When considering the acquisition of a business, the onus is on the Buyer to investigate the target company thoroughly before acquiring it, rather than on the Seller to volunteer problems which may exist within their businesses. Consequently, this creates an imbalance in power whereby the Buyer’s starting position is to assume unexpected liabilities of the target company after acquisition.
Due diligence is crucial
To safeguard against this eventuality, a due diligence exercise is crucial for evaluating the financial health and operations of the target company and for identifying potential risks that the Buyer will assume following the acquisition. This is particularly important when acquiring a private company as the Buyer will have little (if any) ability to source any useful information regarding the target company from the public domain.
Due diligence provides a bird’s eye view of the target company’s business. This helps inform the Buyer of the risks and issues inherent in the target company and helps the Buyer make an informed decision on the soundness of the acquisition as well as to negotiate the purchase price.
There are three fundamental types of due diligence:
1. Commercial Due Diligence
At the outset, the Buyer will need to identify a target company and decide whether to acquire the shares in or the assets of the company as each type of transaction presents a different set of considerations. To read our article on this topic click here.
The Buyer would also need to consider broader issues such as the market in which the target company operates, its competitors, the products and services offered by the target company, etc.
2. Financial Due Diligence
After a target company has been identified, the Buyer usually engages an accountant to conduct financial due diligence by investigating the financial affairs, revenue streams, capital, debts, liabilities, financial performance, cash flow and growth potential of the target company, especially on the matters in 3(b) and (j) below. The accountant would also evaluate the financial risks and opportunities in the proposed acquisition to guide the Buyer in valuing the target company.
3. Legal Due Diligence
Once the Buyer is satisfied with the commercial and financial aspects of the acquisition, the Buyer would usually agree a price and principal terms with the Seller in a Heads of Terms document or Letter of Intent. The lawyers will then begin the legal due diligence. This phase is critical to determine whether there are legal issues which require further negotiation for enhanced protection (usually in the form of warranties and indemnities) or in relation to the purchase price.
Depending on the nature and size of the acquisition, legal due diligence usually covers the following relevant areas to discern whether the target company has conducted its business in accordance with the law:
(a) Corporate structure & records, share capital & shareholders:
We will investigate the background of the target company and its associated companies to understand the corporate landscape and decision-making process of the target company.
(b) Accounts, finance and banking:
We will work with the Buyer’s accountants to review the (audited) accounts of the target company to identify any irregular or suspicious transactions. We also review bank loans, credit agreements along with any security over the assets of the target company to discern the extent of the target company’s financial obligations and liabilities.
(c) Contracts and trading:
We will review customer and supplier contracts to discern the target company’s contractual rights, obligations or liabilities and flag any risky, onerous or unusual obligations which the Buyer may wish to renegotiate. This also helps the Buyer familiarise itself with the trading partners, key customers and suppliers, pricing, profit margins, production, manufacturing and distribution processes, products and services, operational efficiency, methods of handling customer/supplier issues and the cultural fit of the target company.
(d) Assets:
We will gather information relating to the assets, property, plant and equipment owned or used by the target company. This may also stretch into investigating the target company’s IT infrastructure in terms of its computer systems, databases and software. This is important as the Buyer needs to familiarise itself with the subject matter of assets which it is purchasing and the rights and obligations attached to them.
(e) Intellectual property (IP):
We will review the IP rights (patents, trademarks, copyrights and trade secrets) owned, used, enjoyed or held by the target company under any IP agreements or licences to ensure that the target company’s IP rights are sufficiently protected and also to determine whether the target company has infringed any third-party IP rights.
(f) Regulatory & compliance:
We will review the licences, permits, approvals, etc. obtained by the target company to ensure that the target company has the necessary authorisations and complied with all applicable statutes or regulations. If required, we will also look into the data privacy, environmental and health & safety aspects of the target company. This helps ensure that the target company is operating and carrying out business activities in compliance with applicable laws so as not to be exposed to fines, penalties or legal actions.
(g) Litigation and disputes:
We will review any legal claims, disputes or threatened legal action to ensure that the Buyer will not bear the responsibility for any current or future claims, fines, penalties and judgment orders levied against the target company for any breaches by it prior to completion of the acquisition.
(h) Employment:
We will review the employment contracts, service agreements and pension schemes of the target company to discern the target company’s compliance with employment regulations. This also helps the Buyer better understand the target company’s organisational structure, job roles, salaries, employee performance, remuneration, employment policies and benefits and to assess the viability of integration of the target company and its staff into the Buyer’s work culture.
(i) Real estate:
We will review the titles, leases, tenancy agreements and property purchase agreements to establish the target company’s proprietary rights and use of the premises which the target company owns or occupies.
(j) Tax:
We will review the tax records and filings of the target company to ensure it has complied with its statutory tax obligations.
Mitigating risks
After reviewing the matters above, we can help reallocate the risks identified by developing strategies to mitigate against those risks, pre-empting and addressing potential compliance issues prior to the acquisition, negotiating favourable contract terms and structuring the acquisition in a way that minimises the liabilities and maximises the value of the acquisition.
Creative solutions and commercial insight
Oliver & Co Commercial Solicitors can offer prospective Buyers creative solutions and commercial insight to help you navigate your way through the common pitfalls and legal challenges arising from business acquisitions. If you require any further information, please contact us on 01244 312306 or at law@oliverandco.co.uk for an initial free, no obligation consultation.
