Due diligence (also referred to as legal due diligence, pre-acquisition due diligence, etc.) is an essential part of the transaction process. The objective of the party conducting the due diligence is to identify those issues that it considers material for its purposes. We deliberately use the term “party conducting the due diligence” because DD may be carried out by either the buyer or the seller (so-called vendor’s DD).
While the seller generally attempts to identify problematic situations in order to remedy them before the transaction process begins, thereby preparing the target company for sale and limiting the buyer’s ability to renegotiate the purchase price downwards, the buyer (naturally) conducts DD only after the transaction process has begun, usually after the parties have agreed on the key commercial matters of the transaction, or after signing a confidentiality agreement.
The buyer’s objective is to conduct DD before signing the acquisition documentation in order to
(i) assess the asset it is interested in acquiring,
(ii) have the opportunity to address the purchase price – its amount and method of payment,
(iii) propose a system of warranties for defects and address the seller’s liability,
(iv) obtain an overall picture of the condition of the target company / acquired asset (financial, legal, etc.).
In practice, due diligence is conducted in various areas – legal, financial, tax and technical – each of which has further subcategories. DD is conducted by legal advisers and tax advisers; in specific areas (e.g. environmental due diligence), experts in the relevant field may be engaged.
The practical performance of DD is now (one might say) almost identical in every case. The buyer’s legal advisers compile and submit a DD checklist / DD questionnaire to the seller (and the target company itself) – a list of documents and requests for information to be provided by the target company and the seller.
The seller (or, as the case may be, the target company) decides whether the DD will be conducted physically (which in practice means a large conference room full of binders containing documents) or virtually, through a VDR (virtual data room), an online space containing documents from the seller (or the target company), to which both parties’ advisers and the participating parties themselves generally have access, and which contains documents in electronic form. Ideally, documents in the VDR should be printable, as this makes the advisers’ work easier and reduces the time required for DD.
Access to both “spaces” is usually time-limited – so that the DD process has a closing date, which is also used in the transaction documents as an important point in time (more on this in a separate post), but also for practical reasons, so that DD does not take an unnecessarily long time, which could affect the fundamental parameters of the sale of the target company. The buyer sets a so-called materiality threshold for its advisers, i.e. the threshold of what it considers to be a material risk and the scope of the due diligence, so that the lawyers do not investigate matters that ultimately do not constitute a deal breaker or material risk for the buyer.
It is good practice for advisers to have the opportunity to ask management questions, either through virtual forms in the VDR or in person at a management meeting.
The results of the investigation process are set out in a due diligence report, the so-called Report: Full Report (describing the issues and proposing potential solutions), Red Flags Report (an abridged version containing the key issues, particularly according to the materiality threshold). Nowadays, the buyer’s management (the client) generally also requests the preparation of an Executive Summary, which is essentially a bullet-point summary of the main and most significant issues, so that it can become familiar with the status of the findings during the DD process itself; this summary subsequently forms part of the Report.
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