The reasons and processes involved in a due diligence investigation
Article written by Zoë Wort (Barnard Inc.)
Whether you’re buying another company, selling off a division of your company or entering a new alliance, transactions have become increasingly multi-faceted. And, regardless of whether the deal is structured as an asset transaction, a stock transaction, or a merger, make sure you know what you are getting into by requiring detailed information from the seller regarding its business operations and finances. The detailed review of this information is known as a due diligence study – and is typically carried out individually by – or preferably in tandem with – commercial attorneys, intellectual property specialists, financial auditors, banks and reputation specialists.
What is a due diligence investigation?
Due diligence is a thorough investigation into the legal and financial affairs of the entity. And the question of how thorough and to what extent the investigation must be done depends on the purpose of the investigation and the nature of the business of the entity. For example, a study of an entity where a client merely wants to do business with that entity will be much more targeted on specific aspects such as liquidity, any pending or current litigation involving the business, and any general risks that might have an impact on the business relationship that it is being envisaged.
In contrast to a ‘due diligence lite’, in instances where, for example, a client intends on entering into a long term off-take agreement that relates to commodities, it would require the team to investigate health and safety, environmental and compliance to ensure that the entity will not be at risk of losing its right to sell the commodity. This approach would not necessarily be applicable to a transaction that involves software licenses – which may require a deep-dive into intellectual property rights and ‘work for hire’ agreements, for example.
An aspect such as general compliance is central to most due diligence studies as a client would not want to enter into an agreement that is unlawful or based on an illegal activity – this would immediately compromise the enforceability of any terms of the agreement.
In transactions that involve a merger or acquisition, the investigation will place focus on all identified affairs of the business as the parties will end up with the shared liability – depending on how the transactional agreements are drafted – and it is therefore important to understand all potential risks in order to exclude them or add certain measures in the transaction agreements to mitigate latent hazards.
Once the nature of the transaction is understood, a review checklist can be drawn up to specify the fields of investigation. Typical areas of study include the corporate structure; constitutional documents (MOI and shareholders agreements); share registers and certificates; human resources; litigation landscape; general corporate, fiduciary and statutory compliance; intellectual property rights; and material contracts and agreements.
Why does a due diligence matter?
It is easy to disclose certain risks in the process of finalising a transaction, but the extent, effects and repercussions of those risks are not always immediately evident. For example, an entity discloses a liability in the form of a loan, and upon investigation of this seemingly innocuous detail, the client learns that the loan is tied to a convertible preference share that is convertible in the event of default or on demand of the party in which favour the share is held – suddenly there is a risk that the client may end up with a shareholder of whom they were unaware. The same principle would apply in the event of a normal business transaction.
Once the client is made aware of the full extent and repercussions of the risks associated with the potential issues identified, these can then be mitigated in the transaction agreements.
When and how should a due diligence investigation be initiated?
It is best practice to seek advice on any material or substantial transaction, such as large contracts in the normal course of business, any new business venture that the client is considering, and in cases of a merger or acquisition.
All such processes are begun with a confidentiality undertaking, as the parties will be sharing confidential information with each other. It is also advisable that legal advice and assistance is procured as early as possible in the process. Many commercial law practices are equipped to coordinate the spectrum of due diligence subjects.