If you’re a founder or director of a business that’s ambitious for growth, buying an existing company can be a fast-track way to succeed. Mergers and acquisitions can be a great strategic move and lead to faster scaling than organic growth. The process can be risky, however, and it’s essential to have expert legal advisors on board from the outset.
In this article, we look at due diligence – the process by which a buyer evaluates a potential target for purchase. The goal of due diligence is to uncover hidden liabilities and red flags that could affect the value of the target such as legal disputes, financial instability, or compliance issues. This article aims to equip you with the information you need to understand and navigate the due diligence process to get maximum value from the transaction.
In this article we discuss what due diligence means in the context of a merger or acquisition (M&A), the process, and why it is so important to both parties.
Jump to:
- Why conduct due diligence?
- What’s involved in legal due diligence
- Define your scope
- Create a master spreadsheet of documents and records
- Identify critical team members
- Review the structure chart and organisational documents
- Review 3rd party contracts and agreements
- Review financial records
- Employment issues
- Understand the regulatory environment
- Legal disputes
- Property
- Create a master report
- When is the right time to conduct due diligence?
- How long can the due diligence process take?
- What are the challenges associated with due diligence when buying a business?
- What steps can a buyer take to ensure an effective and smooth due diligence process?
- Cross-border elements of due diligence
- Assistance with legal due diligence
Why conduct due diligence?
Ever heard the old adage “buyer beware”? When you acquire a business, you do so at your own risk. Due diligence is, in its simplest form, a risk minimisation exercise for the buyer, intended to help buyers properly assess a target business so as to make a fully informed decision about the acquisition. By scrutinising every element of the business, the buyer can more clearly assess any potential pitfalls and seek to address those and re-balance the risk through the negotiation process and transaction documentation.
By conducting a thorough legal and financial due diligence exercise, a buyer can seek to avoid costly mistakes and understand more fully the business they are acquiring. If you are tempted to skip or skim on due diligence, that could prove to be a costly mistake. For example, Hewlett Packard acquired UK software firm Autonomy in 2011, after conducting an admittedly less than thorough due diligence exercise. Within a year of the $11.1 billion acquisition completing, HP was forced to write down the value of Autonomy by over $5 billion after major, allegedly fraudulent, financial irregularities came to light.
What’s involved in legal due diligence
An effective legal due diligence exercise requires proper preparation and execution. Here are the important elements:
Define your scope
Before you start, sit down with your legal team and explain the objectives of the acquisition. Is it a purely UK deal or does it involve an overseas element? Are you buying the issued share capital of the company or are you buying the business and assets as a going concern? Are there any excluded assets or liabilities? Will there be any pre-completion reorganisation of the business required? These are important distinctions which carry varying risk factors for both the buyer and seller. By properly defining the scope before you start, you can carry out a more efficient and targeted due diligence exercise, potentially saving both time and costs.
The due diligence exercise is essentially a ‘fact finding mission’. Your legal and financial teams can work with you to create a broad list of legal and financial due diligence enquiries with the intention of helping you to properly understand the inner workings of the target business so that you can properly assess the potential benefits and drawbacks of the proposed acquisition.
Create a master spreadsheet of documents and records
The seller, or their advisors, will provide written replies to the due diligence enquiries and will typically provide access, for you and your advisors, to an electronic data room where all of the documents you have requested will be stored for review. Depending on the focus of the due diligence, these will typically include (but not be limited to):
- financial and accounting records
- customer and trading contracts
- corporate governance documents
- property and other asset records
- any litigation or other issues
When you prepare your request, make sure you do this as early as possible, and make time in the process to verify and authenticate the information provided.
Identify critical team members
These will include your internal team, your legal and financial teams and any other specialists.
Turning to the due diligence process itself, here are the essential steps:
Review the structure chart and organisational documents
The company’s articles of incorporation, any shareholders’ agreements and minutes of meetings will contain valuable information about the business’s history. You’ll also need to understand the company’s structure chart and ask about any turnover in key players of the executive team as this can indicate potential disruptions to the business.
Review 3rd party contracts and agreements
The company’s ongoing contractual rights and liabilities will be revealed by their contracts and agreements with third parties. These may include supplier agreements, customer contracts, property leases, IPR licenses and any other sector specific contracts.
Review financial records
Focus on management and annual accounts, tax returns and bank data to get a handle on the target’s financial strength. As well as asking for projections of revenue, look out for any signs of financial stress such as outstanding debts or unexpected liabilities.
Employment issues
You will want to see a full list of staff and look at employment contracts, benefits and pension plans and understand any incentive plans in place. Employment disputes can destabilise the business as well as being a drain on time and cash; ask for details of any current or prior employment disputes or claims, and whether any are pending or threatened.
Understand the regulatory environment
Even if the company you’re buying is straightforward, it will need certain licenses and permits to operate. Make sure these are in place, and that the company is in full compliance with any laws and regulations that apply to it. Ask whether there are any investigations pending or threatened by government agencies or other regulatory bodies.
Legal disputes
A company’s legal history can be very revealing, and taking on an ongoing legal claim is not desirable. Ask to see the details of all past litigation, including any that have been settled during mediation or arbitration. Look for patterns, such as product liability claims or employment disputes that can tell you a lot about the business’s attitude to risk.
Property
Ask your specialists to review the property records for all real property and intellectual property, making sure that the title is held by the company itself. Look for any challenges to rights and any restrictions on assignment to you as the new owner.
Create a master report
Once you’ve completed due diligence and received answers to any outstanding questions, create a master report that begins with a summary of the key risks. Again, this is something your legal team can do if you have engaged them to provide a due diligence report. Create a risk register where the degree of risk is highlighted together with any mitigation strategies you can identify. Finally, decide what impact, if any, your due diligence report conclusions will have on the price or other terms offered for the business.
If any issues do arise during the due diligence exercise, the purchaser has several options. These may include:
- renegotiating the purchase price
- requesting a specific indemnity in the purchase agreement from the seller, under which you can seek to recover your losses in connection with identified risk from the seller should it arise, or
- renegotiating the deal structure or, in extreme circumstances, walking away from the deal altogether
When is the right time to conduct due diligence?
You should start due diligence as soon as you have identified an opportunity you are interested in. You can potentially start to review publicly available information before you start the negotiation process. Bring your legal and financial advisors on board straight away, preferably even before signing a letter of intent (even though they are expressed to be ‘not legally binding’ for the most-part, reliance is usually placed on LOIs so make sure you understand the terms you are agreeing to move forward on!), so that you can uncover any issues with the target company before you move forward.
How long can the due diligence process take?
Due diligence can take anywhere from a few weeks to several months, depending on the target business and the extent of the due diligence exercise. It is important to take the time you need and not to rush it. Trying to gather copious amounts of information while trying to continue to run their business is no small undertaking for a seller, so you need to allow them the time they need to collate their responses, and for you to raise any further enquiries you may have as a result of those responses! Time spent during due diligence is not wasted time and if you can iron out any issues at an early stage that will ultimately lead to a smoother transaction.
What are the challenges associated with due diligence when buying a business?
Due diligence can be time-consuming, resource-intensive and, potentially, costly for both buyer and seller, and a buyer is reliant upon the information that the seller is willing to share. Establishing a good rapport and being realistic about the scope can help establish trust and move the process forward.
Make sure that you have followed this guide and narrowed your scope before you start, so that you can use your time wisely. If you are tasked with preparing a report for internal purposes, put as much energy into this as the diligence process itself. Due diligence is only valuable if the findings are actively considered during negotiations and the transaction, so make your executive summary clear and actionable.
If you are planning a quick purchase, your ability to do due diligence may be limited in terms of scope, so bear that in mind when negotiating the price and key terms. You may require enhanced buyer protections in the purchase agreement as a result, including more extensive warranties or indemnities from the seller for key risk areas, which you may be able to negotiate depending on the wider deal structure and balance of bargaining power.
What steps can a buyer take to ensure an effective and smooth due diligence process?
Here are our top tips for an effective and smooth due diligence process:
- Identify the key commercial driver for the acquisition before starting due diligence
- Focus on early scoping and plan for an efficient process with milestones
- Onboard lawyers early, and don’t handle due diligence alone
- Create a thorough final report with meaningful and actionable conclusions to guide negotiations
Cross-border elements of due diligence
If you are buying a foreign business, then legal due diligence is even more important as unfamiliar legal environments bring unfamiliar risk. Take time at the outset to find a local legal firm that offers an equivalent level of service and cost as your UK lawyers and that you can integrate with your team. You’ll likely be working with your new lawyers in the future, particularly if you intend to continue to operate the target business in the foreign jurisdiction, so don’t skimp on this step.
Pay particular emphasis on:
- Compliance with company and other laws to which the target is subject
- Customs due diligence and compliance with international trade regulations
- Data protection laws and conformity with legal requirements for transferring data across borders
- Intellectual property issues particularly in technology-intensive sectors
- Cultural differences and how this aligns with the buyer’s own corporate culture
Assistance with legal due diligence
Our corporate legal team is highly experienced in conducting due diligence in mergers and acquisitions and can guide you through the process.
To find out more, get in touch on 0800 689 1700, email us at enquiries@harperjames.co.uk, or fill out the short form below with your enquiry.
