“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price” – Warren Buffett, Letter to Shareholders (1989)
It is very common that within the commercial and corporate world, we often hear peers or colleagues mention or brag about working on a huge “M&A” or extensive “DD” project. But what are these exactly?
An “M&A” stands for Mergers & Acquisitions. These include, Google and Android, Verizon and Vodafone, or Heinz and Kraft? How about Disney/Pixar and Marvel? If you require a more technical term, an M&A is a commonly used term that describes the consolidation of companies or assets through mergers, acquisitions, consolidations, tender offers, purchase of assets, and management acquisitions.
“DD” which stands for Due Diligence, is the process where the purchaser in an M&A, requests the disclosure of information by the seller so as to confirm its commercial case for buying the target company.
What aspects are usually covered in a Due Diligence?
There is no concrete work scope to any due diligence exercise, however, the common scope for any due diligence on a target company would include, but not limited to, the following areas:
- Business – normally undertaken by consulting firms;
- Financial – normally undertaken by Financial Institutions or Financial Advisors;
- Tax – normally undertaken by tax advisory firms or independent tax advisors; and
- Legal – normally undertaken by law firms.
The significance of having a wider work scope would allow the purchaser to adopt a clearer picture of the health of the target company. This would, in turn, allow the purchaser to consider the commerciality of the potential transaction before and whilst conducting negotiations.
How do law firms assist in Due Diligence?
A full-service law firm or corporate law firm will often coordinate due diligence for each of the purchaser and the seller.
The role of the law firm for the purchaser will generally be to help identify the scope of due diligence which may be prudent in the business acquisition, conduct due diligence (e.g. by conducting public searches and by reviewing documents provided during the course of DD), and to help the purchaser understand the implications of information found during the DD process.
For a law firm acting for the seller, they will help limit the seller’s liability for misrepresentation, whether in the purchase and sale agreement or in the disclosure letter and will help minimise the risk of the purchaser being able to refuse to close a deal on the basis of a misrepresentation.
Considerations for the Purchaser in Due Diligence
For the purchaser, a core concern in any business acquisition is whether the business and affairs of the target company are consistent with the purchaser’s expectations. A sensible purchaser will wish to (i) satisfy itself that it understands what it is buying before it completes a business acquisition, and (ii) negotiate contractual provisions, including representations and warranties (“Reps and Warranties”), to provide remedies against the seller in the event that the target company’s true state differs from their understanding.
Due diligence is the process where the purchaser requests the disclosure of information so as to confirm its commercial case for buying the target company.
Due diligence may help the purchaser in:
- valuing the target company;
- identifying and understanding the potential risks of the transaction and deciding how to best manage them; and
- deciding whether to proceed with the transaction at a set purchase price.
A prudent purchaser will use due diligence to consider whether to adjust the purchase price and to negotiate Reps and Warranties to provide recourse against the seller in the event that the target company turns out to be different from what the purchaser has agreed to buy.
Considerations for the Seller in Due Diligence
As mentioned above, a fundamental concern for a seller is whether the purchaser can and will successfully complete the intended transaction. This may, under some circumstances, include the question of whether the purchaser can satisfy the contractual agreement to pay the purchase price. However, a purchaser, may in certain circumstances, experience difficulty in meeting regulatory or third-party approvals required for the completion of the transaction.
Depending on the structure of the intended transaction, the seller may rely upon a substantial deposit on the purchase price provided by the purchaser to help alleviate this concern – so if the purchaser fails to pay the purchase price to complete the transaction, the seller will simply take the deposit and walk away from the transaction.
Areas for Due Diligence
During a due diligence exercise, there are a few key areas which are fundamental to any potential transaction, which include, but not limited to:
Legal compliance and licensing requirements
- Generally, these would include filings at the Companies Registry, tax filings, statutory obligations regarding employees and licensing requirements based on the nature of business of the target company (e.g., General Restaurant License for restaurants in HK).
Financial Due Diligence
- Financial due diligence aims to provide assurances as to the financial performance of the target company and to identify transactions which would or may affect the financial position of the target company, including, but not limited to, for example, long term commitments, guarantees, indemnities, other contingent liabilities, or the possibility of significant customers or suppliers ceasing relationships with the target company.
- A purchaser may wish to rely upon the audited financial statements of the target company as part of its due diligence exercise. A purchaser should consider appointing accountants specifically to report on the financial condition of the target company.
Civil and Criminal Litigation Searches
- Due diligence relating to the litigation history of the target company aim to ensure that the target company is not subject to litigation (civil or criminal).
Real Property: Land Searches
- Due diligence relating to property ownership may reveal not only the true ownership of real estate or the right to use particular real estate but also to verify the absence of significant encumbrances and liabilities attached to real estate, through an examination of the land register of the property in question.
Material Assets and Material Contracts
- Due diligence relating to title to assets and material contracts aim to confirm the extent to which the target company, in fact, owns and has access to the assets which are important to its business, including intellectual property, plants and equipment, copyright material etc.
Extent of Due Diligence in an M&A
Each purchaser will need to determine the extent of due diligence (especially the intended work scope) which it requires. There may be constraints on what due diligence the purchaser can conduct. For example, time or cost constraints are comment, which may limit the amount of due diligence which a purchaser is able to conduct.
This article is intended only to provide a summary of the subject covered. It does not purport to be comprehensive or to provide legal advice. No person should act in reliance on any statement contained in this publication without first obtaining specific professional advice.