Due Diligence Process
Legal Due Diligence Process
An agreement in principle or “memorandum of understanding / MOU” document may be entered once the commercial terms are agreed. It is usually legally binding only in relation to the mechanics of the due diligence process, confidentiality, and other collateral issues.
The buyer will wish to undertake a legal, financial, taxation and property due diligence in relation to the company in order to verify its value and the buyer’s expectations.
Where the buyer is already familiar with the company, much of the due diligence may be by way of verification. Where it is less familiar with the company, a more thorough due diligence may be required.
The due diligence is usually undertaken in parallel with the negotiation and conclusion of the share purchase agreement. Matters arising in due diligence will inform the content of the agreement and the negotiation of its terms. Indemnities may be required on specific issues arising in due diligence.
The buyer may prefer to postpone the preparation of the draft documents until it is satisfied that the issues arising from due diligence will be addressed in the documentation in a satisfactory manner. Ideally, the legal due diligence should be completed before the share purchase agreement is issued to the seller’s solicitor. This is not usually possible.
During the due diligence process, the disclosure letter is will be drafted and be the subject of comment. The parties may agree that issues outstanding in the due diligence process may be addressed in the disclosure letter.
Timetable
The party should prepare a timetable setting a period for the initial due diligence, the issue of the draft share purchase agreement and other draft documents, the responsibility for their preparation, timelines for comments and replies etc. Such timetables are unlikely to be legally binding but reflect the parties’ expectations.
The legal due diligence timetable may be delayed due to unexpected issues or inefficiencies. A revised timetable should be prepared and agreed.
The resolution of issues and matters in the course of due diligence may require meetings in order to settle disputed matters and issues of concern.
A seller should seek to furnish such relevant information as it has to hand in relation to significant issues as early as possible, rather than waiting to reply to enquiries. On the other hand, an overload of unstructured information is not desirable.
The initial phase of legal due diligence may commence by the issue of a legal due diligence questionnaire furnished by the buyer to the seller for a response. The buyer may obtain basic corporate information in the Companies Registration Office. Other information may be available for property and intellectual property registers in relation to basic compliance and enforcement matters.
Initial Due Diligence and Timetable
Commonly, the buyer’s solicitor will undertake an initial investigation of the target company before drafting the share purchase agreement. A pre-contract enquiries questionnaire will typically issue which seeks a wide range of information relevant to the company, including, in particular, its financial indebtedness, accounts, basic corporate information about officers, shareholders, shareholdings, capital structure, financial arrangements, intergroup debt and the group structure.
A proposed timetable for the acquisition and arrangement should be set. A checklist should be prepared, listing the responsibility of the respective party’s representatives and advisers to produce, review and complete the required documentation.
CRO Searches
The buyer’s initial searches will include at a minimum, an up-to-date Companies Registration Office (CRO) search, including a search of the basic register and key documents. It should include the latest annual returns, returns relevant to shareholdings and share classes, particulars of directors and other appointments.
The current status of the company should be verified, including in particular that the company is “normal” and not at risk of strike off and needless to say, is not subject to winding up, receivership or another adverse status.
The CRO online search should be capable of confirming and verifying
- the relevant authorised and issued share capital;
- particulars of the directors and secretary;
- interests in shares and certain loans;
- particulars of registered office;
- latest (and earlier) filed financial statements (maybe abridged);
- shareholding and share movements.
Other Searches
Appropriate searches may also be made in respect of the company’s property, in property and intellectual property registers. In addition to Registry of Deeds or Land Registry searches, other information in relation to the real property assets should be sought through planning authority and building regulations searches, which should verify the absence or presence of particular planning applications, decisions, enforcement or other material matters relevant to the property.
In the case of intellectual property, registered trademarks, patents and industrial designs, can be verified in the public registers. The relevant class of registration can be confirmed.
The registration of pensions with the Revenue Commissioners and the Pensions Authority can be confirmed.
A judgments office search can corroborate basic information regarding the credit status of the company. Judgments searches will show registered money judgments. A number of private organisations publish particulars of money judgments that have not been formally registered as judgments as such. They will give some indication of creditworthiness and solvency issues. However, such issues would be better vouched from accounts and access to relevant credit registers, to which access can be had by the company with its consent.
Legal Due Diligence Questionnaire
There are a number of commonly used forms of legal due diligence questionnaires. It is prepared and issued by the buyer’s solicitor and submitted to the seller’s solicitor. The seller’s solicitor should liaise with the seller and take the necessary instructions required to complete the responses to the questionnaire.
The responses to due diligence questions may require further and repeated follow up. The seller may seek to give minimal or evasive answers in which event, the buyer should consider its requirements. If the matter is important, further or repeated questions are required
Particular responses may require further clarification and investigation. In particular, if serious risks or issues arise, detailed consideration and review are necessary. If the risk is minor or trivial, the matter may not be pursued.
Commonly Sought Information
The buyer’s solicitor may have its own preferred form of a questionnaire. Typically, the questionnaire seeks a broad range of information relating to the company including
- Corporate particulars; including name, number, capital, shareholders, group companies, group structure.
- Commercial particulars including particulars of its activities, terms, and conditions of business, supply agreements, key customers, products, material contracts, agency distribution, marketing, manufacturing, license agreements.
- Particulars of properties including leases, surveyor’s reports, statutory notices, charges, mortgages.
- Licences, permits and consents relating to environmental audits, notices, impact studies, assessments.
- Particulars of employees including their details and particulars, contracts, written terms, collective agreements, health and safety policies, disciplinary rules and procedures, policies and handbook etc.
- Pension Schemes including particulars of the scheme, documentation, pension trusts, pension rules, announcements, booklets etc.
- Particulars of litigation or arbitration pending or threatened in respect of the company or particulars of circumstances that may give rise to the same.
- Particulars of intellectual property including registered patents, copyright designs, licences and trademarks, particulars of registration of trademarks and patterns, and particulars of licences and other terms of use of another’s intellectual property.
- Agreements and arrangements which may have implications under competition legislation.
- Copies of insurance policies; premises, employee liability, public liability with particulars of premiums, claims history, risks, coverage denials, risk management reports, circumstances which may lead to a claim.
- Particulars of movable assets, plant equipment, motor vehicles, machinery with details of ownership, leasing and hire purchase.
- Audited financial statements for the current and previous year, management accounts, details of accounting policy, particulars of financial transactions since last audited accounts, details of loans, financial assistance, mortgages, guarantee, and facilities.
Consents
Legal due diligence should ascertain whether consents are required for the sale. Development agencies may have paid grants which may be repayable on the sale of the company. Funding from these agencies may continue in place only with the consent of the agency.
Similar considerations arise in relation to bank finance. If facilities are to be left in place, the consent of the bank is almost always required. A change of control of the business will almost always be an event of default under finance agreement such that funding facilities may be immediately demanded.
Data Rooms
A data room may be made available by the seller. Historically, a room was commonly provided in the seller’s lawyer’s offices containing the information and documentation relevant to legal due diligence. Within the last decade, the data room is commonly made available online. Documents are scanned and organised in an electronic “data room” to which access is afforded by designated representatives of the prospective buyers and persons within its legal advisor firm.
Data rooms are most used in particular where there are a number of prospective interested parties. In some cases, in an auction process, it may be used in a process leading to a preferred bidder from the seller’s perspective. The provision of a physical online data room provides advantages in bringing focus to the due diligence and prevents multiple queries. It gives the seller greater control of the process
The bidders or interested parties may have a limited time only in the physical data room. This is less of an issue with an online data room.
Where there are a number of prospective bidders, a bidder may undertake a limited due diligence on the basis of what is provided. It will pursue a more detailed due diligence if it becomes a preferred bidder, prior to a binding contract.
Information within the data room should be organised logically. It should be indexed and listed with reference to the subject matter of the material.
Delay in Completion of Process
If due diligence is not completed by the time the share purchase agreement is expected to be signed, questions may arise as to whether the delay is the fault of one party or the other. If there has been a failure on the part of the seller to provide adequate information, it would be unreasonable to expect the buyer to sign the agreement without having completed due diligence to its satisfaction. In these circumstances, entering into the share purchase agreement may be postponed.
A share purchase agreement may be signed subject to a condition that the buyer will be satisfied with particular due diligence matters or with due diligence generally. It is preferable from the buyer’s perspective that the agreement not be signed as significant issues may arise. Practical issues may arise in asserting and enforcing a conditional agreement. Where matters must be material or significant, there is significant scope for disagreement between the parties.
Due Diligence Report
The buyer may require its legal advisors to prepare a formal report of their findings in the due diligence process by way of a legal due diligence report. It may be a detailed summary of all documentation with a specialist review or more commonly may be a high-level summary, highlighting important issues.
The buyer’s legal advisor’s firm will usually seek to limit its liability to the buyer. It may provide that no other party can rely on its contents.
The due diligence is likely to be more meaningful and more cost-effective if it is limited to a summary of the material and the principal issues arising in the due diligence process. The due diligence agreement may highlight a list of material issues that require consideration by the buyer or have to be addressed in the share purchase agreement and/or negotiations.
Where the due diligence process is ongoing over a period the buyer may require an intermim legal due diligence report. The report may be in a draft form pending completion of the due diligence process. It may be issued in that form before completion of the full process. It may set out areas and matters on which satisfactory replies are outstanding.
In place of a formal due diligence report, the buyer’s advisors may prepare a list of material issues relating to the target company. This is less structured and is likely to be less costly. A structured report may be required for a larger organsation, which requires review by several parties.
Format
The form of a due diligence report will follow the particular requirements of the circumstances. It may broadly follow the buyer’s, legal firm’s template. It may set out the due diligence undertaken, the methodology. It should refer to enquiries and responses, with relevant details of follow up and further responses, the legal due diligence will seek to segregate its scope from financial accounting and taxation due diligence.
The due diligence report usually contains an executive summary setting out the material issues which have been identified. Where multiple parties have been involved in preparing the document, an editorial may be required so as to identify the relative importance of issues.
The due diligence report may deal with a number of different topics and issues including, for example, corporate employee’s litigation, contracts, insurance, litigation, environmental properties, pensions and financial accounts. It may follow the scope of the legal due diligence questionnaire. It may incorporate the questionnaire and replies.
The report may attach a list of the documents which have been reviewed. In some cases, copies of important documents may be attached or exhibited in the report. They must be clearly referenced and identified.