Due diligence is a vital part of the acquisition process for both the seller and the purchaser. If the due diligence exercise is undertaken professionally and with care, it should result in the transaction being structured and priced correctly and can reduce the risk of issues arising later during the acquisition process. Due diligence can be time-consuming and may, at first sight, seem to result in unnecessary paperwork and hassle, but without it a purchaser may acquire a target company and business suffused with liabilities and risks and a seller may find itself defending numerous warranty claims.
In this article we discuss what due diligence means in the context of a bilateral share sale, the due diligence process, and why it is so important to both parties.
- What is due diligence in acquisitions?
- The importance of due diligence in acquisitions
- What happens if due diligence isn’t done when acquiring a company?
- How long does due diligence take?
- Types of due diligence in acquisitions
- Who does the due diligence?
- What does the seller and the target company do during due diligence?
- The process for acquisitions
- Due diligence reporting
- Acquisition due diligence checklist
What is due diligence in acquisitions?
In a bilateral share sale, where a purchaser acquires the entire issued share capital of a target company from the seller, the due diligence exercise is carried out to allow the purchaser to find out information about the target company and its business prior to completing the purchase. Completion of a due diligence exercise can reduce the risk of a purchaser acquiring a company and business of which they have limited knowledge and which may hide some nasty surprises.
Traditionally, the purchaser and their advisers will lead the due diligence process and will request information and documents concerning the target company and its business from the seller or the target’s management team. This information will then be reviewed by the purchaser’s team. In the case of an auction sale however, it will be the seller who manages the process, often setting up an electronic data room to allow all the bidders access to the information. In this instance, the bidders will usually be subject to a time period during which the data room can be accessed and may be provided with limited information.
The due diligence exercise will vary in size depending on the transaction in question. The process can be lengthy and extremely detailed with many documents requiring review by the purchaser, their internal team, and a myriad of advisers. However, in smaller transactions, the due diligence process may be quite simple with just a few key areas to be considered. This may be the case where the purchaser has been involved with the target company and its business in the past, or where the business is fairly straightforward and not of high value.
The importance of due diligence in acquisitions
Due diligence is a crucial stage of the transaction and can assist both the seller and the purchaser. From the purchaser’s point of view, caveat emptor or ‘let the buyer beware’ applies in English law. This means that any issues within the target company and business will be for the purchaser to deal with post-completion. By conducting due diligence, a purchaser can be protected from striking a poor deal and can reduce the risk of them acquiring a target company and business with hidden surprises. It is a little like buying a second-hand car although potentially on a much bigger scale. Rather than relying on the car dealership’s guarantee, it is important that you try to find out about any problems up-front, prior to handing over the cash.
If any issues do arise during the due diligence exercise, the purchaser has several options. These include:
- renegotiating the purchase price;
- requesting an indemnity in the purchase agreement; or
- in extreme circumstances, walking away from the deal.
Due diligence, combined with warranties and the disclosure exercise, seeks to ensure that the purchaser has as much information as possible about the target company and business before they complete the deal and agree to the purchase price.
In addition, due diligence enables the purchaser to consider and check that the target company and business will align with any other businesses that they run. It allows the purchaser to understand how the target business is managed and places them in a better position to decide how best to integrate that business post-completion.
For the seller, the due diligence exercise helps to organise the paperwork, documents, and information required for the disclosure exercise, which will take place once the warranties in the purchase agreement have been drafted. Often, the information required for due diligence and disclosure may not be readily to hand but gathering the due diligence information focuses everyone’s minds and can make the disclosure process simpler and quicker.
In addition, it can provide protection to the seller from the risk of a warranty claim post-completion. If a purchaser has knowledge of an issue prior to completion, they will find it extremely difficult to bring a successful warranty claim concerning that issue post-completion.
Watch our video on avoiding warranty claims when buying a business:
What happens if due diligence isn’t done when acquiring a company?
Failure to complete any form of due diligence can impose substantial risks on each party. For example, the purchaser could discover problems with the business post-completion which results in the business being worth less than they paid for it, or which, had the purchaser known about it prior to completion, may have resulted in the, walking away from the deal. Although the purchaser may have the protection of warranties in the purchase agreement and could bring a claim for breach of warranty post-completion, a successful claim will only reimburse them financially; they will still own the share capital of the target company and will have to deal with the issue. In addition, the purchase agreement often includes substantial limitations on warranty claims and so the purchaser is unlikely to be fully compensated for any financial loss which arises as a result of a problem which crops up post-completion.
The purchaser may also be reluctant to bring a warranty claim against the seller if, for example, the seller is a client of the purchaser and/or the target company post-completion. Litigation proceedings are likely to damage such a continuing business relationship, and this could be extremely detrimental to the purchaser.
From the seller’s perspective, they could find themselves defending a warranty claim post-completion. This can be time-consuming and costly and could have been avoided if due diligence had been completed as part of the transaction.
How long does due diligence take?
The length of the due diligence exercise can vary depending on its size and complexity. In an auction situation, the seller will provide a given period in which the data room can be accessed. However, in a bilateral share sale, the due diligence process is likely to continue for a large part of the transaction. Usually, the due diligence questionnaire will be sent by the purchaser’s legal advisers to the seller, as soon as heads of terms or a letter of intent concerning the transaction has been signed by the parties. It will probably then continue and run in parallel with the drafting and negotiating of the main transaction documents.
If the due diligence exercise is unable to be completed fully prior to completion, and this may be the case due to time or cost constraints or other factors, the purchaser may be able to request other forms of protection. One option is a purchase price retention where an agreed part of the purchase price is kept in a retention account for a certain period and can be used by the purchaser if any issues arise post-completion.
Types of due diligence in acquisitions
The types of due diligence in an acquisition will depend on the nature of the target business and what is important to the buyer. A list of common areas to be covered by a due diligence table is set out in the list below, but the questionnaire will be drafted with the target company and its business very much in mind and will focus on the areas relating to them.
Common due diligence areas include:
- Corporate information
- Employment and health and safety
- Contracts and trading
- IT / IP
- Finance and bank accounts
- Data protection
- Asset ownership
- Licences and consents
Certain areas will always be covered. Corporate information, for example, will be checked by the purchaser’s legal advisers. This will include ownership of the shares, a review of the articles of association and statutory books of the target company, and a Companies House search about the target company. However, company searches may not always be up to date as certain filings are only required on an annual basis and even the statutory books may not give the full picture. The purchaser’s legal team will therefore have further corporate questions about the target company.
Material contracts, often defined by value, which have been entered into by the target company will also be reviewed as well as significant employment contracts. It is unlikely that all company contracts and all employment contracts will be reviewed as this will be too time-consuming and costly, but the purchaser’s legal advisers will often expect to see an example of a standard contract and then any others which are unusual or significant.
The purchaser’s financial advisers will also conduct financial due diligence about the target company and business. Focusing just on the audited accounts may not give the full picture and case law has held that they cannot be relied upon by a purchaser, so further financial and accounting information will be requested.
Other areas may also be covered by the due diligence exercise. For example:
- If the target company has freehold or leasehold premises or its business is real estate, property searches and related due diligence will be undertaken.
- Environmental consultants may be required to conduct environmental due diligence, if the target business is in manufacturing.
- IT and IP due diligence may be required if the target company runs a technology business.
Different areas will require different specialists and consultants but usually it is the purchaser’s legal advisers who control the process.
Who does the due diligence?
The purchaser, their internal team, and their advisers will complete the due diligence review. As mentioned above (see Types of due diligence in acquisitions), the advisers required will depend on the nature of the target company and its business, and the types of due diligence to be undertaken. Legal advisers and financial advisers are almost always required, but it is important that the purchaser and their internal team also become involved as they will often be in the best position to review the information given from a commercial perspective, and be able to ensure that the target company and business will fit well with their current business holdings.
The purchaser’s legal advisers will usually control the process and it is helpful for the information to go through them as a central base to ensure that the data is sent to the relevant people and that nothing slips through the net. Ongoing communication between the people involved and the team who are drafting and negotiating the transaction documents is also vital to ensure that the documents reflect the outcome of the due diligence process. Certain warranties or indemnities may be required as a result of due diligence findings, or the transaction may need to be restructured, for example, as an asset sale, to allow the purchaser to carve out certain liabilities from the sale.
What does the seller and the target company do during due diligence?
During the due diligence exercise, the seller and the target company’s management team will collate the information and documents required by the purchaser and their advisers as part of the due diligence exercise and send these across to the purchaser’s team. It is important that a seller appreciates that this could be a time-consuming and complex task, as due diligence questionnaires (see The due diligence process for acquisitions below) are often lengthy and detailed. In addition, some information may require hunting down. It should also be noted that due diligence is an ongoing process and so further queries are likely to arise once the purchaser’s team has begun its review of the initial responses and information provided.
Although a seller may wish to keep the terms of the transaction confidential from their employees, it is important that the correct members of the management team are onboard for the due diligence exercise. For example, there will be little point in asking the HR manager about environmental issues or asking the IT manager about employment contracts. The seller should be happy that the members of its internal due diligence team are able to answer questions correctly and knowledgeably about the target company and its business.
Certain contracts or business dealings may be the subject of non-disclosure agreements or confidentiality agreements with third parties. So, a seller may not be able or willing to provide these to the purchaser or may need to obtain consent from a third party before giving this information to the purchaser and their advisers.
A seller also needs to be conscious that providing certain documents to the purchaser’s team may breach data protection rules or result in the document losing its legal privilege. It is important that, as a seller, you discuss this with your legal team to decide which documents can be provided to the other side and which cannot.
A seller needs to be aware that there is no obligation on them to respond to due diligence queries or to provide the information requested. There may be reasons, such as those set out above, why they are unable to fully respond. That said, a recalcitrant seller may hinder or even lose the share sale and, at the very least, could jeopardise any continuing business relationship with the purchaser.
It is important that the seller and their advisers keep copies of all the information and responses that they provide to the purchaser’s team as part of the due diligence exercise and throughout the transaction generally. Not only will this make the disclosure exercise easier but it may also prove invaluable if the purchaser brings a warranty claim post-completion, as it will show whether the purchaser already had knowledge of the issue before completion. As we have seen, the concept of caveat emptor applies to a purchaser under English law (see The importance of due diligence in acquisitions above) and if they have prior knowledge of an issue, the likelihood of a warranty claim being successful in relation to that issue will be much lower.
The process for acquisitions
The acquisition process is not set in stone and may differ depending on the transaction. However, in a bilateral share sale, you could expect the following:
1. Heads of terms/letter of intent signed between the seller and the purchaser. In certain transactions, a non-disclosure or confidentiality agreement may also be signed by the parties.
2. Purchaser’s legal advisers and financial advisers send out the due diligence questionnaire to the seller’s legal advisers and begin any relevant searches. This is the document which lists out the initial due diligence queries about the target company and its business. If there is anything specific that the purchaser is concerned about or would like to know about, it is important that you communicate this to your legal advisers so that they can incorporate the questions into this document.
3. Seller and their management team review the due diligence questionnaire, answering the questions and providing related documents. These will then be sent back to the purchaser’s legal advisers.
4. Purchaser’s advisers begin their review of the information provided and send out any follow-on queries. Drafting of the transaction documents begins.
5. Ongoing communication between the parties and their advisers concerning due diligence. This is likely to affect both the warranties and indemnities required in the purchase agreement and the disclosure exercise and could, in certain circumstances, result in a restructuring of the transaction.
6. Purchaser’s advisers prepare a due diligence report covering the salient issues which have come out of the due diligence exercise. None of these issues should come as a shock to the purchaser as any significant or potentially significant issues should have been communicated during the due diligence exercise. This report will often be signed by the purchaser’s advisers on or shortly before completion.
7. Finalisation of the transaction documents.
Due diligence reporting
Once the due diligence exercise is well underway, the purchaser’s advisers will begin to prepare a due diligence report setting out their main findings. This is likely to include an executive summary, followed by more detailed sections covering the various areas reviewed.
From a legal perspective, templates are often used for reporting purposes, to ensure that everyone involved in the reviewing of the documents covers the same ground and checks the pertinent points. For example, when reviewing material contracts, it is important that the following terms are checked:
- Parties and execution – who are the parties to the contract, and has it been properly signed and entered into?
- Is the contract effective? – are any of the terms vague, for example, the price, which could lead to the contract being deemed unenforceable?
- Term of the contract – is the contract about to expire?
- Termination provisions – how and when can each party to the contract terminate it?
- Change of control or assignment provisions – in a share sale, it is important to know if completion will trigger a change of control clause. If so, consent from the other contracting party may be required prior to completion. If the transaction is structured as an asset sale, an assignment clause may have the same effect.
- Liability under the contract and the provision of any warranties or guarantees.
- Any unusual or onerous terms.
It is important that the purchaser’s advisers are aware of their remit and responsibilities during the due diligence exercise. For example, the accountants need to know what financial documents they will be reviewing, and the legal team need to know whether they will need to review the same documents or not. These responsibilities are usually set out in each adviser’s engagement letter with their client, in this case, the purchaser.
The purchaser and their advisers should ensure that copies of all the due diligence documents and responses are maintained by them post-completion. In the event of an issue arising post-completion, they may require further review to check whether the issue was known to the purchaser prior to completion. If so, a breach of warranty claim is unlikely to succeed.
Acquisition due diligence checklist
Although the purchaser’s legal advisers will usually lead the due diligence exercise, it is important that the purchaser and their internal team are aware of what is going on and are involved to ensure that any concerns of theirs are covered and dealt with.
Areas for a purchaser to bear in mind include:
- Are the shareholders of the target company who you expect them to be?
- Are there any pre-emption rights over a sale of shares such that a third party has a first right of refusal to buy any shares?
- From a commercial point of view, will the target company and business fit with your current businesses?
- Are there any change of control clauses in significant contracts which require third party consent before the shares are sold?
- Are any significant contracts about to terminate?
- Is the financial position of the target company and its business as you would expect? Case law has shown that the audited accounts alone may not necessarily be relied upon and so it is important that adequate financial due diligence is carried out.
- Are there any potential environmental liabilities which you might be acquiring unwittingly?
- Are any leases about to expire?
- Is there any ongoing or potential litigation to which the target company is party?
- Are there any tax liabilities to consider?
- Is any insurance policy about to expire? Have there been any recent insurance claims or are any ongoing? Has insurance ever been refused?
- Is any bank financing in place? What are the repayment terms? Has there been any default?
- Does the target company own its assets? If not, what are the terms of hire?
- Are any licences or consents which are required for running the target company or its business about to expire or been revoked?
These are just some of the questions which may be dealt with in a due diligence exercise and which will assist you, as a purchaser, to understand the nature of the transaction that you are considering entering into. Our corporate solicitors have plenty of experience dealing with all the elements involved in a share sale transaction and are always happy to answer your questions if you are considering entering into such a transaction. Using our expertise, we can guide you through the process, to make sure it runs as smoothly and efficiently for you as possible.