What is Due Diligence?
Due diligence is a term that is commonly used across various disciplines in the legal and corporate world. Simply defined, due diligence is “an investigation or an audit of a potential deal or investment opportunity”.
In the context of a business sale, due diligence is the process by which a Buyer or an investor in a company, asset or business (“the target”) investigates the records of the target to ascertain/confirm its stated value and to find out whether there are matters on which it requires additional information or which it should use as a lever to renegotiate the stated price.
The due diligence process is a time for the Buyer to learn more about the target’s products, value and prospects, identify risks, liabilities and business problems in the target , assess how it will fit in with the Buyer ’s portfolios or companies before finalising the transaction thereby potentially avoiding financial loss and bad publicity.
Due diligence is an essential activity for a Buyer and Seller in a Business sale or purchase. It is a time consuming and intensive process as the Seller spends time and resources compiling information which the Buyer must then vet rigorously.
The process is usually conducted by the Buyer ’s accountants and legal representatives , who will raise enquiries relating to the target, its staff, business operations, accounts and historic trading performance along with its tax history. Purchasing a business without doing due diligence substantially increases the risk to the Buyer. It is therefore important for the Buyer ’s legal representatives and accountants to work closely together to ensure that the appropriate legal, commercial and financial due diligence enquiries are being raised in respect of the target business or company and that the relevant information is provided.
Categories of due diligence
Due diligence investigations can be divided into two categories – Seller due diligence and Buyer due diligence. For our current purposes we will be focusing on the Buyer ’s due diligence process in a Business Sale. However before doing so we will briefly touch on the Seller due diligence process.
Seller due diligence
From a Seller’s perspective due diligence is usually undertaken to make the Buyer feel secure and more comfortable that their expectations regarding the transaction are correct. However due diligence may occasionally be to the Seller’s advantage as going through the rigorous financial investigation may actually reveal that the target is worth far more than what was initially thought to be the case. Therefore it is not uncommon for Sellers to prepare due diligence reports themselves before marketing the potential transaction.
Seller due diligence commonly means two things:
The investigation into the target carried out by the Seller at the outset to show potential Buyers that the target is in good financial health. In this case the Seller will prepare a comprehensive assessment of the business to be sold at the beginning of the sale process. The assessment will provide a detailed understanding of the business’s historical performance and track record usually combined with an independent view on the achievability of the business’s future plans and projections.
The investigation into the Buyer carried out by a Seller to ascertain whether the Buyer is financially viable and in a position to purchase the Seller’s company or business. However this is less common than the Seller due diligence described above.
Seller due diligence removes the need for a Buyer to have in depth access to do their own due diligence as they will be able to rely (partly, if not fully)on the Seller’s due diligence report.
Buyer due diligence
When you are buying an asset or a company or investing in a major project you need as much information about what you are buying or investing in.
The Buyer ’s due diligence is generally commissioned by a potential Buyer of a business at the outset of the transaction. It can also be phased in, in the case of a deal process with multiple rounds. In this case the Buyer will investigate the company’s finances (accounting records) its contracts with suppliers, and other business records to ensure that they are happy with the state of the target as it is prior to buying the target.
The Buyer ’s due diligence is a detailed investigation and appraisal of the current and historic condition of the target business or company being acquired. The information obtained during this process will assist the Buyer in:
Understanding what it is acquiring as part of the acquisition
Establishing the Seller’s ownership of the target business or shares in a company;
Ensuring the right price is being offered for the target business or company;
Identifying any risks or liabilities which may affect how the deal is structured
Identifying any risks or liabilities for which the Buyer may require protection in the main sale agreement through warranties and indemnities;
Identifying any third party consents which may be required prior to the acquisition; and
Ultimately deciding whether it wishes to go ahead with the purchase.
Scope of Due Diligence
Due diligence starts when the parties have in principle agreed to a deal but have not yet signed a binding agreement. The scope of due diligence can be very diverse, encompassing a range of areas such as commercial, financial, and operational due diligence. It also includes tax, legal, compliance, human resources, IT and sustainability considerations. The due diligence process can last several weeks or months depending on the acquisition in question. In a large complex business or company the process can take up to 4 months. To reduce the time frame, if you have decided to sell your business it is essential to be prepared for the process before marketing the sale.
The standard procedure is for the Buyer and its legal team to send a due diligence questionnaire or checklist to the Seller and its legal team. The Seller and its legal team will then collate the requested information and provide appropriate replies to the enquiries raised. The Buyer and its legal team will then evaluate the information and replies provided following which they will prepare a due diligence report, highlighting the main areas of concern or risk to the Buyer .
Reasons for Due Diligence
Due diligence is essential for the following reasons:
It provides the Seller and the Buyer with greater certainty over the nature of the business and its cash flow.
It adds credibility to the facts, figures and information provided by the Seller in the memorandum of sale
It will enable identification of any critical issues or potential defects in the deal or investment opportunity which may affect the sales process giving the Seller the opportunity to put things right and thus avoid a bad business transaction.
It enables the Buyer to obtain information that would be useful in valuing the deal thereby reducing the risk of uncertainty for potential Buyers and potentially justifying increased offers
It aims to address the issues and concerns that a potential Buyer may have.
It enables the parties to ensure that the deal or investment opportunity complies with the investment or deal criteria.
Main Types of Due Diligence:
To obtain a full picture of the target business or company, the Buyer will need to examine numerous aspects of the target including its operations, finances and legal issues.
General Due Diligence:
This will include an examination of the target’s general records and business plan to understand the corporate structure and standing of the target.
Questions to be asked would include the following:
Why is the owner selling the target?
Has the owner tried to sell the target before?
How complex is the target in terms of its products, services, subsidiaries etc?
What are the target’s business plan and its long-term strategic goals?
What is the corporate and geographical structure of the target?
Has the target recently merged or acquired other businesses or companies?
Ownership/ Organisation and Administration
This will include an examination of the target’s structure from a personnel aspect eg directors, employees etc and would also cover administrative information about the target such as the business facilities, occupancy rate and workstation numbers. It may also involve an investigation of the cultural dynamics of the target in areas such as the values, perceptions, traditions and working styles of the target’s employees.
Corporate matters, Compliance and Regulation
This will cover a review of the organizational, regulator, compliance and corporate records of the target eg the constitutional documents of the target (if a company) , partnership agreements etc, the security holders documentation eg options, warrants, preferential stock, debentures etc, current shareholders and voting agreements, and recapitalization and restructuring documents (if applicable).
Legal
This will include a review of all legal matters facing the target, any pending, settled or threatened litigation or disputes and any related risks around contracts or litigation.
Financial/Accounting
This is an investigation of the target’s financial performance and includes an examination of the company’s historical statements, trial balances, general ledgers, current operating results, business plans, budgets and forecasted financial information. The scope of this due diligence generally incudes an examination of the working capital and capital expenditure requirements and an analysis of the historical quality of earnings (such as EBITDA), quality of net assets, net debt and projected future performance. The aim is to understand the target’s current financial position, identify any unreported liabilities, and determine if the target’s earnings are sustainable. These activities help ensure a realistic valuation of the target and justification of the purchase price.
Operational
This will include an examination of the target company’s systems and processes to identify any risks arising from execution of the business function. In this case, the Buyer will assess the effectiveness of the target’s operating model — this will include its sales, technology, supply chain, production and marketing — to determine any gaps and the potential areas where development or investment are required. The main objective is to ascertain whether the target’s current state of operations can support the business plan it has provided.
Commercial
This is an analysis of the target’s ecosystem to determine its place in the market. This analysis will look into market conditions, trends, opportunities/threats , competitors and the customer’s perception of and loyalty to the target’s product or services.
Environmental
This analysis identifies the health and safety and environmental issues that could directly affect the value and reputation of the target. The factors to be considered include the target’s compliance with environmental laws, the history of the property and assessments of any sustainability issues. On-site inspections and a review of the target’s property records will probably be needed
Tax
This will include an analysis of the target’s tax returns and tax structure. The analysis will focus on income and non-income tax areas, employment/payroll, property and transfer tax items, sales and use. Tax examination is an important area of due diligence, as the Buyer will be liable for any tax issues it inherits. The most common risks found are overstated net operating losses, failure to charge VAT, payroll tax errors, underreported tax liabilities and non-filing exposures.
Technological
This is an analysis of the target’s IT assets ie the quality of the target’s technology and intellectual property(or lack thereof) ie capacity, systems in place, outsourcing agreements and recovery plan of the target’s IT to assess sustainability, value, costs, scalability and evolution capabilities, as well as how computer systems would integrate into the Buyer ’s company or portfolio
Physical assets
This is an analysis of the tangible assets possessed by the target and their value based on appraisals, leases, mortgages, permits, surveys and zoning approvals. The target’s fixed assets (such as its vehicles, machinery and office furniture) will also be analysed and the analysis should document the description, acquisition date, price, depreciation years, accumulated depreciation, netbook value and location of the fixed assets. Further the inventory is considered a material asset so should be assessed to establish quantity, value and condition.
Intellectual property
In a lot of companies and especially in technology-driven industries, a target’s IP portfolio largely determines its value and relevance to the Buyer. The standard things to look for here are issues of licensing agreements, patents, trademarks, copyrights ownership, trade secrets, chain of ownership documents and reliance on open-source code.
Human resources
The human resources element is an important part of the due diligence process. The standard things to look for here are the total number of staff, the demographics, its human resource policies, rewards and current compensation structure, benefit plans, management incentives or bonuses, employment contracts, its organizational structure and detailed background on the target CEO and CFO. It is essential to ascertain whether there are any employee-relations issues that need to be dealt with, whether there are contracts in place that the Buyer needs to take on, the key personnel in place, employee severance pay packages, employee stock option benefits, employee retention policies etc.
Strategic Fit
Strategic due diligence is essential. The issue here is whether the target is a strategic fit with the Buyer ’s current business/portfolio. The Buyer must look at the results of the due diligence process and answer the following question: How does this business/company fit in with my current business/portfolio? What are the value drivers of this deal? What synergies will be obtained? Are there redundancies that I will need to make to achieve synergy between our businesses? What products or services will be provided that I do not already have? Will the business plan hold up to market realities? Will the likely outcomes of this purchase or merger be worth the effort put into integration and transition? Will there be a strategic fit with my current business/portfolio?
If the target does not fit strategically with the Buyer’s business or portfolio the fact that the target is currently profitable is irrelevant.
Conducted properly, due diligence is an intensive and painstaking process but ultimately rewarding. A Buyer can be tempted to skim over some areas of due diligence to save time and money. However, investment in a thorough due diligence process at the outset can help prevent costly surprises later on — and increase the chances of a successful business purchase.
How Can Pure Business Law Help?
If you are a business or an individual considering a sale or purchase of a business, please contact us and book a consultation with one of our expert Business and Commercial Law Solicitors. We are specialist Business and Commercial Law Solicitors based in Bedford and London and operating nationally.
Our highly experienced Business and Commercial solicitors can advise you on all business matters including the Sale and Purchase of Businesses (M&A deals)..
If you would like to discuss anything raised in this article, please contact us, and speak with one of our solicitors. Pure Business Law is regulated by the Solicitors Regulation Authority and is a licensed member of the Law Society of England and Wales.