Purchasing a business – do the right thing

Commercial Directions

A guide to due diligence

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?

Why due diligence is critical

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:

  • Whether the information provided by the seller about the business – on which you’ve based the purchase price and decision to proceed – is true and accurate.
  • The nature of the assets being sold – what are the steps required to get ownership effectively transferred to you?
  • The key risks in the business, now and in the future – are there any problems, issues or ticking time bombs that could affect its value?

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.

What do lawyers do in due diligence?

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:

  • Whether the contract is secure or whether it contains broad termination rights allowing the customer to terminate without cause or on little notice
  • Whether the contract contains change of control / assignment clauses that require the customer’s consent before the contract can be transferred to you
  • Insurance requirements
  • Any unusual legal risks contained in the contract and to which you would be exposed after the sale concluded, and
  • Whether the customer is a competitor of your company.

We would also want to see:

  • Whether the target has in place written supply arrangements that enables the target to meet its customer obligations, and
  • Whether any suppliers or customers are competitors of your company.

However, if the target’s business relies heavily on a unique process or product, legal due diligence would focus on:

  • Who owns the intellectual property (IP) in this process or product
  • Whether the IP can be transferred or assigned to you, and
  • What difficulties would your company face if a competitor business was using this process or product, or if the business you acquire is no longer able to use it because the licence was not assignable.

If the target is a manufacturer whose success is significantly dependent on its specialist plant and equipment, we would be concerned with whether:

  • There is free and clear title to this plant and equipment
  • There are appropriate maintenance contracts and other supplier contracts that are assignable to ensure the continued and smooth running of the business after a sale, and
  • There is evidence of previous claims for supply of defective goods.

Alternatively, if the target is predominantly a business of salespeople, we would look at:

  • Whether the workforce has been sufficiently trained in competition and consumer law
  • If certain employees are critical to the business and, if so, the methods used to retain them (e.g bonuses, employee share plans, KPIs) and how the business would be affected if these key employees were to leave shortly after the sale, and
  • What would happen if employees went to work for competitors. For example, are employees subject to restraints of trade? Are there appropriate written agreements in relation to ownership of IP and requirements to maintain confidentiality?

In addition to these industry-specific questions, there are standard categories of information that will apply to most legal due diligence processes, including:

  • Corporate structure and registers – particularly relevant where there is an acquisition of shares rather than business assets
  • Customer and supplier records and contracts
  • Litigation, claims and disputes made against or by the target
  • Employee policies, records and contracts / awards
  • Insurance requirements of the business
  • Real property – owned or used by the target
  • IP – owned by the target and otherwise used (e.g business names, web addresses, domain names, trademarks)
  • Plant and equipment – ownership, condition, value, maintenance obligations
  • Compliance, including industry specific and general compliance practices.

The risk of inadequate due diligence

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.

Conclusion

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.

Author attribution:

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.


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