When it comes to purchasing a business, the importance of due diligence cannot be overstated. Whether you're a seasoned entrepreneur or a first-time business buyer, conducting thorough due diligence is essential to ensure that you make a well-informed decision.
At Stephensons, we have seen first-hand how a comprehensive due diligence exercise can safeguard buyers and sellers from potential pitfalls and set the stage for a successful acquisition. In this blog, we will explore the multifaceted nature of due diligence and why it is so critical in the business acquisition process.
Understanding due diligence
Due diligence is the process of gathering information about the company you are buying to gain a clear understanding of the target business and how it is run to minimise risk. It is usually conducted during the early stages of a transaction and is a pivotal part in the context of share purchases and asset purchases.
The principle of "caveat emptor," which stands for "let the buyer beware," applies in the context of business purchases. This means that the seller is not legally obligated to disclose any flaws or certain liabilities of their business that could alter the buyer’s perception of how well the business is doing. Therefore, it is crucial for the buyer to be vigilant and conduct their own detailed investigation of the target business. This ensures that the business aligns with the buyer’s objectives and that any uncertainties are uncovered and minimised before completion. Sometimes, due diligence can even reveal major issues that could affect the value of the business or dissuade the buyer from proceeding with the acquisition.
Due diligence highlights the most important assets of the target business and what the buyer may rely heavily on to continue the business’s success. Despite the inclination by some to make shortcuts in the due diligence phase to reach completion sooner, gathering this information thoroughly and in a timely manner is imperative for the parties to have the best chance at success when taking over the business.
Key areas of due diligence
1. Financial due diligence
Financial due diligence is at the core of the evaluation process. It involves a thorough review of the company’s financial statements, including balance sheets, income statements, cash flow statements, and tax returns. The objective is to verify the accuracy of financial records and assess the company’s profitability, revenue streams, and financial stability. This step also includes scrutinising the business’s accounts receivable and payable, debts, and financial projections.
Your accountant can assist you with this phase of the due diligence process. We will also collaborate closely with your accountant after due diligence to safeguard your interests during the finalisation of the sale and purchase agreement. If you don't have an accountant specialising in business sales, we would be happy to refer one to you.
2. Legal due diligence
Legal due diligence entails a comprehensive review of the company’s legal standing. This includes examining corporate governance documents, contracts, leases, licenses, intellectual property rights, and any pending or potential litigation. Understanding the legal landscape helps identify any existing or potential legal issues that could affect the business’s operations or value.
We will take responsibility for this phase of due diligence, reviewing all provided documents and preparing a detailed report on the implications and possible solutions following the disclosures.
3. Property due diligence
Property due diligence is a crucial aspect of business acquisition, ensuring that the buyer is fully aware of the property's condition, legal status, and any potential liabilities. During this process, we play a vital role by thoroughly reviewing property titles, zoning laws, environmental reports, and existing lease agreements. They help identify any legal issues that could affect the transaction, such as unresolved disputes, easements, or compliance with local regulations. By providing a detailed analysis and advice, we can help protect the buyer’s interests, ensuring a smooth transition and minimising the risk of future legal complications.
4. Operational due diligence
This aspect focusses on the company’s operational efficiency and capabilities. It involves assessing the business’s infrastructure, technology, production processes, supply chain, and customer base. Understanding the operational framework is vital to determine whether the business can continue to run smoothly post-acquisition.
This responsibility lies with the client, but we can address any issues that arise after the client's due diligence when negotiating the sale and purchase agreement.
5. Commercial due diligence
Commercial due diligence evaluates the market position and competitive landscape of the business. It includes analysing market trends, customer demographics, competitive positioning, and growth potential. This information is crucial for assessing whether the business has a sustainable market advantage and opportunities for future growth. This allows your lawyers to device a comprehensive and robust anti-competitive restrictions on the sellers post-acquisition.
This will be a collaborative effort, with the responsibility resting on the client and their accountant to assess the market position and value of the business.
6. Human resources due diligence
Human resources due diligence involves reviewing the company’s employment practices, employee contracts, benefits, and any labour-related issues. Given that employees are a significant asset to any business, understanding the workforce dynamics and any potential HR liabilities is essential. We can assist you in conducting employment-related due diligence, helping you identify potential issues and providing effective solutions.
Why is due diligence so important?
1. Risk mitigation
The primary purpose of due diligence is to mitigate risks. By thoroughly investigating all aspects of the business, buyers can identify and address potential issues before they become costly problems. This proactive approach helps in avoiding surprises that could derail the acquisition or lead to financial losses.
2. Valuation accuracy
Accurate valuation is crucial for negotiating a fair purchase price. Due diligence provides the necessary insights to assess the true value of the business, considering its assets, liabilities, market position, and growth potential. This ensures that buyers do not overpay and that the deal reflects the business’s actual worth.
3. Regulatory compliance
Ensuring that the business complies with all relevant regulations and laws is a critical component of due diligence. Non-compliance can lead to legal penalties, fines, or operational disruptions. A thorough legal review helps to confirm that the business adheres to industry standards and regulatory requirements.
4. Informed decision-making
Comprehensive due diligence equips buyers with detailed knowledge about the business. This information is crucial for making informed decisions regarding the acquisition. It enables buyers to negotiate better terms, plan for integration, and develop strategies for future growth.
5. Post-acquisition integration
Understanding the intricacies of the business through due diligence facilitates smoother post-acquisition integration. Buyers can identify areas that need improvement, align operational processes, and effectively merge the acquired business into their existing operations.
6. Identifying obstacles
Due diligence is key in identifying obstacles that a buyer needs to overcome for a successful acquisition, such as identifying change of control provisions in material contracts between the target business and third parties, such as suppliers. Such provisions could mean that the buyer would need to gain consent from the third party in advance of completion to renew the contract or take steps to terminate the contract if the change of control provisions do not allow it. The buyer needs to be aware of these provisions and how they are going to approach them if they expect to receive the benefit of such contracts on completion.
7. Impact of the pandemic
The importance of due diligence has been further magnified post the pandemic. Economic conditions have been volatile due since COVID-19, and sellers may have been forced into unforeseen situations and new ways of working. Finding out the effects the pandemic has or continues to have on a target business is an essential part of due diligence at this time. For example, for a target business heavily dependent on its employees, a prospective buyer will need a clear picture of COVID-19 specific employee matters, such as furlough arrangements, remote working setups, and health considerations. This again emphasises the benefits of due diligence, ensuring that the buyer fully understands the circumstances in light of the pandemic.
8. Providing for warranties and indemnities in the sale and purchase agreement
A through due diligence exercise enables the buyer to assess robust and protective warranties, indemnities, and set-off provisions. Warranties are assurances provided by the seller about the state of the business, covering aspects such as financial status, legal compliance, and asset conditions. Indemnities, on the other hand, are commitments by the seller to compensate the buyer for any specific liabilities or losses that arise post-acquisition, often related to identified risks that are identified during a due diligence process. Set-off from deferred consideration allows the buyer to deduct any claims made under warranties or indemnities from future payments owed to the seller. This mechanism protects the buyer by ensuring that any issues uncovered during due diligence, which could lead to financial losses or liabilities, can be addressed by adjusting the deferred payments, thereby aligning the financial interests of both parties and mitigating potential risks.
Due diligence process
So, what actually takes place when conducting due diligence?
Due diligence typically begins after the parties have agreed on terms for how the transaction will proceed. The buyer then needs to establish what information it needs from the seller about the business to make an informed decision and highlight any key areas of risk. This is often in the form of a tailored due diligence questionnaire sent to the seller and/or their solicitor.
The seller will then gather the relevant supporting documents in conjunction with providing written replies to the questions put to them. This is then sent to the buyer/their solicitor for review and comment. The responses and supporting documents are now normally accumulated using a data room, which is a virtual room where electronic documents are uploaded and accessible by other parties for review in a safe way.
Conclusion
Due diligence is an indispensable part of the business acquisition process. It provides potential buyers with the insights needed to make informed decisions, negotiate fair terms, and ensure a successful transition. At our firm, we emphasise the importance of meticulous legal due diligence to safeguard our clients' interests and help them achieve their business objectives. If you are considering purchasing or selling a business, we are here to guide you through the legal, property and employment related due diligence process and ensure a seamless acquisition experience. Call our corporate law experts today on 0161 696 6170.
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