evaluating the financial health of the target company is critical for assessing investment viability.

• Audited Financial Statements: Verify the last 3 to 5 years of audited financials as per Section 129 of the Companies Act, 2013.

• Tax Compliance: Ensure compliance with Income Tax Act, 1961, and review tax return filings, TDS certificates, and GST returns.

• Loans and Liabilities: Examine loan agreements, guarantees, and financial liabilities under Section 180 of the Companies Act.

• Contingent Liabilities: Identify contingent liabilities and assess potential financial risks.

- Regulatory and Compliance Due Diligence

Compliance with Indian regulations ensures the business operates within the legal framework.

• ROC Filings: Confirm that annual filings with the Ministry of Corporate Affairs (MCA) are up-to-date.

• GST Compliance: Verify registration under the Goods and Services Tax (GST) regime and review tax return filings.

• Income Tax Compliance: Examine income tax filings and confirm payment of taxes under the Income Tax Act, 1961.

• Foreign Investment Compliance: Check compliance with FEMA, 1999, for foreign investments, approvals, and reporting with the Reserve Bank of India (RBI).

• SEBI Compliance (if applicable): If the company is listed, ensure compliance with SEBI Listing Obligations and Disclosure Requirements (LODR).

- Contractual Due Diligence

This involves reviewing all contractual obligations to identify risks or contingencies.

• Vendor Agreements: Examine major contracts with suppliers and vendors for obligations and liabilities.

• Customer Contracts: Review agreements with key clients to ascertain long-term revenue commitments.

• Employment Contracts: Verify terms of employment, notice periods, and non-compete clauses.

• Loan and Lease Agreements: Review obligations under financial contracts and property leases.

- Intellectual Property (IP) Due Diligence

Protection of intellectual property is crucial for businesses operating in competitive sectors.

• IP Ownership: Verify ownership and registration of trademarks, patents, copyrights, and designs.

• IP Filings: Ensure filings under the Trade Marks Act, 1999, and Patents Act, 1970.

• Licenses and Agreements: Review IP licensing agreements for compliance with Indian IP laws.

- Human Resource (HR) Due Diligence

Employee management and labor compliance are key to long-term business sustainability.

• Compliance with Labour Laws: Verify compliance with the Employees' Provident Fund and Miscellaneous Provisions Act, 1952, Employees' State Insurance Act, 1948, and other labor laws.

• Employment Policies: Review HR policies related to gratuity, leave, termination, and employee benefits.

• Pending Disputes: Identify any labor disputes or litigation involving employees.

- Litigation and Legal Dispute Due Diligence

Pending litigations can severely impact an investment’s viability.

• Review Pending Cases: Check for ongoing litigation, including civil, criminal, and tax disputes.

• Litigation Impact: Assess potential financial and reputational risks arising from pending cases.

• Arbitration Clauses: Examine contracts for arbitration clauses and jurisdiction details.

- Environmental and Social Compliance

For certain sectors, environmental compliance is essential.

• Pollution Control Licenses: Verify compliance with the Environment Protection Act, 1986, and applicable pollution control board regulations.

• Waste Management Compliance: Ensure adherence to waste disposal and hazardous material regulations.

• CSR Compliance: Review compliance with Section 135 of the Companies Act, 2013, concerning corporate social responsibility.

- Insurance Due Diligence

Adequate insurance coverage protects the company from unforeseen risks.

• Review Policies: Verify coverage of assets, property, business liabilities, and employee insurance.

• Claims History: Check for past claims and settlements to assess risks.

• Policy Renewals: Ensure insurance policies are current and renewed as per guidelines.

- Exit Strategy and Valuation Review

Exit strategies are vital for investors.

• Shareholder Agreements: Check for exit clauses, restrictions, and valuation formulas.

• Valuation Reports: Review independent valuation reports to assess the fair market value.

• Exit Routes: Evaluate potential exit routes like IPO, secondary sales, or strategic buyouts.

Key Sections and Provisions to Note

• Companies Act, 2013: Sections 92, 129, 134, 135, and 248.

• Income Tax Act, 1961: Sections 44AB (audit requirements) and 139 (filing of tax returns).

• SEBI Regulations: LODR and ICDR regulations for listed companies.

• FEMA, 1999: Regulations governing foreign investment and reporting.

• Environmental Protection Act, 1986: Guidelines for environmental compliance.

Frequently Asked Questions (FAQs)

- Why is due diligence necessary in private equity?

Due diligence helps identify legal, financial, and operational risks, ensuring informed investment decisions.

- What are the consequences of non-compliance in due diligence?

Non-compliance may lead to legal disputes, financial loss, and reputational damage post-investment.

- Who is responsible for conducting due diligence?

Legal advisors, auditors, financial consultants, and compliance experts conduct due diligence.

- How long does the due diligence process take?

It typically takes 4-8 weeks, depending on the complexity of the target business.

- What is the role of the Companies Act, 2013, in due diligence?

It governs corporate filings, statutory records, financial disclosures, and compliance requirements.

- How does tax compliance impact private equity due diligence?

Tax liabilities, assessments, and pending dues can significantly impact the valuation and decision-making process.

- What are common red flags in private equity due diligence?

Pending litigations, non-compliance with tax regulations, weak corporate governance, and financial irregularities.

- How is intellectual property checked during due diligence?

IP registrations, licensing agreements, and enforcement rights are verified for authenticity and compliance.

- What financial documents are reviewed during due diligence?

Audited financial statements, tax returns, bank statements, and loan agreements.

- Is environmental compliance important for all businesses?

Yes, especially for manufacturing and industrial sectors that must adhere to environmental regulations.

Conclusion

Due diligence in private equity investments is critical to mitigate financial, legal, and compliance risks. Adhering to provisions under the Companies Act, 2013, FEMA, SEBI regulations, and environmental norms ensures that the investment is secure and sustainable. Thorough due diligence not only helps in better decision