Due diligence is the process of gathering information about the company you are buying to gain a clear understanding of the target business and how it is run to minimise risk.
It is usually conducted during the early stages of a transaction and is a pivotal part in the context of share purchases and asset purchases.
Why is Due Diligence so important?
The principle “caveat emptor” which stands for “let the buyer beware” applies in the context of business purchases, in that the seller of a business is not legally obligated to disclose any flaws or certain liabilities of their business which may alter the buyer’s perception of how well the business is doing.
It is therefore important that the buyer needs to be vigilant when conducting their own detailed investigation of the target business. In doing so, this will ensure that the target business aligns with the buyer’s objectives and that any uncertainty can be uncovered and minimised before completion. It may even be the case that a major issue comes to light through a due diligence investigation which could have an effect on the value of the business, or even disincentivise the buyer to proceed any further with the acquisition.
Furthermore, the due diligence process highlights the most important assets of the target business and what the buyer may rely heavily on, in order to continue the business’ success.
Despite the inclination by some to make shortcuts in the due diligence phase in order to reach completion sooner, gathering this information thoroughly and in a timely manner is so imperative for the buyer to have the best chance at a success when taking over the business.
Due diligence is also key in identifying obstacles that a buyer needs to overcome for a successful acquisition, such as identifying change of control provisions in material contracts between the target business and third parties, such as suppliers. Such provisions could mean that the buyer would need to gain consent from the third party in advance of completion in order to renew the contract or take steps to terminate said contract if the change of control provisions do not allow. The buyer therefore needs to be aware of these provisions and how they are going to approach them if they are expecting to receive the benefit of such contracts on completion.
In light of the pandemic
The importance of due diligence has been further magnified by the pandemic. Economic conditions have been volatile due to COVID-19 and sellers may have been forced into unforeseen situations and new ways of working. Finding out the effects of the pandemic on a target business is an essential part of due diligence at this time.
For example, for a target business who is very dependent on their employees, a prospective seller will need a clear picture on COVID-19 specific employee matters, such as whether or not furlough arrangements have been put in place, whether or not any employees work from home, do any of them need to ‘shield’ etc. This, again, emphasises the benefits of due diligence as it ensures that the buyer fully understands the circumstances in light of the pandemic.
Due Diligence Process
So, what actually takes place when conducting due diligence?
Due diligence will typically begin after the parties have agreed terms for how the transaction will proceed.
The buyer then needs to establish what information it needs from the seller about the business so that it can make an informed decision and highlight any key areas of risk. This is often in the form of a tailored due diligence questionnaire and is sent to the seller and/or their solicitor.
The seller will then gather the relevant supporting documents in conjunction with providing the written replies to the questions put to them. This is then sent to the buyer/their solicitor for review and comment. The responses and supporting documents are now normally accumulated using a data room.
A data room is a virtual room whereby electronic documents are uploaded and which will then be accessible by other parties for review.
There are various different areas which can be covered by a due diligence exercise, and these are normally catered to the type of business being purchased but typically include information regarding:
Assets of the business
Contracts in place between the business and any customers/third parties
Corporate structure of the business
Employees of the business
Health and safety
Litigation concerning the business
Pensions in place
Property where the business trades
Regulatory and compliance
Technology (e.g. computer systems used by the business)
If you are buying or selling a business and require advice on due diligence or any matters which have been discovered through due diligence, our corporate law experts are on hand to help. Please call 0845 287 0939 or contact us by email today.