Part 2: Due diligence – What is it? What do I need it for? What do I need to consider?
Structured and comprehensive preparation and planning of a transaction process is also essential for small and medium-sized enterprises (“SMEs”) (see also the opening article of this series here). Once those responsible have made the strategic decision to sell or acquire the company or a specific part of the company, i.e. have gone through the (i) planning and preparation phase, (ii) formed the team of advisors to be involved, (iii) developed a transaction concept, (iv) defined the responsibilities and (v) established contact with interested parties, the next step is to manage the upcoming phase of due diligence.
Due diligence – what exactly is it and why does it require all this effort?
The term “due diligence” comes (how could it be otherwise?!) from Anglo-American law and means “due care”. This is exactly what needs to be done when reviewing a company as a potential acquisition target. Or in the words of an esteemed colleague: “You wouldn’t think of buying a used car without at least checking whether the vehicle has at least four wheels, a steering wheel and an engine!”
Basically, due diligence is no different. As part of the due diligence process, the company or parts of the company to be acquired or sold are examined by the interested party/parties with regard to the key factors. As a rule, it is recommended that at least the triad of tax, financial and legal due diligence is adhered to and that an audit is carried out in these areas. However, this is not mandatory and it always depends on the actual circumstances of the individual case. The same applies to the scope and level of detail of the due diligence review. This ranges from a so-called “full-scope” due diligence to a “red-flag” due diligence limited to essential areas.
The legal framework of the due diligence and its significance for the seller and buyer is closely linked to the pre-contractual and contractual obligations and therefore requires an overall view of the various phases of the transaction process. Not least in view of the fact that the risks identified in the due diligence review have an impact on the subsequent contract drafting and negotiation phase or, in the worst-case scenario, can even lead to the transaction being terminated.
Leaving the worst-case scenario aside, the results of the due diligence review serve to better classify risks and regulate specific issues in the subsequent contract drafting and negotiation phase, in particular:
- the breach of pre-contractual (information) obligations and the associated question of the definition of fraudulent intent/intent on the part of the seller;
- the structure of the guarantees/exemptions agreed in the purchase contract;
- the structuring and negotiation of the purchase price;
- the classification and definition of the standard of liability/duty of care of the parties;
A structured process is essential!
Due diligence plays a central role in the transaction process. In addition to the correct (tax) legal structuring of the transaction, the company valuation for the purpose of determining the purchase price and the correct drafting of the purchase agreement, a professionally conducted due diligence review is the fourth pillar of a successful transaction. It cannot be emphasized often enough that comprehensive planning and a structured process are also essential here. The following (rough) steps can be used as an initial guide:
- Definition and coordination of the scope and areas of the upcoming due diligence review, e.g. using a checklist;
- Putting together a project team consisting of contact persons from the companies involved in the transaction as well as appropriate (specialist) advisors and defining responsibilities during the due diligence process;
- Preparation of the documents to be made available and the (usually virtual) data room for the due diligence review;
- Planning and structuring the Q&A process during the due diligence process. Scheduling of human resources of the aforementioned project teams to answer queries from interested parties during the Q&A process.
All this effort for SMEs too?
In view of the reduction of risks described above and the increase in the chances of a successful transaction (keyword: professional and structured handling of the transaction process vis-à-vis interested parties), a due diligence review should also be carried out for corporate transactions involving SMEs. The extent to which the aforementioned due diligence is then carried out depends on various factors, in particular the size of the company to be sold and the quality and content of any information provided in the preliminary discussions and otherwise.
The concerns of many SMEs that their companies will be scrutinized by “strangers”, sometimes even direct competitors, are taken into account by setting up the due diligence process accordingly and considering the issues of “confidentiality” and “data and competition protection” in the planning.
If, contrary to all previous recommendations, a medium-sized entrepreneur carries out a transaction without a due diligence review, this is not prohibited. However, they must then be aware that the acquirer will provide significantly more guarantees (in particular “hard” balance sheet and equity guarantees as well as guarantees with regard to future cash flows) as well as extensive indemnities (e.g. taxes).
Does this price justify the supposedly saved effort due to the omitted due diligence? – In the vast majority of cases, probably not!
Outlook
This series of articles provides small and medium-sized companies with an initial guide on how a transaction process can be structured and successfully mastered. To this end, the following articles will present the key topics in the context of an M&A transaction in a compact and practice-oriented manner. In the next article, we will continue with the main topic of “due diligence” and my colleague Sebastian Keilholz LL.M. will provide an overview of data protection due diligence, the importance of which has increased significantly in recent years.
Do you have questions about the typical challenges? Please feel free to contact us.
The author and your usual contacts will be happy to answer any questions you may have!
Christian Schon
schon@tigges.legal
+49 211 8687 284