Understanding legal due diligence in M&A

What is due diligence?

Due diligence is an essential part of the process of selling a business. It is the information gathering process carried out by a prospective buyer to find out as much information as possible about the target company early in the transaction negotiations. Through this process, the buyer aims to gain a complete picture of the target’s financial, legal and operational status, as well as its critical success factors, strengths and weaknesses in order to ensure they are making a sound investment decision.

Why is due diligence important for sellers?

Due diligence is equally as important for sellers as it is for buyers. Conducting due diligence allows sellers to uncover any potential issues, such as legal liabilities, compliance violations, or financial irregularities, that could reduce the value of their company or jeopardise the deal. It is advisable for sellers to make a start on legal due diligence as early as possible, ideally pre-transaction, so that they can mitigate potential risks, identify value drivers and improve their bargaining position when it comes to negotiating with prospective buyers. If a comprehensive vendor due diligence exercise has been conducted pre-transaction, sellers can then anticipate and resolve potential issues before they result in price-chipping or worse, dealbreakers. This will also help facilitate a smoother transaction and reduce the time and resources required to negotiate and close the deal.

What information will the seller need to provide to the buyer?

Legal due diligence usually involves responding to a detailed questionnaire from the buyer’s lawyers requesting information and sight of supporting documents from the seller via the seller’s lawyers. The buyer will request information relating to the various aspects of the target business including:

• Corporate: the buyer will want to see copies of any key corporate documentation such as the statutory registers, articles of association, existing shareholders’ agreement, share options, loan notes etc.
• Property: the buyer will want to investigate the real property assets (i) to ensure that the seller has the right to transfer the real estate and informs the buyer in relation to encumbrances on the title, (ii) so that the parties can account for real estate risks in decision-making processes and modify the deal structure to resolve real estate issues if necessary
• Commercial: the buyer may want to be made aware of the key terms of the material customer and supply contracts the target is entered into such as termination provisions, change of control provisions and governing jurisdiction. The seller may be required to provide information relating to the target’s data protection policies, its registered and unregistered intellectual property as well as it’s IT systems
• Employment: the buyer will want to expose any key areas of potential employment law liability within the target company/business. A seller may be expected to provide documentation relating to: employment contracts, any bonus schemes, any outstanding cases in the employment tribunal, status of employees (visas) etc.
• Pensions: the buyer will want to be satisfied that the target is compliant with its pensions auto-enrolment obligations and whether there any defined benefit schemes in place
• National Security and Investment Act (NSIA): the buyer will want to know whether the seller undertakes any specified activities in the UK in the sensitive sectors of the economy and whether a notification is required
• ESG: as public and investor consciousness of ESG continues to grow, buyers may want information relating to the target’s ESG strategy and its impact on key stakeholders
• Other aspects such as disputes, intellectual property, corporate governance and data protection.

Separate to the legal due diligence process is the financial due diligence which will examine, in detail, the financial health of the business, including its historical and current financial performance. Key aspects of financial due diligence involve scrutinising financial statements, accounting policies, assets, debts, tax liabilities, cash flow, and projections to verify their accuracy and truthfulness.

How will the information be obtained?

In addition to responding to the information request list provided by the buyers, there are various other steps in the due diligence process which sellers can expect:

• Data Room: the seller’s lawyers will be expected to set up an electronic encrypted data room which is used to store the important files and documents related to the transaction. The data room will provide a single space for multiple parties to access critical business information in a secure way and allows the due diligence process to be conducted in a safe, efficient and cost-effective manner
• Meetings with Management: it is beneficial for both buyers and sellers for the buyers to conduct face-to-face meetings with the target’s management team and key personnel. It is quite often the quickest method to identify, discuss and resolve and key due diligence issues and also helps in building a transparent relationship between the parties
• Site Visits: it is the duty of a prospective buyer to inspect the property and be comfortable with the valuation of the assets involved. Site visits help buyers understand the operations and capacity of the target company and this can be done by checking the exterior of the workplace, reviewing working conditions, analysing the performance of mechanical and software systems etc. Sometimes site visits are tricky to arrange especially when the existence of the deal is confidential to employees. However, the parties usually find a way to undertake these investigations.

What is the impact of due diligence?

If the due diligence reveals liabilities, problems or information that were not known at the time of negotiating the deal, it provides the buyer with an opportunity to renegotiate terms or seek an indemnity from the seller to cover specific identified risks. It may well be that an issue which has arisen in due diligence is a dealbreaker for the buyer and the transaction may not proceed beyond due diligence.

The due diligence process also feeds into the disclosure stage of the transaction, which is important to protect the seller from a future breach of warranty claim. A lot of the key information provided in the due diligence stage will translate into the seller’s specific disclosures contained within the disclosure letter. If there has been a delay between the due diligence stage and the disclosure process, the specific disclosures provides an opportunity for the seller to essentially update their responses to due diligence requests via disclosing against the warranties contained in the share purchase agreement.

Therefore the due diligence stage of M&A transactions is a key part of any deal. The exercise, although usually fairly extensive, is useful for all parties for various different commercial reasons, ranging from achieving best value to managing risk.

If you have any questions about the topics raised in this article, please get in touch.