What is due diligence?

The phrase “doing your due diligence” has become something of a well-known phrase, usually taken to mean that you should carry out investigations before taking the plunge, and due diligence has the same meaning in a business purchase transaction. Due diligence is the process of investigating the state of the business before buying the business.

The due diligence exercise is one of the most important steps of the acquisition process, because when you purchase a business the principle of “caveat emptor” (or “buyer beware”) applies. In other words, the seller has no legal obligation to tell the buyer if there are any problematic areas or hidden liabilities in the business. The buyer buys the business as they find it; so it is imperative the buyer carries out a due diligence exercise to acquire as much information about the business as possible, before legally committing to buy.

The usual way to carry out the due diligence exercise, is by having a due diligence questionnaire sent to the seller which asks extensive questions on a number of areas about the business such as:

• Financial and accounting – details of the accounts (audited or unaudited); charges; and borrowing.
• Assets and contracts – what are the key assets and equipment? What are the material contracts with customers and suppliers?
• Company information – where you are buying the shares of a company you need to know: who the shareholders (or actual owners) are? What is the company’s structure? Has the target company got any subsidiaries or holding companies?
• Employment – employees; employment contract terms; salaries and bonuses; staff handbooks; grievances and disputes; and pension schemes.
• Litigation and regulatory – are there any disputes the company is involved in (or reasonably anticipates)?
• Property – details of any properties owned, leased or otherwise occupied by the business.

The seller will give their answer to each question raised and also disclose to the buyer a number of documents in connection with those answers, for example the seller is usually asked to disclose: all contracts that the business is a party to; property deeds; and the last three years of accounts. The buyer’s solicitors will then collect those documents, review them and report to the buyer.

Depending on what is being bought, input may be needed from various other advisors. If property or employees will be acquired, then specialist advice should be sought from property lawyers and employment lawyers, respectively. If the buyer wants to confirm the accounts are accurate (which is strongly advised) the buyer should ask its accountant to review the accounts and carry out a financial due diligence exercise.

If the buyer does find out information from the due diligence exercise that is negative, for example perhaps the company is stuck in an expensive legal claim, the buyer has a number of options: they can re-negotiate the purchase price; include certain protections in the sale agreement, such as warranties and/or indemnities; or if the issue is particularly concerning to the buyer, they can walk away from the deal.

This is a brief summary of the points that should be considered whether you are buying or selling a business.

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Please note the contents of this blog are given for information only and must not be relied upon. Legal advice should always be sought in relation to specific circumstances.