What is due diligence and how do you perform it?

You have probably heard of the expression Caveat emptor, or let the buyer beware? In business, as in other walks of life, it is important that a buyer undertakes their own detailed investigations before signing a contract. How do you go about doing this, what process or tools are available, why is it important? Let’s take a look.

Topics to be answered in this article

What is due diligence?

In a business transaction, beyond some basic statutory and legal requirements, the seller is under no duty to disclose to the buyer every problem, liability, or issue that may exist. In many cases, the seller may not even be aware of all the issues. It is therefore really important that a buyer conducts a thorough review of what is being offered. This formal process is known as due diligence, and is a vital tool for risk management.

There are many facets and different types of due diligence depending on the transaction that you would like to undertake as a buyer. There is also a solid argument for sellers to perform their own due diligence exercise before going to market in order to minimise delays or issues that may crop up causing a buyer to potentially withdraw from a sale. Parties might also decide to limit the scope of the due diligence process, to allow for a quick sale, and if this is the case then the purchase price should favour the buyer to reflect this deal.

Common Types of Due Diligence

Financial

The buyer may wish to undertake a financial due diligence exercise to assess the monetary risks of the deal. This would include checking the target’s accounts, management accounts, budgets projections and forecasts, for example checking the financial standing of the seller and assessing the extent of any tax liabilities with HMRC. What you focus on will be dictated largely by the industry the target is in.

Liabilities associated with the target will be crucial to the final terms that the buyer will strike with the seller.

Legal and Operational Due Diligence

A prudent buyer will check the target’s rights and obligations (which, depending on the outcome, could mean a renegotiation of the purchase price) to fully understand the nature and effect the proposed transaction may have on those rights and obligations. This will include looking at the commercial contracts and agreements entered into by the target.

It will be important to check on any unusual contractual terms or change of control terms within customer and supplier contracts – the last thing you want to find following the acquisition of a business is that a change of control clause will lose you a key customer or supplier.

Perhaps the most important element of due diligence is title. The seller’s title to what they are selling to you (whether equity or assets) and should be carefully checked to ensure that you will take full title on completion.

The scope and focus of the due diligence questions that will be asked on behalf of the buyer should be specific to the industry and to highlight any particular areas of concern. It will be important to ensure that any questionnaire which gets sent across to the seller is targeted and specific to that business as this will help in complying with an appropriate and targeted response when the replies are received.

Typically, we would want to see the following key documents as a minimum:

  • Memorandum and Articles of Association including board minutes, resolutions, and shareholders meetings
  • Material customer and supplier contracts.
  • Property details (any freehold or leasehold land)
  • Details of any litigation (past or present).
    Accounts including financial statements and tax returns
  • Business plans
  • All employment contracts and details of any issues that have arisen in connection with any employees
  • Details of any pension liabilities
  • Intellectual property details
  • Environmental reports
  • Details of all loans and credit agreements

The above is by no means an exhaustive checklist but is a good starting point for buyers. The goal is to obtain as much targeted information about the business to enable you to make as informed a decision as possible before entering into the contract.

Other Types of Due Diligence

In addition to the areas of finance, legal and operations, there are other areas which can be the subject of due diligence. Some examples include:

Environmental: Ensuring that environmental regulations are being met, for example in waste removal or carbon emissions, and that pledges to stakeholders are being met.

Human Resources: focusing on relevant, effective, and legal HR policies to recruit, retain and manage staff effectively.

Intellectual Property (IP): looking at the effective management of all IP, including patents, know-how, trade secrets, copyright, and trademarks.

Commercial: evaluating market dynamics such as market size, market share, customer base, competitors, and external market factors.

How does due diligence affect the transaction?

Once all the information has been gathered following a due diligence procedure, the buyer should carefully read through and consider with their accountant and solicitor to ensure that they understand all the risks involved in the transaction and, if there are any red flags, ensure that these are dealt with either by way of renegotiation of the purchase price or within the contract.

When the due diligence review is complete the buyer can proceed with confidence knowing that they have done all they can to minimise the risk for themselves going forward with what is often one of the largest and most important purchases that they will make. By performing due diligence carefully, you are ensuring that you are investing your money wisely and avoiding costly mistakes and Goughs can assist you at every step of the way to ensure that there are no unpleasant surprises at the end of a deal.

How to go about Due Diligence

The exact process for undertaking due diligence depends on the nature of the transaction being considered. Typically, for the purchase of a business the steps might include:

  • Agreeing the scope of the due diligence
  • Understanding the target business, products, services etc
  • Review of accounts for a proportionate amount of time, typically 3-5 years
  • Understanding and evaluating the management structure and team
  • Review of any prior, existing, or pending claims or legal settlements
  • Evaluating the competitive landscape and marketing strategy
  • Assessing the route-to-market and supply chain, including review of contracts
  • Review of intellectual property
  • Sales pipeline analysis, including how this relates to financial forecasts
  • SWOT analysis

As you can see, this involves a significant amount of work, and for this reason, a business undertaking due diligence may choose to engage a professional third party to help in specialist areas, such as Goughs for legal, IP and contractual issues.

Common Pitfalls and Risks

This can be as a result of not fully understanding the subject being reviewed, for example the cyclical nature of a business, or impending legislation. Understanding legal contracts to ensure that the sale of a business will not render them void is another good example.

Missing something important: This can be as a result of not fully understanding the subject being reviewed, for example the cyclical nature of a business, or impending legislation. Understanding legal contracts to ensure that the sale of a business will not render them void is another good example.

Too much focus on trivial matters: Not everything is equal! It’s important to focus precious time and resources on the areas that matter. This is often linked with the point above.

Leaving it too late and then hitting a problem: Discovering a potential problem at the last minute can lead to poor decision making, and that can be expensive!  Allow plenty of time and look for problems early.

Poor communication: There will be multiple parties involved in the due diligence process and it’s important they all communicate clearly and effectively.  Silos of information are the enemy.

Paying too much or bidding too little: The more you understand about a business, the more accurate the price you can achieve. Good information is vital, and that’s what proper due diligence can help provide.

How can Goughs help?

We have many years of experience in providing targeted bespoke due diligence questionnaires on behalf of our buying clients and can also assist our selling clients to prepare as much as possible in advance of a potential sale and manage the due diligence process. If you would like advice or to discuss any of the issues raised above, please do not hesitate to get in touch with us.

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Author Bio

Jonathan Carter-Lewis

I was first attracted to a career in law when I did an internship for a large conglomerate working in their corporate & commercial team, in Hong Kong. That gave me my first taste of what a lawyer does. 

I enjoy problem solving and being thrown into something that isn’t straight-forward. Finding ways to make my clients’ lives easier, putting smiles on their faces, and building strong working relationships are just a few of the highlights of the legal profession.

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