Why due diligence is important

Why due diligence is important

Businesses start commercial relationships and make agreements with other organisations and people on a daily basis, including customers, suppliers, employees, lenders and investors.

Due diligence reduces the commercial, legal, financial and reputational risks which come with business transactions.

What is due diligence?

It’s important for businesses to know who they are dealing with, what their background, track record and reputation is and whether they are financially sound.

  • a supplier will want to check the credit status of a new customer.
  • a company commissioning a contractor to build an IT system will want to know about the contractor’s previous projects.
  • an employer will take up references on potential new employees.

This is basic business or commercial due diligence.

Some due diligence is required for legal/regulatory reasons.

  • a financial adviser must verify the identity and source of wealth of new customers.
  • a law firm has to carry out checks to confirm the identity of clients, that their transaction has a legitimate purpose and where their funds come from.

For a transaction to acquire a business, or to invest in a company, the purchaser or investor will want to carry out commercial, financial, tax and legal due diligence on what it is buying or investing in. This is transaction due diligence. It is designed to give the buyer or investor knowledge of the subject of the transaction, and the associated risks, before making a legally binding commitment.

What is the main focus of transaction due diligence

The main focus areas of transaction due diligence are:

  • ownership: making sure that the seller actual owns what is being sold free and clear of anyone else’s claims and that they have the right to sell it.
  • verification of purchase price and other financial terms: for an acquisition, this includes checking the historic revenues, costs and profits of the target entity or assets. For an investment, it supports the valuation of the business and which then dictates the terms of the investment and how much the investment will be for.
  • commercial: checking that the customer, supply and other contracts of are what the buyer or investor expects them to be and will not be adversely affected by the transaction.
  • risk mitigation. checking that there are no unknown or contingent liabilities or financial obligations.
  • post-transaction integration: helping to plan for how the combined businesses will operate after closing.

When is transaction due diligence performed?

Transaction due diligence is usually done once commercial terms have been agreed in principal but before legal agreements are signed.

  • acquisition: a buyer will usually want to agree a letter of intent or heads of terms on a subject to contract basis before spending the time and money on due diligence.
  • investment: due diligence will customarily follow once a non-legally binding investment term sheet has been agreed.

A buyer may also require an exclusivity agreement is entered into before carrying out due diligence. This will provide a period of time during which the seller cannot sell the business or assets to anyone else, allowing the buyer to incur costs in carrying out due diligence and in preparing and negotiating the sale documents in the knowledge that the seller is not simultaneously engaged in similar discussions with another rival bidder.

How are due diligence issues covered?

Issues which come to light during due diligence can then be dealt with in a number of ways:

  • renegotiation of terms: the terms of the transaction may change, for example a buyer could seek a reduction in the purchase price or exclude an asset or liability from the deal.
  • pre-conditions to transaction: the buyer may require the seller to carry out certain pre-sale actions, such as obtaining any missing legal consent or an assignment of IP or other assets used in the business
  • warranties or indemnities: specific warranties or indemnities in the sale documents, breach of which will give rise to the buyer being able to claim for damages or loss which has been suffered
  • withdrawal: if the issue is sufficiently material and cannot be solved, or the parties are unable to agree terms to address it which they both agree on, either of them could decide to withdraw from the transaction

How is legal due diligence carried out?

As a starting point, the buyer (or its advisers) will send a due diligence checklist to the seller, comprising a series of questions and requests for information on the target company or assets. The seller should respond to the specific questions and provide copies of relevant documents. Depending on the answers and documents provided, the buyer may have follow-up questions.

The buyer may include in the share purchase agreement either a general warranty or specific warranties regarding the accuracy and completeness of the answers and information provided. Care should be given in answering the requests, due to potential claims for breach of warranty and misrepresentation.

The answers and materials provided by the seller should also form the basis of the specific disclosures to be made by the seller in the disclosure letter which will accompany the share purchase agreement.

PaperRock provides a range of legal business templates for the due diligence process. These are drafted by qualified lawyers and are clear, easy to use and legally up-to-date. They include a range of different forms of legal due diligence checklist, depending on the nature of the transaction, and a form of template legal review of a contract. Exclusivity agreements are also available, again depending on the nature of the transaction.

Each template is written in plain English and is accompanied by clear explanatory guidance on the document and its use. Experience legal expertise at your fingertips. Visit www.paperrockdocs.com.

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