M&A due diligence – is it necessary?
Historically, many companies have viewed the due diligence process as a tick box exercise undertaken by junior lawyers producing a long report often not viewed by senior personnel or integration managers.
The process has increasingly changed over recent years – buyers are focusing on the importance of meaningful due diligence as this approach will help to determine whether the purchase is a success. It also allows senior management, post-acquisition, to carefully manage the risks arising from the purchase.
What is the purpose of due diligence?
Under English law the principle of ‘caveat emptor’ (buyer beware) applies.
This means that due diligence is crucial because it:
- ensures that the seller or the target company has good title to the assets being sold
- identifies the full extent of any assumed liabilities – it is essential that the buyer is aware of the liabilities which it could be taking on
- allows the buyer to assess whether the acquisition represents a sound commercial investment – due diligence is in effect a legal audit of the target’s affairs
- allows the buyer to renegotiate the terms of the agreement if any known liabilities are identified
- allows the buyer to plan the integration of the target business or target company within its group
- allows the buyer to seek appropriate contractual protection by way of indemnity for any identified risks (the warranties will be limited by disclosure or other contractual provisions).
It is therefore critical to the bargaining position of the buyer as it allows him to make a final decision about whether to proceed with the acquisition (knowing the liabilities it will be taking on) and, if so, at what price.
Can you get away without it?
It is possible for a buyer to undertake minimal due diligence and rely on contractual warranties or indemnity protection, on the basis that this could be a good cost saving exercise, given the expense of an acquisition.
However, this is usually a short-sighted approach as:
- a buyer should understand the business it is buying – this will help in trying to negotiate the correct warranties and indemnities
- there are often limitations on the liability of the seller in relation to a breach of warranty claim or in some cases an indemnity claim
- warranty claims may be difficult to prove – it is better for the buyer to identify the problem and deal with the issue pre-completion
- if the warranty claim goes to the goodwill or reputation of the business, the damage may not be readily quantifiable or even capable of remedy
- if the acquisition is funded through third party finance, a finance provider will expect the buyer to carry out a due diligence review.
How to manage it efficiently
It is important that due diligence is managed efficiently, given the number of different advisers involved in the process who will need to look at the documentation and the fact that the parties are often working at numerous locations and to very tight timelines.
It is now becoming increasingly common to have a virtual data room (VDR). This is normally set up by an external provider such as Merril Datasite, Intralinks or Ansarada and ensures that the acquisition will be run efficiently because:
- an up-to-date index of the VDR of documents is maintained
- new documents can be added to the VDR quickly – they are flagged as new documents and the members allowed to view the VDR are notified
- records are kept as to who has reviewed the documents and when they reviewed them, with a watermark being applied to any print-outs – this helps with confidentiality and any leak of information
- the whole pre-contract enquiry process can be managed centrally as the responses can always be uploaded to the VDR – this means that there will be fewer emails flying around between personnel especially on large scale transactions.
What sort of due diligence report is required?
If the buyer requires a due diligence report from his lawyers he should inform them of the style of the report required from the outset. The options are:
- a full report – a standard long-form report with in-depth coverage of all the documents reviewed which would identify any key issues
- an exceptions report – this focuses only on crucial issues that may go to the acquisition price or where indemnity comfort is needed
- an informal report – a summary of the issues found during the due diligence process which have been reported via emails or telephone calls.
Different buyers require different types of reports. It is important that whatever the report it is prepared in a succinct manner so that senior management can identify the key risks involved. Even with a long report, it should be possible to highlight key risks in an executive summary or by identifying them throughout the report as low, medium or high risk.
For advice on any of these issues, or when buying or selling companies or businesses, please speak to any of our corporate & commercial partners.