Due diligence refers to an investigation which is carried out before a substantial legal transaction. It is particularly important in a business acquisition as the investigation will aim to uncover any hidden liabilities or potential problems with the target business. Here we look at why and how due diligence is carried out on the acquisition of a business.
Due diligence helps to improve the quality of information available to buyers which then contributes to informed decision making. In a legal M&A context, due diligence will normally take place before a buyer invests in or acquires a business. The aim is to give the buyer a concise, well-focused report which is then used by the buyer to decide whether or not to proceed with the transaction. It can also be used as a negotiation tool should any underlying issues be identified that need to be addressed.
The buyer will be acquiring an entity along with its assets and liabilities; it is therefore important that the buyer seeks to identify what those assets and liabilities are and that the seller is able to transfer legal title to them. This allows for a smooth transaction with the risk of any problems materialising post-completion being reduced.
Why is due diligence important?
The due diligence process is the first step in the buyer seeking to protect itself from unknown liabilities which may exist within the target business. Due diligence may throw up potential problems and the buyer may be dissuaded from continuing with the transaction if the target company looks less desirable than first thought.
Due diligence also helps to identify the most beneficial structure for the transaction.
The process can also give the buyer reason to negotiate; this could be a renegotiation of the purchase price or it could lead the buyer to request extra protection in the form of indemnities or warranties in the purchase agreement.
Spotting a potential issue during the due diligence process will allow the buyer to get it sorted before completion. If the issue is only discovered post-completion, then a claim against the seller for breach of warranty may be the only answer. But this is something the buyer will want to avoid as it will be both time consuming and costly, and there is no guarantee of any award.
Forms of due diligence
Due diligence will take different forms during the acquisition process and professionals with different areas of specialist knowledge will be involved.
Legal due diligence will be completed by the buyer’s solicitors. They will aim to identify, amongst other things:
- whether the seller has good title to the assets or shares being sold;
- the key issues for negotiation with the seller; and
- the steps required to integrate, seamlessly, the target into the buyer’s existing business.
Most importantly, they will be on the lookout for any hidden liabilities that may impact the buyer post-completion.
Financial due diligence covers the financial situation of the target. Accountants will consider:
- historical performance;
- future prospects and forecasts; and
- financial sensitivities and current cashflows.
There are other forms of due diligence which may be necessary depending on the nature and scope of the target business. For example, due diligence relating to the commercial aspects of the deal, pensions, or the environmental impact may be undertaken.
Focusing on legal due diligence, the process will usually begin with the buyer’s solicitor sending an ‘information request’ to the seller’s solicitor. This document is used to obtain information and copies of documents from the seller which will form the basis of the final due diligence report. The request is often lengthy and will include requests for financial information, information on corporate and commercial arrangements and confirmation that the seller holds full legal title to the assets of the business.
Following this, the seller’s solicitor responds and the buyer’s solicitor will receive a large number of documents in return. These will be reviewed and a request for further information may be made.
Once the buyer’s solicitor has completed the due diligence process to the required standard and everything has been obtained, they can advise the buyer on the proposed transaction by producing a due diligence report for the buyer.
The report identifies the key issues with the target business and sets out how the issues could be resolved as part of the transaction process.
Virtual data rooms
It is now common, as part of the due diligence process, for documents to be reviewed within a data room set up by the seller. A data room can be a physical space (often at the offices of the seller or its lawyers) but is increasingly a virtual data room where the materials are stored on an online data site. It allows documents to be reviewed from a central location which is quicker and more effective for parties who may not be located close to each other. It also allows multiple parties to review the documents at the same time (particularly useful in an auction sale context) and removes the need to copy or scan documents and distribute them by some other method.
Using electronic data rooms enables the seller to control access to documents – entry to the data site will be password-protected – and track who has had access to specific documents.
The due diligence investigation is an important part of the transaction process but at times it can seem cumbersome and unwieldly. Understanding the process and using technology to streamline it as far as possible, can help to make it a smoother ride for all involved.