An introduction to legal due diligence
When buying a business or shares under English Law it is important to understand that the principle of 'caveat emptor' ('buyer beware') applies. This means that a seller is under no obligation to provide information to a buyer and that the buyer assumes all risk in relation to the condition of the business or assets that they are purchasing.
A prudent buyer must therefore carry out their own research and make their own enquiries of the seller. Ultimately this process will help a buyer to establish whether they will actually get what they think they are buying, and minimises the risks of nasty surprises arising post-acquisition.
In this article we will be considering some of the key characteristics of legal due diligence. A buyer will often carry out various forms of due diligence before going ahead with an acquisition – including legal, financial, tax and commercial – and many of the principles discussed here will be applicable to each of these.
Why should a buyer carry out legal due diligence?
Buyers will often require sellers to provide warranties about the condition of the business and assets that they are selling. However, whilst warranties undoubtedly provide a level of comfort for a buyer, it is always better to uncover and resolve potential issues before proceeding with a deal rather than having to rely on the possibility of bringing a subsequent claim against the seller.
In the early stages of a negotiation, the buyer will have based all of their decisions upon information provided by the seller – typically a teaser document, information memorandum and publicly available information such as filed accounts. Conducting due diligence allows a buyer to form a more objective view of the business it is considering buying by requesting and scrutinising a fuller range of documents and information, and asking for more detail where there are concerns that only part of the picture has been revealed.
From a buyer's perspective, carrying out due diligence should always lead to a positive outcome; either they will proceed with the acquisition (reassured that the target business is in rude health), require the seller to make certain concessions prior to completion (such as reducing the price, putting right problems which have been identified or providing indemnities in the legal documentation) or decide not to proceed with an unacceptably risky transaction.
The due diligence exercise will also help a buyer to identify what needs to happen post-acquisition to ensure a smooth handover of the business.
What does legal due diligence involve?
Whilst due diligence should always be tailored to the particular transaction, it will generally involve most or all of the following steps:
- A Seller will usually require the Buyer to enter into an NDA and heads of terms before it is prepared to reveal confidential information. This may also protect a buyer where it is entering into detailed conversations with the seller about its future plans
- The buyer, in conjunction with its lawyers, will normally prepare a due diligence questionnaire. This will usually contain a wide range of questions about the target business and ask for various documents and information to be provided. The due diligence questionnaire will be tailored to reflect the nature of the target's business, the approach of the buyer and the size of the deal
- The seller, in conjunction with their lawyers, will prepare detailed responses to the due diligence questionnaire. They will also provide the information requested, which is normally uploaded to an electronic data room. These documents will be carefully reviewed by the buyer and their lawyers
- The buyer may wish to arrange meetings with the seller, management and key employees to get a fuller picture of the current state of the business and what will be required going forward
- Further enquiries and requests for information will usually flow out of the seller's initial responses to the due diligence questionnaire
- The buyer's lawyers will normally prepare a due diligence report for the buyer detailing issues that have been identified during due diligence. This may be a high-level 'red flag' report, or a more thorough analysis which analyses all known risk areas
- If issues arise that are potential deal breakers to the buyer then the seller may be asked to resolve them before a deal can proceed. For example, if problems have arisen regarding the ownership of vital intellectual property then the seller may be required to remedy this
- Ultimately, as the due diligence process starts to reach its conclusion, the parties will each need to consider whether they are prepared to do a deal on the basis of the deal that is on the table at that point.
Next steps for buyers
Due diligence is usually driven by a buyer and their advisers, so it is sensible to establish at the outset:
- The nature and scope of legal due diligence that is required, including who will carry it out, the level of detail and investigation required and the budget that is to be allocated to this part of the transaction
- The form of due diligence report that is required. Thought should also be given to whether any other parties (such as a lender or insurer) will need to review and rely on the report
- Who will be managing the due diligence process and be responsible for evaluating the significance of issues that arise
- What is likely to be a deal breaker, what is significant but can be resolved by chipping the price or obtaining an indemnity from the seller, and what risks you are comfortable taking on.
Next steps for sellers
Whilst due diligence is generally buyer-led, there is much that well-organised sellers can do beforehand to prepare themselves. This will help to reduce the burden during the transaction, and may help to avoid the risk of a buyer seeking to change the terms of the deal as a result of their findings.
If you are considering selling your business, it is sensible to:
- Speak to your lawyers early to understand the nature of due diligence that a potential buyer is likely to undertake in light of the nature of your business, the anticipated price and the type of buyer that you are likely to attract
- Identify known areas of risk or weakness that a buyer will pick up on during due diligence, and where possible take steps to remedy them beforehand
- Start collating information that you know a buyer is going to want to see. For example, saving copies of all new contracts or arrangements so that these are ready once the sale process begins in earnest.
Whilst legal due diligence can be a time-consuming and expensive process, it is an essential component of a successful deal. Getting the right advisers on board and preparing thoroughly beforehand can make life much easier and minimise the potential for nasty surprises for all involved.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.