This blog considers the purpose, scope and practical aspects of due diligence when buying a business. In the past, studies have shown that, for a number of reasons, a large number of acquisitions fail to meet expected targets and some high-profile disasters have brought the question of acquisition planning and management sharply into focus. It is therefore crucial that there is good management of the acquisition process and, in particular, the due diligence exercise.
Purpose of due diligence when buying a business
On any significant acquisition, the prospective buyer will want to be sure that the seller and (in the case of a share purchase) the target company have good title to the assets being bought and to know the full extent of any liabilities it will assume. For acquisitions subject to English law, the principle of caveat emptor, or buyer beware, will apply. It is therefore essential that the buyer carries out its own investigation of the target business at the negotiating stage through a due diligence review.
The primary purpose of carrying out due diligence when buying a business is to obtain sufficient information about the target’s business to enable the buyer (or other parties with an interest in the transaction) to decide whether the proposed acquisition represents a sound commercial investment. Due diligence is effectively an audit of the target’s affairs – legal, business and financial. It is therefore a crucial bargaining tool for the buyer.
Business due diligence when buying a business
Business due diligence looks at broader issues such as the market in which the business operates, competitors, the business’ strengths and weaknesses, production, sales and marketing, and research and development. Obviously, some of the results of this part of the due diligence review will be relevant to the legal investigation which focuses on the full extent of any liabilities the buyer will assume.
Financial due diligence when buying a business
As part of the due diligence process, the buyer may instruct accountants to prepare a report on the financial aspects of the target business. This financial due diligence is not the equivalent of an audit, and accountants’ reports will usually make this clear. However, financial due diligence should focus on those areas of the target’s financial affairs that are material to the buyer’s decision so that the buyer can assess the financial risks and opportunities of the deal and whether, given these risks and opportunities, the target business will fit well into the buyer’s strategy.
Legal due diligence when buying a business
The legal due diligence exercise will focus on a number of core areas mainly to establish the ownership structure in the target, the target’s position under its key customer and supplier contracts, whether any litigation is ongoing and the extent to which the target is behaving in a legally compliant way.
On the basis of this information, the buyer can determine whether it is appropriate to:
- Proceed with the transaction on terms that have been negotiated.
- Seek to renegotiate the terms of the acquisition to reflect any issues or liabilities identified during the due diligence process.
- Withdraw from the transaction.
In addition to identifying any issues that may affect the buyer’s decision to enter into the transaction (or the terms on which it is prepared to proceed), the information revealed during the legal due diligence exercise will assist the buyer and its solicitors in:
- Determining the scope of the warranties that should be included in the share purchase agreement (SPA).
- Identifying any areas of risk that should be subject to specific indemnities
Who carries out due diligence when buying a business?
It is essential that the acquisition team is made up of appropriate people under clear leadership and with good reporting structures. The team carrying out the due diligence must involve the buyer’s own personnel as well as its legal and financial advisers and accountants. Only the buyer’s own personnel will be able to make effective judgements as to the commercial importance and potential risk brought to light by the information uncovered.
Due Diligence Questionnaire
The cornerstone of any due diligence exercise is the questionnaire or information request which sets out the areas of investigation and a list of questions and enquiries to be put to the seller. These questions will usually be supplemented by further requests as the negotiations proceed and as the buyer learns more about the target.
Confidentiality and data protection
Although a seller will typically require prospective buyers to enter into a confidentiality agreement, these are difficult to enforce in practice. Where the buyer is a competitor or potential competitor, a seller may be particularly reluctant to disclose sensitive information about the target business until it can be sure that the sale will go through. The knowledge that a business is for sale can also be unsettling for employees, customers and suppliers. At worst, it can lead to a permanent loss of customers; even at best it may involve loss of sales and possibly key staff during the course of the sale process. In some cases, the seller will wish to keep confidential from all but the most senior management its intention to sell the target. Of necessity, this will limit the scope of the information available for a full due diligence enquiry.
The seller will want to ensure that no approaches are made to its customers, suppliers, management or employees either with a view to poaching them or obtaining more information. On an auction sale particularly, although confidentiality undertakings are required as a matter of practice, it is more difficult to maintain confidentiality because of the number of parties involved. The seller may be reluctant to risk the consequences of a breach of security during the information-gathering process or may be concerned that the only purpose of obtaining more information is to renegotiate the price. Bridging the gap in expectations between the seller, who is concerned to restrict the release of information, and the buyer, who will want to gather as much information as possible, is a crucial element of the initial stages of any transaction.
The due diligence report
Once the enquiry is complete, the information will be summarised in the due diligence report, which should cover the business, financial, legal and other specialist areas of the investigation. For certain transactions, this may be a fairly informal report focusing only on matters material to the transaction. For others, it will comprise a complete audit of the target’s business including an in-depth summary of the target’s material contracts. Some clients may wish to have a board presentation in addition to a written report. In any event, the due diligence report should be easy to read and have an index. It should be written in a clear and concise manner and should be free of legal jargon, bearing in mind that it will be read by non-lawyers. The executive summary – the part of the report that everyone will read – should summarise all of the key findings of the due diligence review
International transactions, by their very nature, throw up a number of added risks and challenges. These fall broadly into three categories:
- On a practical level, there may be difficulties relating to language, the added number of people involved, time differences, and so on.
- Buyers should carefully assess the impact of a foreign country’s law on a transaction.
- In some jurisdictions, investigations of the level which have now become invariable practice in the UK or US may be seen as damaging the spirit of mutual trust between seller and buyer or even as a sign of mistrust or bad faith on the part of the buyer.
Here to help
This blog is only an introduction to due diligence when buying a business. If you have any questions about due diligence more specifically or if you need help undertaking such an investigation please contact our specialist corporate lawyers.