When looking to acquire a business, the general principle is that it is the buyer’s responsibility to investigate the company or assets that it wishes to purchase, rather than the onus being on the seller(s) to disclose any problems. Consequently, the starting point is that the buyer assumes the risk of there being unexpected liabilities of the target company or defects in the assets, or the seller’s title to them.
This article is part of a series that provides an overview of the processes and considerations involved when buying a business.
One of the ways in which a buyer can mitigate the risk it is assuming, is by thoroughly investigating the target and all aspects of its assets and operations before the acquisition takes place. This can highlight anything likely to emerge that could derail the target business or make the deal economically unattractive. This investigation is known as ‘due diligence’. The process usually kicks off once agreement in principle for the acquisition has been reached and heads of terms have been signed, but before negotiation of detailed legal documents begins – though it is likely to be ongoing while documents are being negotiated.
Due diligence typically includes financial, tax, commercial and legal due diligence, and may include more specialist technical due diligence depending on the nature of the business. The buyer’s legal advisers will submit a detailed questionnaire to the seller(s), via their legal team, requesting information and various confirmations regarding all aspects of the target business.
Legal due diligence usually covers the following areas, to a greater or lesser extent:
Incorporation and ownership of the target company
This includes reviewing its books and records to ensure they have been properly maintained; its filing history at Companies House; any capital transactions (eg share buybacks or reductions of capital, which may be void if defectively carried out); and identifying anything in its current articles of association that may affect the proposed acquisition. To read more about the importance of proper record-keeping, click here.
Banking and finance
Buyers should look at current arrangements, how they will be affected by the transaction and any steps that will need to be taken as a result.
Customer and supplier contracts
This includes reviewing key contracts to understand if they may be affected by a change of control of the target. In a business and asset sale context, it should be understood if they permit assignment by the seller, or if the counterparty may be entitled to renegotiate their terms, along with any other unusual or onerous provisions.
Intellectual property (IP)
Depending on the nature of the business, verifying that the target has the legal right to exploit any IP rights required for the continuation of the business and if any such rights, in particular, those created by (non-employee) founders or contractors, have been properly assigned to the target.
Information technology (IT) systems
IT systems used by the target, how they are used – including if they are shared – and the associated contractual commitments should be investigated.
Data protection (DP)
Given that infringement of DP legislation can result in substantial fines, assessing a target’s compliance with DP obligations, including its internal policies and procedures, is an increasing area of focus in due diligence.
Human resources and immigration
This means investigating compliance with relevant legal requirements relating to employment and employees having a legal right to work in the UK, understanding the target’s employment relations history and policies, any trade union recognition or collective bargaining, and any outstanding disputes or claims.
Employee incentives/share options
This involves evaluating any schemes to understand the effect of the proposed transaction on existing options. Our share incentives team finds many of the purportedly tax-favoured employee share incentive schemes that they review in due diligence fail to meet all of the qualifying criteria for having tax-favoured status. Consequently, this area needs to be carefully managed from an employee-relations point of view.
It is crucial to identify early on the type of pension scheme which current and any former target employees belong to, as it may be necessary to involve the Pensions Regulator, and this can have a significant impact on the timing (and cost) of the transaction. The due diligence will also consider compliance with the relevant legislation.
Liabilities to carry out environmental remediation work can take a long time to crystallise. The extent of any due diligence required will depend on the nature of the target’s operations and any premises it occupies. Adoption of sustainable working practices and environmental, social and governance reporting and compliance is becoming an area of increasing focus in due diligence. To read more about how ESG considerations can affect corporate transactions, click here.
The target’s ownership or right to use any premises it owns or occupies, considering termination or change of control provisions in any leases, along with any liabilities a target may have regarding any previously occupied property, should be investigated.
If there are any ongoing, or potential, disputes involving the target at an early stage, they could incur significant legal costs before the matter concludes.
Having a team of well-selected advisers with an understanding of the buyer’s rationale for making the acquisition and its future plans for the target business is a crucial part of risk-management, in turn helping to scope the due diligence appropriately and maximise value for the buyer.