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The importance of due diligence

By Andrea Smith

Franklins Solicitors

WHEN you decide to buy a business, the first thing that you need to do is evaluate what you are purchasing – both the good (assets) and the bad (liabilities).

The Due Diligence (DD) process is the pathway for you to:

* Obtain information about the company – is it a good deal or not?

* Get a feel for what conditions and warranties you need going forward;

* Assess the appropriate corporate structures (to acquire and for the target) and put those in place;

* Make sure all the regulatory or other consents are in hand (or made conditional) prior to the acquisition;

* Agree a price and a mechanism for adjustment if necessary.

Why should you undertake DD?

The primary purpose of the DD review is to obtain sufficient information about the target’s business to enable the buyer to decide whether the proposed acquisition represents a sound commercial investment. DD is effectively an audit of the target’s affairs – legal, business and financial. It is therefore a crucial bargaining tool for the buyer.

A DD enquiry should establish the following key information about the target business:

* Does the seller have good title to the shares in the target company (on a share purchase) or the assets being sold (on an asset purchase)?

* Are there any unstated or understated liabilities?

* Detailed information on the target business so that the buyer is in a better position to:

o Make a final decision on whether to proceed with the acquisition and, if so, at what price;

o Bargain with the seller;

o Plan the integration of the target business;

o Determine any consents that may be required for the transaction. For example, the consent of industry regulators, tax authorities, competition authorities, shareholders or important customers of the target. Where one of the main assets of the target is customer contracts, it will be imperative for the buyer to find out through due diligence whether there are any contractual prohibitions on transfer; and

o Determine whether any ancillary documents will be needed (for example, a transitional services agreement).

As well as answering these questions, the DD process should put the buyer in a better position to identify the steps necessary to take effective control of the target’s business.

Financial DD

As part of the DD process, the buyer may instruct accountants to prepare a report (the accountant’s report or long-form report) on the financial aspects of the target business.

This financial DD is not the equivalent of an audit, and accountant’s reports will usually make this clear. However, financial DD should focus on those areas of the target’s financial affairs that are material to the buyer’s decision, so that the buyer can assess the financial risks and opportunities of the deal and whether, given these risks and opportunities, the target business will fit well into the buyer’s strategy. Financial DD may also help quantify:

* Potential synergies;

* The best acquisition and financing structure;

* The impact of the acquisition on the buyer’s performance metrics. When the buyer’s accounting policies are more conservative than those followed in the target business, it may be necessary to make appropriate adjustments in order to measure the true impact.

How can Franklins help?

The scope of a DD investigation will depend on the value and the purpose of the acquisition. The extent of the investigation tends to be influenced by practical realities:

* How much time do you have?

* What resources are available?

* What is the overriding need to get the deal done?

* How transparent is the seller in terms of providing information?

* Do you have internal or third party resources to back up what the lawyers can find?

Franklins can help throughout – from agreeing the appropriate scope of the DD exercise through to data room protocols, document analysis and formal reporting. We have a whole range of specialist sector experience and can bring market expertise as well as legal advisors, which means we can offer a wrap-around service.

Only the buyer’s own personnel will be able to make effective judgements as to the commercial importance and potential risk brought to light by the DD process, but Franklins can make sure that this information is presented in an accessible and useful format and informs all subsequent negotiations.

For more information contact the Due Diligence team at or call 01908 660966 or 01604 828282.

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