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.
What is due diligence in acquisitions?
In a typical 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 legal 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.
Along with legal due diligence it is typical to see financial and commercial/operational due diligence occurring in the same process with different advisers reviewing different documents.
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 because the purchase acquires the target with all its historic and current liabilities. 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, may help to 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 and it is properly disclosed as such in accordance with the sale agreement, they will find it extremely difficult to bring a successful warranty claim concerning that issue post-completion.
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. The purchaser acquires the target with all its historic and current liabilities and a wise purchase will want to know what these are prior to the sale completing. 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 them 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. Better to know about these problems in advance and if necessary, seek indemnity protection in the sale agreement in relation to any specific issue.
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.
The merger and acquisition process
The acquisition process is not set in stone and may differ depending on the transaction. Learn more about the seven steps of an M&A transaction and what to expect in our article.
Making sure you have experienced legal and financial advisors on board together with early preparation and planning are the key takeaways to achieve a successful M&A process.
For more answers to commonly asked questions and advice on company acquisitions, consult our M&A solicitors.