This article will drill down into more detail on the due diligence and disclosure exercise. We will discuss how best to prepare (and survive!) this very important phase of the sale process.
What is Due Diligence?
Once a deal is agreed, a buyer will usually conduct a 'due diligence' exercise. During this process the buyer will gather information about the target business to try and ascertain any potential liabilities which could impact the purchase price or be a deal-breaker altogether. It is at this stage where the seller will have to open up their business to close scrutiny. Therefore, it is important that sellers are well-prepared for this exercise to maintain the buyer's confidence and get the best possible deal.
Due diligence is roughly split into three sections: commercial, financial and legal. Your accountant, tax advisor and corporate financier should be instructed to prepare and respond to due diligence enquiries relating to commercial, tax and financial matters. Legal due diligence is handled by legal advisers. During this process they will investigate and collect information in order to assess all the legal risks associated with the target business. Issues revealed by this exercise will have a large impact on how the sale documents are negotiated and framed.
During due diligence, the buyer’s legal advisor will usually send a comprehensive list of questions (a 'Due Diligence Questionnaire') to the seller to complete by providing responses and copies of documentation requested. The scope and extent of due diligence carried out by the buyer will often depend on the value and complexity of the transaction and the buyer’s specific requirements.
Although traditionally led by buyers, due diligence is increasingly initiated by prospective sellers as auction sales and virtual data rooms become more common. A proactive seller may prepare a 'Seller’s Pack' which comprises of a list of documents and issues that a buyer is likely to want to have access to and provide this to prospective buyers at the outset of a negotiation.
Often parallel to the due diligence exercise is the disclosure process.
The main sale agreement (SPA) will usually contain a schedule of warranties. These are contractual statements which take the form of assurances from the seller as to the condition of the business which the buyer will be entitled to rely on. The warranties provide the buyer with a remedy (claim for breach of warranty) in the event that a statement later proves to be incorrect or untrue, as a result of which there would be a reduction in the value of the business.
Warranties also encourage a seller to disclose known problems and issues with the business. This is because the buyer will not be able to bring a breach of warranty claim if a seller properly discloses the facts that give rise to the breach before completion. This disclosure is usually done by way of a disclosure letter with “general” and “specific” disclosures. The seller and along with their advisers should review each warranty in the SPA carefully and ensure that there is nothing that is problematic or untrue. Disclosure may be a time consuming exercise but is essential to protect your liability post sale.
Warranties should be distinguished from 'indemnities' which are a contractual promise to reimburse a buyer in respect of a particular liability should it arise. The purpose is to shift the risk of a particular event or matter from the buyer back onto the seller and to allow the buyer to receive reimbursement from the seller on a pound for pound basis in respect of that matter or event. Indemnities cannot be disclosed against.
A proactive seller should be considering due diligence and disclosure even before a potential buyer is found. We have discussed the benefit of ensuring your business is in order and will stand up to the forthcoming scrutiny in part 1 of the series.
Sellers should try to avoid surprising the potential buyer with previously undisclosed issues, such as a legal dispute that has lain dormant or outstanding customer complaints that haven’t been resolved. Sellers should be honest and up front with any potential issues so this can be disclosed and dealt with in the sale documents.
Avoid deal fatigue
Poor preparation and slow responses to buyer’s enquiries can lead to 'deal fatigue'. If key information and documents aren’t readily available or the seller does not respond in a reasonable time, the period of due diligence will take longer (and cost more).