Due Diligence in M&A Transactions
February 9, 2012 By Grata Law Firm
1. Introduction - The 'Due Diligence' in English means ensuring the due good faith. Due Diligence is a comprehensive study of the operating, financial and legal activities of a company and the totality of relations within the company and its interaction with the environment where it operates. Such study can form an objective view on the company.
The objective thereof is the appraisal of possible business financial or legal risks, as well as reduction or avoidance of such risks. Due Diligence is aimed at the comprehensive check of the validity and business attractiveness of a proposed transaction or investment project. In the course of Due Diligence there is penetrating understanding of financial statements of a company and extensive legal evaluation of all documents of the company.
In the course of Due Diligence the following risks may be revealed:
- risk of the overvalued acquisition of a company (block of shares);
- risk of initiation of litigations and adverse effects thereof;
- risk of the property seizure or application of other injunctions;
- risk of a transaction invalidation;
- risk of bringing to the tax, administrative or criminal liability;
- risk of the IP forfeiture (trade mark, industrial design, invention, know-how, selling idea, business plan, etc.);
- risk of non-obtaining or loss of the relevant permits, licenses, approvals etc. that affect the company's activities.
There are various grounds for performing Due Diligence, for instance:
- sale/purchase of a company;
- evaluation of investment attractiveness of a company;
- IPO;
- M&A;
- establishment of a joint venture;
- commercial lending;
- check of the counter-party's reliability;
- acquisition and lease of large assets.
By making the company's activities clear a company can attract potential investors since they may see that the company is ready to an open dialogue. Therefore, to attract potential investors, in addition to the above, in recent years more and more companies are willing subject themselves to the Due Diligence (so-called vendor due diligence). In addition, an investment seller is interested in the maximum selling price. To that effect, legal analysis may also be initiated before it will be performed by a buyer, in order to identify and correct any violations, if possible. As a result, by the start of negotiations the buyer will have more information about the company, which may lead to an increase in its value.
At present, one of the most popular aims of the Due Diligence is the preparation to M&A transactions. This article, specifically, considers the legal Due Diligence for M&A transactions.
2. Due Diligence within the framework of M&A transactions
Due Diligence performed within the frameworks of M&A transactions is an important preparatory stage of a proposed transaction since it may be considered as the check of compliance of the company's actual status with the earlier declared, as well as the identification of negative effects, which an acquiring party may further face. In case of neglecting this stage, the risk of losses may increase.
Due Diligence is aimed at the confirmation or denial of the information received with respect to the target-company. This, however, do not mean the distrust to a partner, but it is important for each party to enter into the transaction on advantageous terms. A seller has to disclose to a buyer all information on its business, including possible risks, before any audits and checks - at the stage of negotiations. In practice, the subjects of M&A transactions are very rarely free of risks, so the seller should not conceal the information on such risks from a potential buyer. If the Due Diligence results in revealing negative facts, then the buyer gets strong arguments for reducing the purchase price.
The Due Diligence procedure engages qualified experts in the area of finance and law. Depending on the specific nature of a company, engineers, environmental experts and other specialists may also be involved. The more qualified a team that performs the Due Diligence, the more complete and accurate the report reflecting all possible risks, and the fewer problems in future.
Duration of the Due Diligence may vary from some weeks up to several months depending on:
- size and structure of a company;
- access options to the documents and information;
- materiality of proposed due diligence;
- audited period and level of details;
- cost that the buyer wishes to bear.
Prior to the Due Diligence it is required to define the most important area for the check. Moreover, in order to increase the effectiveness of the study, it is necessary to prepare the list of required information.
During the Due Diligence, the focus should be made on the following issues:
- whether all legal requirements have been met in registering the company;
- liability of the company with respect to the existent obligations;
- availability of the rights to immovable property;
- availability of licenses and permits;
- structure of the company;
- observance by the company of labor and environmental laws;
- existence of disputes and disagreements with third parties, property seizures, involvement in legal proceedings.
The specific attention should be paid to the company establishment issues since a legal entity may be liquidated due to the gross violations of the law admitted when establishing the company, if such violations are incurable. In practice, the cases of such claims are not frequent since the concept of 'gross violation' and 'incurable nature' is just evaluating concept. For the purposes of Due Diligence any violation committed when establishing a company is normally considered as material, if it took place less than ten years before the due diligence. A number of detected violations, if consider those admitted when increasing the charter capital, etc., as a rule, is directly proportional to the duration of the company's history.
One more important part of the check is the inspection of commercial activities of a company with the analysis of business relations of the company and the whole contractual framework for compliance with laws and interests of the company, performance by the parties of contractual obligations, possible risks incurred from relations with counter-parties and creditors.
The closer attention should be paid to the study of claim-related activities of a company - study of debt collection possibilities, analysis of the current litigations with the definition of future prospects.
During the Due Diligence, a checking party may face different issues and difficulties associated with obtaining of documents and information about the company. One of the possible obstacles for the Due Diligence may be at best a lack of cooperation, and at worst - the obstacles from management or shareholders of the company, such as the failure to provide documents and information and referring to employees, who do not have required information.
To avoid this, the main issues of the Due Diligence should be discussed on the stage of negotiation between the buyer and seller, and it is better to be as a written agreement. Such agreement may specify terms of the Due Diligence, assistance of the manager of an audited company in ensuring full cooperation and access to internal company's information, as well as the procedure of access to documents.
When the Due Diligence is performed for the purpose of the subsequent purchase of a company, it may not be necessary to familiarize the company's management with the Due Diligence report, since the draft of a final Due Diligence report may reveal such issues, which can be further used in negotiations of the price or the contract. In other cases, when you need to obtain the confirmation from the audited company that the Due Diligence report is accurate with respect to the information contained, you may disclose all or a part of the report without disclosing the findings of the report.
The checks are often complicated by the fact that information about the upcoming sale of a business may serve for employees as a push to change the job. The dismissal of a key manager, who has full information about the business, may hamper the check.
Following the review results, the buyer may have different opinions on the value of the reviewed object, and, therefore, there may be three basic options. Optimistic option: initial assumptions of the buyer have been substantiated, and it makes a deal. Pessimistic option: there have been material problems identified, such as significant legal risks, and the transaction regarding the purchase is in question. In practice, the most common is third option, when Due Diligence reveals some problems such as tax risks, additional liabilities, etc. In this case, the transaction price may be changed, the cost of the buyer to remove these risks may be compensated for by the seller, or the risks may be removed by the seller prior to the transaction.
In practice, there are rare cases when after the Due Diligence the transaction price is considerably changed. In case of identification of any significant violations or the risks, in most cases the transaction is cancelled.
The seller usually tries to embellish its business. Examination of the company's business allows meeting the expectations of both parties, eliminating the imbalance between the quality and content of the information available.
3. Conclusion
Summarizing, it could be said that the Due Diligence results to the fact that a potential investor will be able to get absolutely all necessary information about the company it is going to invest to. Objectivity and reliability of the information brought to its attention allows an investor to take an independent and best decision, while the lack of Due Diligence may cause poor financial results after the change of owner, lawsuits, tax and financial audits and other more unpleasant consequences.
The Due Diligence is an effective tool to form an objective view about the investment object, which includes investment risks, independent assessment of the the investment object and other factors. The completeness of the information provided in this form of checking as well as the qualification of experts conducting the Due Diligence allows investors or business partners more deeply evaluating advantages and disadvantages of the cooperation. In this respect, it is particularly important to engage professionals with deep industry knowledge and skills to perform a comprehensive examination.
AUTHOR: Dina Daumova, Lawyer (Almaty), GRATA Law Firm
Copyright Grata Law Firm
More information about Grata Law Firm
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
In the course of Due Diligence the following risks may be revealed:
- risk of the overvalued acquisition of a company (block of shares);
- risk of initiation of litigations and adverse effects thereof;
- risk of the property seizure or application of other injunctions;
- risk of a transaction invalidation;
- risk of bringing to the tax, administrative or criminal liability;
- risk of the IP forfeiture (trade mark, industrial design, invention, know-how, selling idea, business plan, etc.);
- risk of non-obtaining or loss of the relevant permits, licenses, approvals etc. that affect the company's activities.
There are various grounds for performing Due Diligence, for instance:
- sale/purchase of a company;
- evaluation of investment attractiveness of a company;
- IPO;
- M&A;
- establishment of a joint venture;
- commercial lending;
- check of the counter-party's reliability;
- acquisition and lease of large assets.
By making the company's activities clear a company can attract potential investors since they may see that the company is ready to an open dialogue. Therefore, to attract potential investors, in addition to the above, in recent years more and more companies are willing subject themselves to the Due Diligence (so-called vendor due diligence). In addition, an investment seller is interested in the maximum selling price. To that effect, legal analysis may also be initiated before it will be performed by a buyer, in order to identify and correct any violations, if possible. As a result, by the start of negotiations the buyer will have more information about the company, which may lead to an increase in its value.
At present, one of the most popular aims of the Due Diligence is the preparation to M&A transactions. This article, specifically, considers the legal Due Diligence for M&A transactions.
2. Due Diligence within the framework of M&A transactions
Due Diligence performed within the frameworks of M&A transactions is an important preparatory stage of a proposed transaction since it may be considered as the check of compliance of the company's actual status with the earlier declared, as well as the identification of negative effects, which an acquiring party may further face. In case of neglecting this stage, the risk of losses may increase.
Due Diligence is aimed at the confirmation or denial of the information received with respect to the target-company. This, however, do not mean the distrust to a partner, but it is important for each party to enter into the transaction on advantageous terms. A seller has to disclose to a buyer all information on its business, including possible risks, before any audits and checks - at the stage of negotiations. In practice, the subjects of M&A transactions are very rarely free of risks, so the seller should not conceal the information on such risks from a potential buyer. If the Due Diligence results in revealing negative facts, then the buyer gets strong arguments for reducing the purchase price.
The Due Diligence procedure engages qualified experts in the area of finance and law. Depending on the specific nature of a company, engineers, environmental experts and other specialists may also be involved. The more qualified a team that performs the Due Diligence, the more complete and accurate the report reflecting all possible risks, and the fewer problems in future.
Duration of the Due Diligence may vary from some weeks up to several months depending on:
- size and structure of a company;
- access options to the documents and information;
- materiality of proposed due diligence;
- audited period and level of details;
- cost that the buyer wishes to bear.
Prior to the Due Diligence it is required to define the most important area for the check. Moreover, in order to increase the effectiveness of the study, it is necessary to prepare the list of required information.
During the Due Diligence, the focus should be made on the following issues:
- whether all legal requirements have been met in registering the company;
- liability of the company with respect to the existent obligations;
- availability of the rights to immovable property;
- availability of licenses and permits;
- structure of the company;
- observance by the company of labor and environmental laws;
- existence of disputes and disagreements with third parties, property seizures, involvement in legal proceedings.
The specific attention should be paid to the company establishment issues since a legal entity may be liquidated due to the gross violations of the law admitted when establishing the company, if such violations are incurable. In practice, the cases of such claims are not frequent since the concept of 'gross violation' and 'incurable nature' is just evaluating concept. For the purposes of Due Diligence any violation committed when establishing a company is normally considered as material, if it took place less than ten years before the due diligence. A number of detected violations, if consider those admitted when increasing the charter capital, etc., as a rule, is directly proportional to the duration of the company's history.
One more important part of the check is the inspection of commercial activities of a company with the analysis of business relations of the company and the whole contractual framework for compliance with laws and interests of the company, performance by the parties of contractual obligations, possible risks incurred from relations with counter-parties and creditors.
The closer attention should be paid to the study of claim-related activities of a company - study of debt collection possibilities, analysis of the current litigations with the definition of future prospects.
During the Due Diligence, a checking party may face different issues and difficulties associated with obtaining of documents and information about the company. One of the possible obstacles for the Due Diligence may be at best a lack of cooperation, and at worst - the obstacles from management or shareholders of the company, such as the failure to provide documents and information and referring to employees, who do not have required information.
To avoid this, the main issues of the Due Diligence should be discussed on the stage of negotiation between the buyer and seller, and it is better to be as a written agreement. Such agreement may specify terms of the Due Diligence, assistance of the manager of an audited company in ensuring full cooperation and access to internal company's information, as well as the procedure of access to documents.
When the Due Diligence is performed for the purpose of the subsequent purchase of a company, it may not be necessary to familiarize the company's management with the Due Diligence report, since the draft of a final Due Diligence report may reveal such issues, which can be further used in negotiations of the price or the contract. In other cases, when you need to obtain the confirmation from the audited company that the Due Diligence report is accurate with respect to the information contained, you may disclose all or a part of the report without disclosing the findings of the report.
The checks are often complicated by the fact that information about the upcoming sale of a business may serve for employees as a push to change the job. The dismissal of a key manager, who has full information about the business, may hamper the check.
Following the review results, the buyer may have different opinions on the value of the reviewed object, and, therefore, there may be three basic options. Optimistic option: initial assumptions of the buyer have been substantiated, and it makes a deal. Pessimistic option: there have been material problems identified, such as significant legal risks, and the transaction regarding the purchase is in question. In practice, the most common is third option, when Due Diligence reveals some problems such as tax risks, additional liabilities, etc. In this case, the transaction price may be changed, the cost of the buyer to remove these risks may be compensated for by the seller, or the risks may be removed by the seller prior to the transaction.
In practice, there are rare cases when after the Due Diligence the transaction price is considerably changed. In case of identification of any significant violations or the risks, in most cases the transaction is cancelled.
The seller usually tries to embellish its business. Examination of the company's business allows meeting the expectations of both parties, eliminating the imbalance between the quality and content of the information available.
3. Conclusion
Summarizing, it could be said that the Due Diligence results to the fact that a potential investor will be able to get absolutely all necessary information about the company it is going to invest to. Objectivity and reliability of the information brought to its attention allows an investor to take an independent and best decision, while the lack of Due Diligence may cause poor financial results after the change of owner, lawsuits, tax and financial audits and other more unpleasant consequences.
The Due Diligence is an effective tool to form an objective view about the investment object, which includes investment risks, independent assessment of the the investment object and other factors. The completeness of the information provided in this form of checking as well as the qualification of experts conducting the Due Diligence allows investors or business partners more deeply evaluating advantages and disadvantages of the cooperation. In this respect, it is particularly important to engage professionals with deep industry knowledge and skills to perform a comprehensive examination.
AUTHOR: Dina Daumova, Lawyer (Almaty), GRATA Law Firm
Copyright Grata Law Firm
More information about Grata Law Firm
View all articles published by Grata Law Firm
Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.
