EM Law are experts in conducting and advising clients on due diligence processes. Our lead corporate lawyers are Barry Doherty, Neil Williamson and Anca Toma-Thomson who have extensive experience in advising clients on a wide range of corporate matters.
Having made a decision to acquire a business, the buyer will be concerned to ensure that the acquisition will be a success, not just in terms of the acquisition process itself but, more importantly, the long-term integration of the new 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.
One are that is key to a successful acquisition is the good management of the acquisition process and, in particular, the due diligence exercise.
Purpose of due diligence
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 the due diligence review 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.
Armed with the information provided in the due diligence report (including the target’s critical success factors, strengths and weaknesses), the buyer is in a better position to assess the risks and rewards of the purchase and can seek to renegotiate the terms of the purchase agreement where appropriate.
The buyer will inevitably seek contractual protection from the seller in the form of warranties but, in practice, the protection offered may be limited by disclosure and other contractual provisions. Damages for breach may be difficult to quantify and to secure. The buyer may have an action in misrepresentation for any false or misleading pre-contractual statements about the target business, but such actions are often excluded by the contract.
Who carries out due diligence?
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.
The buyer and its advisers will need to identify the main areas of risk and liability inherent in the industry in which the target operates. This will set the emphasis of the due diligence exercise and assist in seeking appropriate contractual protections from the seller.
It should consider the following issues:
If people are important, enquiries will need to focus on employment conditions and motivation. If the sector is heavily regulated, such as financial services or broadcasting, questions about regulation need to be satisfactorily answered in advance. If the post-acquisition performance depends on a few critical contracts, it will be very important to ascertain the attitude of the other parties to the contracts to the acquisition before it takes place.
Large potential contractual liabilities may be characteristic of the way the industry operates. Where the buyer is a significant player in the market already, this may be part of the risk which it expects to take on when buying the business (although this may affect what the buyer is prepared to pay and the buyer may still decide to seek warranty protection as to the upper monetary limit on contractual obligations).
Depending on the nature of the target’s business, the buyer may want to instruct experts such as environmental experts, surveyors, IT or other relevant specialists.
Environmental due diligence
The acquisition of a company which is a manufacturing or processing company, or whose assets include land used or previously used for industrial processes, will raise the question of the need for environmental due diligence. The issues include the value of the target and its assets, potential responsibility for any clean-up and liability generally in relation to environmental damage. If such concerns are or may be relevant, a buyer must decide on the level of investigation it wishes to undertake. This may range from a brief site visit and “desk top survey” (that is, a review of information including historical maps, geological or hydrological surveys and process information) to a more detailed survey involving detailed sampling of soil and ground water. The aim will be to determine and allocate responsibility for clean-up and to obtain protection where appropriate from the seller.
IT due diligence
If the target company is heavily dependent on IT, or its business is the provision of IT services or products, then IT due diligence can be important to both buyer and seller. There are three factors which distinguish due diligence in an IT context:
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.
Other sources of information
As well as the questionnaire, information about a target company can be derived from a variety of sources such as Companies House, the Intellectual Property Office and the Land Registry.
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.
Review of information
The first step in the review is to consider the completeness of the responses to the enquiries. Have all documents requested been supplied and all questions satisfactorily answered?
In addition to specialist areas (such as audits relating to environmental, intellectual property, real property, employment, litigation and IT-related issues the principal areas of review in most transactions include the review of corporate information and material agreements.
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.
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