Into the unknown - the importance of due diligence
What is due diligence?
Due diligence is a process of investigating a company or transaction to determine whether there are any particular legal issues that may require further agreement or resolution, or which may even be a deal-breaker.
Most commonly understood in the context of business, property and asset acquisitions and mergers. However, due diligence is usually carried out by lawyers in some form or another even on the smallest of transactions.
Company directors (particularly public companies) may need to ensure that proper due diligence is carried out or as part of their obligations to act in the best interests of the company.
Reasons for due diligence
There are several reasons for undertaking due diligence:
- To identify any issues with the business that may be able to tidy up prior to settlement, for example unregistered leases.
- To identify matters that could be potential deal breakers.
- To permit the buyer to renegotiate the terms of the deal to a more suitable price where issues have been identified.
Potential deal breakers
Some examples of potential deal breakers are as follows:
- An agreement that is to be assigned to the buyer under the terms of the sale contract contains onerous clauses involving future liabilities that are not immediately recognized under the existing balance sheet and profit and loss statement of the business.
- The business is reliant on income and lead generation from a single source and that source is not subject to any form of long-term agreement.
- Is there a significant dispute or potential liability that has or could result in significant claims being made by a third party against the target company?
- There are key persons within the business who have significant face to face contact with, and relationships with, key clients of the business and those employees are not subject to any restraints of trade or other preventions of protections of the company's goodwill.
Other matters considered by your lawyers during due diligence: are agreements able to be assigned, have leases been properly registered so as to be able to continue the protection granted by registration. Have employees been employed as employees and not contractors?
Commencing due diligence
Before commencing due diligence the following matters need to be considered and resolved:
From the seller’s point of view it is important to put in place a non-disclosure agreement which ensures that the potential buyer is not able to use the confidential information obtained during due diligence for its own competing purposes and also to ensure that that confidentiality is maintained should the transaction not proceed.
Due diligence is also likely to be more comprehensive when the target being acquired is shares in a company rather than simply the acquisition of business assets. The reason for this is that the seller is acquiring all of the trading history - including past liabilities of the company which can include unpaid tax debts, potential claims by creditors and third parties and the like. This creates a necessity for a strong and robust due diligence process.
Any due diligence conducted should be proportionate to the size and complexity of the transaction involved. For example, there is not much point in undertaking a large due diligence operation involving director’s questionnaires and other expensive steps for the purchase of a small café. To do so will just ultimately alienate the seller and could cause the deal to fall over.
A good due diligence report should contain useful information about the business being acquired without providing unwarranted detail.
Most importantly it should identify particular issues that may need to be rectified and provide realistic advice in relation to the risks of proceeding and/or the ability to minimize or eliminate those risks in the negotiation process.
There are three ways that risks can be resolved following due diligence:
- Conditions - once issues have been identified, the contract (or a variation to the contract) can be amended to put conditions on the seller to cover any risks that are able to be rectified.
- Warranties - Warranties can be obtained from the seller to ensure that if any claims do arise the seller is required to foot the bill. It is always preferable to obtain confirmation by way of due diligence rather than by way of warranty as the warranty route requires the buyer to suffer the loss before seeking compensation which is an uncertain and potentially costly process. Identify problems first.
- Terminate - Alternatively, if the issue is too important to be resolved, the contract should always provide that the buyer may terminate if it is not satisfied with the results of due diligence.