Summary
From a corporate law perspective, due diligence is a core part of a transaction. Key points:
- Meaning: the process of investigating and verifying information before completing a corporate transaction such as the purchase of a business or its assets.
- Purpose:
- From the buyer’s perspective: to uncover any issues with a business or asset to ascertain its full value. Those risks can be managed in many different ways.
- From the seller’s perspective: to reveal the issues to miniseries the risks of legal claims in the future.
- Process: the due diligence process commences with initial enquiries, then a due diligence questionnaire and the corresponding exchange of due diligence information.
- If you’re the buyer, you will use the information obtained via due diligence to tailor the transaction documentation and your representatives will produce a summary of the process in a due diligence report.
- If you’re the seller, you will collate all your responses into a disclosure letter which will be the key document used to qualify certain contractual terms in the transaction documents.
- Common pitfalls: incomplete responses and incomplete questions. Due diligence should be as robust as is commercially reasonable.
Introduction
The term due diligence can have a wide variety of meanings in a legal context. It most often crops up in meetings about corporate transactions, when someone is buying, selling or investing in a company.
In corporate transactions, put simply, the meaning of due diligence is the process of investigating and verifying key information before entering into a transaction. It allows a buyer, investor or commercial partner to properly understand what they are paying for and the risks they are taking on. It equally allows the seller to give the buyer as much information as is necessary to protect itself from any post-sale claims from the buyer.
In this blog, we explore the meaning of corporate due diligence, the different areas typically reviewed during the process and why it matters for businesses of all sizes.
The meaning of due diligence in a corporate transaction
Consider the following example: you’re a prominent SaaS business that is looking to expand its product offering. You’ve identified an AI start-up that offers a solution that works really well with your existing products and services. You want to buy the AI start-up so it can enhance your business. You offer the shareholders £millions; the shareholders are interested. Everyone thinks this is going to be a great success.
But how can you be sure (or, at least, as sure as you can be) that everything will be fantastic? That is where the process of due diligence comes in.
Due diligence allows a buyer or investor to get under the bonnet of a company and understand its prospects and risks to its business. From the seller’s or investee’s perspective, the due diligence process allows the seller to put all their cards on the table and obtain legal protections by disclosing all the issues (or potential issues) within the company. This, in effect, prevents the buyer from complaining (or, more importantly, bringing a legal claim) about things it was aware of. The legal maxim ‘caveat emptor’ (“buyer beware”) very much applies to acquisitions in the UK.
In a corporate transaction, due diligence can be broken down into three workstreams:
- Financial due diligence (FDD). This is the process of looking into the company’s finances to ascertain (a) its value and (b) its financial health. It is usually led by accountants or other financial professionals. These professionals can be external (auditing firm) or in-house to the buyer.
- Legal Due Diligence (LDD). As the name suggests, this is the process of looking into the legal risks that the company or transaction may pose to the buyer or the investor when it proceeds through the transaction. It involves looking at all legal aspects of the business – commercial contracts, employment, property, data protection, intellectual property and so on. LDD is almost always led by lawyers (external or in-house). However, if only assets are being sold, the scope of due diligence may be less. LDD is usually tailored toward the type of business and what exactly is being sold.
- Tax due diligence (TDD). Tax due diligence considers the tax exposure that a business has or will have in the future. For larger organisations, this can be a significant undertaking. TDD is usually undertaken by a mix of lawyers and financial professionals, as tax liabilities have both a financial and legal aspect.
The meaning of due diligence from the buyer’s perspective
The due diligence process from the perspective of the buyer can be broken down as follows:
Initial inquiries
As part of the initial valuation process, the buyer’s representatives will ask for financial information from the seller in a structured or instructed format. This information will typically determine the price that the buyer is prepared to pay for the seller or its assets.
This initial price, and the basis on which it is calculated is usually recorded on a Heads of Terms (HoT). Properly drafted Heads of Terms will state that the purchase price is subject to further due diligence, enabling the buyer to make price adjustments if it discovers a substantial risk in the due diligence process.
Due diligence questionnaire
The buyer’s representatives will typically send a questionnaire which asks many questions about the business, such as queries regarding commercial contracts, property and data protection. Depending on the level of detail required by the buyer, the due diligence questionnaire can be between 15 – 60 pages, and sometimes more, for very complex transactions. The due diligence questionnaire would primarily be focused on legal due diligence and tax due diligence, but the buyer’s team conducting financial due diligence will also want to review and input into the due diligence questionnaire as well.
For example, a question might be: ‘Please provide details of, and copies of documents relating to, all registered Company intellectual property rights owned by the Company.’
The response to this question should enable the buyer’s legal representatives to understand what IP rights are in the business and how well they are protected, by both reviewing the answer and the documentation underpinning the answer.
The scope of the answer is usually subject to negotiations. A business that has been going for a few years is likely to have hundreds of commercial agreements. Therefore, for example, it is common for the buyer and the seller to agree that the due diligence process will only focus on “Key Contracts” (contracts with a value of greater than x%). This enables both sides to carry out and respond to due diligence enquires in an efficient way.
Follow up questions
Once the seller has provided its initial response, inevitably there will be further questions. The buyer can resolve these informally over emails or meetings, or issue a further questionnaire.
Tailoring the warranties and indemnities
The transaction will be executed using a legal document. What type of document this is depends on the transaction, but primarily it will be either a:
- Share purchase agreement (SPA); or
- Asset purchase agreement (APA).
Both the Share Purchase Agreement and the Asset Purchase Agreement will contain representations and warranties that are legally binding commitments about the state of affairs of the relevant company or the relevant asset.
Likewise, the relevant agreement is likely to contain indemnities (promises to pay losses and costs) that cover particular legal risks, such as claims of intellectual property infringement from third parties.
The buyer will want to make sure that the representations, warranties and indemnities in the transaction agreement cover any risks identified in due diligence.
A common example is data protection compliance. The due diligence process will typically uncover that there has been a potential breach of the UK GDPR because the seller has not been fully compliant in some respects. Usually this crops up with smaller businesses where they have not carried out a legitimate interests assessment (LIA) or developed a fully compliant privacy policy.
The transaction agreement, tailored by due diligence, is then sent to the seller for review. The share purchase agreement or asset purchase agreement may continue to be tailored in parallel to the due diligence process.
Due diligence report
At the end of the due diligence process, the buyer’s representatives will usually prepare a Due Diligence Report which summarises the findings of the due diligence process.
The due diligence report would highlight key risks and other significant points of relevance to the buyer. However, points of material relevance are almost always communicated before the due diligence report has been finalised so those points can be incorporated into the negotiations for the sale. For example, if the buyer discovers that a significant contract is going to be terminated, that may have an impact on the purchase price.
The meaning of due diligence from the seller’s perspective
The seller will engage in the buyer’s due diligence process as outlined above. The process of responses to the due diligence process is usually called “disclosure.”
The process of disclosure is one of the key mechanisms that a seller has in order to protect itself from legal claims in the future after the sale has gone through.
The seller is incentivised to be as open and transparent as possible with all issues in the business. Otherwise, unless other strong protections have been negotiated and reflected in the transaction agreement, the buyer is likely to have a claim against the seller if it suffers a loss in relation to something it asked about during the due diligence process but did not receive an honest or (more often) a complete response.
The seller will respond to the due diligence questionnaire in writing. It will also upload the corresponding documentation to a “data room” that is accessible to the buyer and its representatives.
The responses to the due diligence questionnaire and the documentation in the data room is almost always treated as “disclosed.”
But what does “disclosed” mean?
As above, the mechanism in a transaction agreement is that the buyer gives various warranties and representations about the state of the business being sold or its assets.
A warranty may read: ‘The Company has complied with all of its obligations under the GDPR.’
Therefore, if the Company has in fact not complied with all of its obligations under the GDPR, the buyer would have a claim against the seller.
To manage this, the warranties are drafted as being qualified by disclosure. In plain English: if the seller has told the buyer anything as part of the due diligence process that means a warranty is untrue, then the buyer will not have a claim in this specific respect.
To return to the above example, if in response to the due diligence questionnaire the seller confirms that “the Company does not have a privacy policy” – then, against the above warranty, the buyer will not have a claim because it knew about this but went ahead with the transaction in any event: buyer beware.
Of course, there is usually an awful lot of discussions about the due diligence process at any time during the transaction. Therefore, to provide certainty, the responses to due diligence are usually recorded in a “disclosure letter” which records all the relevant disclosures that qualify the warranties.
Due diligence – why does it matter?
To summarise the advantages of due diligence from the different perspectives, due diligence helps the buyer fully understand what it is getting into so there are no surprises when it buys a company or an asset.
Equally, due diligence affords the seller the opportunity to reveal all the issues with the business or its assets so that it reduces the risk of legal claims down the line.
Due diligence is one core compontent of a corporate transaction. There are other mechanisms, both legal and commercial, that can help reduce risks to both buyers and sellers. Due diligence should be taken seriously but parties to a business sale should not lose sight of other protective mechanisms.
EM Law is a corporate law firm based in central London. Our corporate lawyers regularly advise on due diligence and the sale or purchase of businesses and assets. If you need help navigating due diligence or the sale process, please contact us here or visit our Corporate Law Firm page for more information.
