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So your company has decided that it is time to grow and diversify. You’ve identified a business owner that is interested in selling and it appears to be the exact kind of business that your company is after. However, you need to move fast as there are other prospective purchasers that are considering acquiring this business. Your bank manager is on board, your accountant is excited about the future growth possibilities and now, you just need to get legal documents sorted.
Your lawyers have recommended that you undertake due diligence – financial, legal and commercial due diligence. They’ve set out a process that could go for weeks and that requires finding lots of old documents, asking lists of questions, establishing a ‘data room’ and more. Frankly, it all seems like overkill. To top it off, your lawyers start asking you all sorts of probing questions about why your company is buying this business. You don’t see why your lawyers need to concern themselves with all this. Can’t they just give you a standard business sale contract and be done with it? Do you really need to do due diligence at all?
Due diligence is the process where you, as the prospective purchaser, review the inner workings of the target business. This is usually with the assistance of various advisers and specialists, such as lawyers and accountants, and sometimes also tax specialists, insurance brokers and other commercial specialists relevant to the target business (e.g IT specialists, HR specialists).
The general purpose of this exercise is to identify:
Comprehensive due diligence also has the practical benefit of assisting you to hit the ground running if you do buy the business – it enables you to go into the business with eyes wide open, knowing where the issues are and (hopefully) with a plan of how to address them. In addition to identifying particular legal risks, the process of due diligence often uncovers other practical issues that may affect the business going forward, such as issues in workplace culture.
While the scope of due diligence conducted is ultimately a matter for you, as lawyers we often review a wide range of documents and issues relating to the nature and operations of the target business.
Firstly, we want to know why you are buying this business and what you see as the key assets of the business. Your answer will alert us to those issues that are particularly sensitive or important to your company as a purchaser and will focus our advice on the relevant issues for you.
Once we understand the specific value that you are hoping to obtain from the acquisition, we set out to identify and advise on matters which can detract from this value, or can make it difficult or impossible to realise.
For instance, if the target business operates in a services industry where the value lies in long-term or large contracts with customers, we would investigate written contracts with the key customers to identify:
We would also want to see:
However, if the target’s business relies heavily on a unique process or product, legal due diligence would focus on:
If the target is a manufacturer whose success is significantly dependent on its specialist plant and equipment, we would be concerned with whether:
Alternatively, if the target is predominantly a business of salespeople, we would look at:
In addition to these industry-specific questions, there are standard categories of information that will apply to most legal due diligence processes, including:
You wouldn’t buy real estate without a building and pest inspection, and you shouldn’t buy a business without a due diligence report. Without performing a comprehensive due diligence, you are entering into a sale blind to the possible risks. Had you been aware of these risks, you might not have agreed to pay as high a purchase price, or you may have negotiated additional protections into the contract, or perhaps you would have chosen not to purchase the target business at all.
Why can’t you just rely on warranties in the sale of business contract and sue the seller if something goes wrong? It’s true that sale of business contracts typically include a range of warranties, or promises, that the seller makes in relation to the state of affairs of the target business. If a warranty given by a seller turns out to be incorrect, the purchaser may be able to sue the seller for breach of contract. However, while warranties are certainly important and are a critical aspect to managing the purchaser’s legal risks, no matter how well drafted, a warranty is of little comfort to a purchaser if the seller does not have the financial ability to meet the claim. The loss suffered by a purchaser due to a significantly inflated purchase price or due to liability that may materialise after the sale may exceed the seller’s financial capacity. After you add up the purchase price, the management time and costs associated with the acquisition and post-completion integration phase, and the costs of litigation, you are unlikely to fully recover all of your loss from the seller. You may also have foregone other prospective acquisition opportunities during this time.
The upshot is that there is no substitute for thorough due diligence performed by experts who understand your company’s true drivers. The amount of time and resources that you invest up-front for this process will pay dividends later and will help to ensure that you have chosen the right target, paid the right price and adequately protected yourself from the relevant business risks.
Further information / assistance regarding the issues raised in this article is available from the authors, Tina van Epen, Partner, and Stacey Noonan, Senior Associate, or your usual contact at Moray & Agnew.
Tina van Epen