In the words of Gary Cohn, “If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky business”. Risk and uncertainties are inherent in any business transaction between two companies. The magnitude of such risk, its impact on the transaction and the overall well-being of the companies should be ascertained and appropriate steps should be taken to mitigate such effects.
Risk management is the process of identifying, analysing, and responding to risks that could impact a business. Effective risk management involves taking proactive steps to control future outcomes, rather than simply reacting to problems after they occur. There is a thin line between ‘risk’ and ‘uncertainty’. Any event which can be quantified and controllable up to a certain extent is a risk. Any contingent event that cannot be foreseen while entering into a transaction is an uncertainty.
Risk management is paramount for the success of any business. Every company should have an appropriate risk management framework in place which will aid in mitigating risks that may arise in the course of any transaction that is crucial to the business. Risk can be of many facets depending on the nature of the transaction. In the common parlance, the following are the risks that are prevalent in business transactions:
- Financial risks – These risks are related to the financial health of the companies involved in the transaction. For instance, if one of the companies is in a financial crisis, it may not be able to fulfil its part of the obligations under the terms of the transaction.
- Operational risks – Operational risks refer to any uncertainties that may cause disruption to the day-to-day operations of the companies to a transaction. For instance, if there is a disruption in the supply chain, it could impact the ability of the companies to meet their obligations under the terms of the transaction.
- Legal risks – It is important to consider all the legal aspects before entering into a transaction. If the transaction is not properly structured and in compliance to the existing laws, the same can be challenged legally whereby the companies have to go through the tedious process of litigation, imposition of penalties etc.
- Political risks – These risks are related to the political instability of the countries in which the companies operate. For instance, if there is a change in government, it could impact the ability of the companies to continue doing business in that country.
In order to effectively mitigate any risk, it is important to identify the risks involved in a transaction. Risk identification can be done by conducting a SWOT analysis, having a thorough discussion with the parties to the transaction etc.
Once the risks have been identified, they need to be assessed. This involves determining the probability of each risk occurring and the impact that it would have if it did occur. The probability of a risk occurring can be assessed using historical data or expert judgment. The impact of a risk can be assessed by considering the financial, legal, operational, and political implications.
This entire process of risk identification, assessment and mitigation can be carried out by devising appropriate strategies in order to effectively complete a transaction. The following are some strategies that can be implemented by companies to safeguard their interests and increase the likelihood of a successful transaction.
Due Diligence
Due diligence refers to the comprehensive process of gathering information about a company or asset in order to make an informed decision about whether to enter into a transaction. It is one of the most crucial steps to be carried out by any company before entering into a transaction. During the process of due diligence, confidential, legal, or financial and other material information are exchanged, reviewed and appraised by the interest companies who are going to enter into a business transaction. The objective of due diligence is to ascertain any contingencies that may arise in the due course of entering into a transaction. It is primarily required in transactions like mergers and acquisitions, joint ventures, collaborations, partnerships, outsourcing agreements, venture capital investments etc. The extent of due diligence that is conducted will vary depending on the nature of the transaction. For instance, transactions like an acquisition require extensive due diligence by both the acquiring company and the acquired company in order to prevent any misrepresentation or fraudulent dealing. The key focus areas of a due diligence should be to ascertain the financial stability, operational capabilities, legal and regulatory compliances, reputation and ethical values of the company.
The process of due diligence involves the following stages:
- Pre-Diligence process – The parties to the transaction sign a ‘Letter of Intent’ and the company doing the due diligence provides a checklist of documents required. A ‘Data Room’ is created whereby confidential data of the company related to business process, trade secrets, technology information, intellectual property rights etc. are disclosed for the purpose of due diligence.
- Diligence Process – This process involves reviewing of all the documents provided by the company and preparation of a Due Diligence Report recording the observations with respect to the review.
- Post-Diligence Process – This process involves discussions on the observations in the Due Diligence Report and further courses of action to be initiated for rectification of any non-compliances ascertained and recorded in the report.
Clear definition of objectives and expectations
It is of paramount importance for the companies in a transaction to clearly define their objectives and the desired outcome from any transaction. Since the objective is the cornerstone for a transaction, any ambiguity in relevance to the same may lead to misunderstanding and conflicts in the future. The following are the key considerations in the process of defining objectives:
- Strategic fit – The parties shall ensure that the transaction aligns with their long-term strategic goals or is in furtherance to the achievement of such goals. This will ensure mutual success for both the companies to the transaction, individually and as a team.
- Roles and responsibilities – The companies shall mutually agree and clearly define the roles and responsibilities of each of the parties to the transaction in order to ensure smooth functioning and prevention of any ambiguity.
- Timelines and milestones – The parties must set clear timelines for fulfilment of their obligations with respect to the transaction and milestones to be achieved at specific junctures. This will prevent any lapses or unnecessary delay in execution of the transaction.
- Establishing performance metrics – Performance metrics should be established in order to track the progress achieved and identifying any error in the process of executing the transaction.
Robust Contracts
Another important aspect of risk management is to ensure that the terms of the transaction are written in the form of a legally binding contract which is signed by parties to the transaction. The contract shall outline all the necessary rights, obligations and terms required to be fulfilled by the parties in pursuance to the transaction. The following are the key elements to be included in such a contract:
- Object and consideration – The contract shall elaborate on the object of the parties and also the consideration payable including the terms of payment.
- General terms and conditions – This includes warranties, indemnities, dispute resolution mechanisms, and termination clauses.
- Confidentiality – The contract should clearly specify that the parties to the transaction shall not disclose confidential information to any third party in order to protect their business interests.
- Protection of Intellectual property rights – The terms shall address the ownership, licensing, and protection of intellectual property rights to safeguard against potential disputes and unauthorized use.
- Condition Precedent and Condition Subsequent – The contract shall specify the conditions required to be fulfilled by the parties prior to executing the terms of the contract and subsequent to execution of the contract.
- Regulatory Compliance – It is important to ensure that the parties are legally authorized to execute the contract and the terms enumerated in the contract are in compliance with the statutory laws and regulations governing the transaction.
To sum up, mitigating risks and uncertainties is crucial for the success of any transaction. By conducting thorough due diligence, defining clear objectives and expectations, and establishing robust contracts, companies can minimize potential pitfalls and maximize the chances of a successful outcome. It is also important to note that risk management is a continuous process and involves constant monitoring, evaluation, rectification and adaptation to changing needs so as to achieve long-term growth and overall business objectives.
