Understanding due diligence in Mergers and Acquisitions

From a buyer's perspective, due diligence is a crucial step in any share or asset purchase during mergers and acquisitions.

What is due diligence and why is it important?

Due diligence is the process of gathering information about a person or business before committing to purchase the target business. It aims to take an in-depth look into the current operations of the business, allowing a prospective buyer to confirm they are purchasing what they believe they are.

Due diligence places the buyer in a better position to assess the risks and benefits of the acquisition. If the findings are not as favourable as expected, the buyer may wish to renegotiate the terms of the purchase. This could involve reducing the purchase price, demanding that the sellers rectify the concerns before completion, or including contractual protections such as warranties and indemnities. In extreme cases, the buyer may choose to withdraw from the transaction completely.

Not only does due diligence provide the buyer with the comfort that they are making a sound investment, but it also equips them with valuable knowledge of the business to support a smooth and efficient transition following completion.

What are the different types of due diligence?

A due diligence questionnaire is often divided into separate sections, typically covering the commercial, financial, tax, and legal areas of the business.

Commercial due diligence aims to identify the operational aspects of the business, such as key customers, suppliers, the size and position the business holds in the market, competitors, and opportunities or limitations for future growth. 

Financial due diligence examines the current and past financial affairs of the business. This helps the buyer determine the price they are willing to pay for the business, assess the business's liquidity, and, if necessary, gauge the need for further investment.

Tax due diligence identifies the historical and current tax liabilities of the business. Tax claims can arise after completion, so it is important for the buyer to investigate the likelihood of any non-compliance or mistakes made by the sellers. Tax penalties and interest can be costly and serious.

Legal due diligence typically focuses on identifying the key legal issues affecting the target business, including the legal obligations and liabilities that the buyer will potentially acquire and any legal risks fundamental to the transaction. Typical investigations include:

• Responsibilities due to employees and their pensions
• Ownership of any property or obligations under a lease
• Intellectual property used by the business
• Business or customer terms and conditions
• Banking agreements/facilities
• The corporate structure, and much more

The areas investigated are tailored to each business and considered thoroughly by the buyer and their advisors.

How do you ensure a thorough due diligence process?

The depth of due diligence largely depends on the buyer's appetite for risk, their knowledge of the current business sector, and the purpose of the transaction.

Typically, a buyer will consult multiple professionals, including legal advisors and accountants. It is important for the professional advisors to communicate with one another to ensure risks across all due diligence areas are identified and that effective protections are negotiated and implemented within the sale documentation.

Purchasing a business comes with its risks (as well as benefits). Therefore, it is important to allow sufficient time to ask the right questions and make additional inquiries if necessary.

What common issues are uncovered during due diligence?

Change of control or assignment provisions – Some contracts contain change of control provisions, meaning you must notify and seek the other party's consent to continue the contract under the same terms. This is particularly important in the case of leases, as the buyer will want to ensure they can continue to trade from the business premises following completion. This is equally important if the business relies heavily on one contract, whether that be a large customer or supplier.

Pending claims or litigation – Most businesses experience litigation or other claims from time to time, which can be expensive. It is important to consider the merits of such claims, the likely costs associated with them, and whether any reputational damage could result.

Licences or permits – Some sectors require approval from a regulatory body or local authority to operate. A thorough investigation is required to establish if these permits or licences are transferable or if consent or a new application is needed.

Outstanding loans or charges on assets – Whether it is an outstanding director loan, a Covid bounce-back loan, or charges over company assets, it is essential the buyer is aware and agrees with the seller on how these are managed or settled. In some cases, the seller may have a charge over their shares or a charge over business assets, which could impede the transaction.