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Company Law

Analysis - guidance - compliance

09 JAN 2015

“Due Diligence”- what does it really mean?

“Due Diligence”- what does it really mean?

Part 1 on Due Diligence

“Due Diligence” is a term frequently banded around by lawyers, accountants and investment bankers as an essential part of any project, most notably mergers and acquisitions; but what does this really mean?

Put simply, “Due Diligence” is ensuring proper investigation is made, facts checked and risks assessed. So in a merger or acquisition situation, as a purchaser, you go into a transaction knowing what you are purchasing and knowing what and where the risks might be. Due Diligence covers a wide range of subjects, and in part will depend on the type of transaction being proposed and the profile of the target. A thorough Due Diligence exercise in the context of a merger or acquisition will cover almost everything from financial matters to properties; people to environmental; contracts to data protection and so on. 

It is quite normal for the purchasing team to check out the financial records of a company or business early on, ensuring that they make sense and do not show any significant underlying problems. But is it also necessary to investigate the other elements of a business? This is often done through asking the seller a series of questions, often called the ‘Due Diligence Checklist’ or ‘Pre-Contract Enquires’ and seeking information and copies of documents. This information can be provided to you in hard copy or electronic copy or, more commonly now, through the establishment of a virtual data room where the seller can post information which it expects you to request. From that you can then hone in on potentially problematic or risky areas, in order to fully ascertain the risk, or negotiate a price reduction or other remedy.
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What should you be investigating? The list can be very long, but should be tailored to what you are purchasing. What is being offered for sale – if it’s a company then corporate and statutory information is required as well as details of directors, shareholders and decisions taken. You will need to know about funding arrangements, loans and bank security which may exist over shares or assets. But you also need to look into the underlying business. What assets are there; are they owned or leased; what condition are they in; are they the correct assets for the company to operate? What are the stock levels; what condition are raw materials; what is the supply chain? 

Employees and workers are important. What are the terms of their contracts; what are the termination provisions, age profile, experience – are they are right people for the business? Is the business relying on contractors or seasonal workers, and if so what are the terms and how secure are they? If you are buying the business or the shares then you will inherit all employees on their existing terms and conditions which might be very generous – how will these fit with the terms and conditions of your existing employees? Even if the transaction is only for assets, you will need to be clear that you are not acquiring people as well and so the questions need to be asked and the information analysed.

The business may have a number of sites. Are the properties owned or leased; on what terms; what is the condition of them; is the roof in need of urgent replacement; are there any outstanding rent reviews on leased properties; are any properties let to third parties; are they all in the name of the target being acquired?
Depending on the business of the target, environmental issues may be high on the list of concerns; have there been any spillages of hazardous materials; is there an underground oil tank; how has waste been dealt with; is the site liable to flooding; is there asbestos; and if shares rather than a business are being acquired, then historical environmental issues and potential liabilities should be considered.

A review of contracts is a central part of a Due Diligence exercise, but depending on the size of the target, there may be a materiality threshold agreed to avoid all contracts being reviewed. Alternatively you can request that the seller provide a schedule of main terms of contracts to enable you to take a view on which contracts to look at in more detail. Clearly the long term or high value contracts are important, but also unusual contracts, loss making contracts, ones with directors or related parties or ones which are fundamental to the business (even if short term or low value). Contracts relating to IT back up or disaster recovery are also key to business continuity, as are software licences.

If the business is reliant on technology, then reviewing the terms of licence agreements will be essential, as will checking to see what patents, process or trademarks are registered and thereby providing protection against third party use. However processes to protect confidential information will also need to be considered, as protection is more important than recovery.

A general review of processes is also very helpful as an indication of whether the seller takes legal compliance seriously; good processes and record keeping will give some comfort that the company has been kept in proper order and recognises legal obligations. Specific questions about data protection processes or anti-bribery procedures are also helpful as is information on tax and corporate filings. Question on whether there are any threatened claims, or circumstances which might give rise to claims by third parties are just as important as questions on existing litigation or claims – you don’t want to take over a business which then becomes embroiled in historic legal claims.

If a response to one of your questions does not make complete sense, or raises another issue, then respond with a follow up question or request for information – the key is to ensure you feel comfortable that you know what you are buying and are fully aware of any inherent costs or risks before you sign on the dotted line in the contract.

Kate Anthony Wilkinson
© KAW - December 2014