Of interest.

Due diligence: What to check before buying a company

The term “due diligence” is an established term within M&A (transactional) advisory that refers to the legal, economic, financial or technical review of a company that is subject to a transaction (often referred to as a target). The specifics of each transaction require an accurate, thorough and tailor-made due diligence, which increases the pressure on the involvement of competent advisors, who follow recent trends in the area of due diligence.

Why is it important to properly set the scope of due diligence?

Before buying a company, it is necessary to conduct a due diligence review. During this review the buyer often obtains the first comprehensive picture of the target company’s assets, debts, business partners and, in general, the legal situation of the target company in its entirety. Based on this information the buyer is able to make an informed assessment of the transaction risks, to estimate the value of the company and to make a qualified negotiation of the purchase price. Obtaining the right information about the company during due diligence is therefore extremely important for the buyer.

However, in order to obtain relevant information about the company, the buyer must first determine what information is substantial to him and adjust the scope of the due diligence accordingly. For time and financial reasons, the buyer cannot simply request all documents and information related to the company’s business. The preparation and collection of all such data would burden the seller considerably, and the buyer would also needlessly invest funds in the study of non-relevant information. Needless to say, this would generate significant personnel and financial costs on both sides. From the point of view of the timing of the transaction, submitting irrelevant documents and their subsequent study by the buyer would result in disproportionate prolongation of the transaction.

What should be reviewed in each due diligence?

A well-defined scope of due diligence, i.e. the volume and composition of documents and information requested from the seller or the target company itself, is a prerequisite for the buyer to be able to assess whether the intended transaction is feasible and economically meaningful.

It is not just a matter of checking whether the target company was properly established, and whether the seller owns the respective shares in the company. The non-feasibility of a transaction in the broader context also includes economic considerations, which can relate to much more subtle details. For example, in case the target company uses public sources of financing (subventions / subsidies), it is also necessary to examine the relevant terms and conditions of such financing in order to make sure the target company will not violate any such requirements as a result of the transaction. That can happen, for instance, in the case where completing the transaction and subsequent implementation of the target company in the buyer group results in loss of the status of small/ medium enterprise, which the company is obliged to maintain for a certain time. As a result, the target company could be obliged to refund the subsidy which could mean the loss of the economic reason to purchase the target company.

Another example where the execution of the transaction is often regulated are credit (loan) agreements. If the buyer finds out during the due diligence process that the target company uses external financing, it is necessary to examine the relevant loan agreements, including loan terms and conditions, in order to determine whether the change of ownership needs the bank’s prior consent. The banks are typically entitled to immediately accelerate the unpaid debt and claim its full repayment when the ownership structure of the target company is changed without the required prior consent. In addition, contractual penalties are not exceptional in these cases.

What should be further checked in due diligence?

The scope of due diligence will always depend on the nature of the target company, its business area, the timeframe in which the transaction is to be completed, and the costs that the buyer is willing to spend on these investigations. It is also almost exclusively the buyer who determines the amount of the information and documents to be examined. And it is only the buyer who will bear the consequences of an incorrectly chosen scope of due diligence.

The focus of the due diligence should correspond to the area in which the target company operates. For example, if the target company leases stock premises, the focus of the due diligence should be on the real estate, its proper acquisition and potential real estate financing. Furthermore, the buyer should not underestimate the lease agreements under which the company leases its property and the insurance contracts for the leased property. On the other hand, a buyer generally would not have to consider performing a local measurement of soil and groundwater pollution, which would be required in case of acquisition of a heavy industry company. When purchasing an IT company, the focus of the due diligence should be on reviewing license agreements and regulation of the copyright in employment contracts, etc.

What may be helpful?

A helpful guideline for the buyer for setting the extent of due diligence may be IBA Corporate and M&A Law Comittee Legal Due Diligence Guidelines released last year by the International Bar Association (hereinafter referred to as “Guidelines“). The Guidelines provide practical information on the important areas of due diligence, as well as tips on how to effectively organise due diligence and thus save the time and costs of all parties involved. The Guidelines provide mainly information for the buyer, whose interest in a properly performed due diligence is essential. However, the Guidelines also include several recommendations addressed to the seller, not just in connection with negotiation of a non-disclosure agreement.

In addition to the general rules, the Guidelines provide a list of specific information and documents that buyers should request from the seller during due diligence. The Guidelines outline the basic areas that should be examined (e.g. corporate, real estate, contracts, IP/IT, personal data protection, employment, competition). For each area, the Guidelines list the main documents and information that the buyer should examine in due diligence.

The aim of the Guidelines is to provide basic orientation in the due diligence process for the parties involved and help the buyer in setting the scope of due diligence. In addition, the importance of the Guidelines may strengthen in the future in case that they are considered as a reference framework, i.e. a sort of standard ruleset for performing the due diligence. In such a case, failure to comply with the standards set out in the Guidelines could burden the buyer with all negative consequences arising therefrom. It is also possible that the courts will take this non-binding document into account while deciding disputes stemming from the issues not regulated in the transaction documents.

Conclusion

The specifics of each M&A transaction require an accurate, thorough and tailor-made due diligence, which increases the pressure on the involvement of competent advisors, who follow recent trends in the area of due diligence.

Our law firm PEYTON legal is strongly focused on M&A transactions and regularly develops and updates the processes in this area. Our experienced lawyers have provided legal services in many significant transactions and have always been strong and reliable partners guiding not only buyers, but in many cases also sellers, through the entire transaction process. Please do not hesitate to contact us at any time if you would like to benefit from our experience as well.

 

Mgr. Martin Heinzel, attorney-at-law – heinzel@plegal.cz

JUDr. Tadeáš Petr, partner – petr@plegal.cz

www.peytonlegal.cz

 

13. 05. 2019

 

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