Beyond the balance sheet—M&A transactions and private company due diligence
Associate Olivia Bailhe delves into the crucial process of due diligence in corporate transactions, shedding light on the extensive research buyers conduct into a target company.
What is due diligence?
Due diligence in corporate transactions is the process of gathering important commercial, financial and legal information about a company. A buyer will want to carry out due diligence into the target company to inform negotiations, identify risk and assist with forward planning.
A formal due diligence exercise will normally involve solicitors conducting their own investigations into the target online and, more importantly, posing a series of enquiries to the seller in the form of a due diligence questionnaire.
Find out more information on how a seller can prepare their business for the due diligence process.
What information about a private company can be obtained online?
The first step a potential buyer can take to conduct research into a UK private limited company is to look it up on Companies House. This is free to access and contains a significant amount of publicly available information, including:
- incorporation documents and articles of association
- any accounts that have been filed annually
- information as to who the directors and people with significant control (PSCs) over the company are
- details of share capital
- security over the company’s assets
A review of online records will assist in verifying information provided by the seller and confirming that the seller has been keeping their online filing records up-to-date, but is not always definitive – which is why there will also be a number of queries in the due diligence questionnaire relating to the areas listed above.
Other online searches of publicly accessible information that can be carried out include:
- UK Intellectual Property Office – for details of any IP registered in the target company’s name such as patents or trademarks
- HM Land Registry – for details of any freehold or leasehold property ownership (and mortgages or charges over such property)
- UK Financial Conduct Authority Register – for details of any authorisations held (relevant where the target company operates a financial services business)
- HM Courts & Tribunals Public Search – for an insolvency search against the target company (and seller, if a company)
- A bankruptcy search against any individual sellers can also be carried out online at HM Land Registry
Some of these searches will require a nominal fee to be paid.
What is typically covered by due diligence enquiries?
Enquiries will be made as to the legal, financial, tax and commercial position of the target company. Typical topics covered in the legal due diligence include requests relating to share ownership and corporate structure, assets and real property, third party contracts and trading, IP ownership and rights, use of IT, employment, insurance, litigation and compliance with laws.
Typically the buyer’s solicitor will prepare a due diligence report for the buyer summarising the main outcomes from the due diligence process and highlighting any red flags.
What if something negative is discovered during due diligence?
If this is material, it may trigger renegotiation between the parties, potentially leading to a reduction in the purchase price. The outcome will depend on the facts of the situation and the buyer’s willingness to accept the associated risk.
There are other ways in which material issues can be addressed short of a straightforward price reduction. For example:
- including an indemnity in the share purchase agreement relating to the issue
- having a retention from the price, i.e. an amount is held back for an agreed period of time, and is paid out (or not) on agreed terms depending on whether the risk crystallises
- requiring the seller to take action to remedy the issue prior to completion at its cost – this is likely to be the best option if it is feasible in the circumstances
What happens next?
The buyer’s solicitor will usually produce the first draft of the share purchase agreement and within this, they will include a set of warranties, some of which may focus on specific issues that arose during the due diligence process.
Warranties are statements of fact made by the seller as to the state of the business and other matters relating to the target company. If such statements are later found to be untrue, the buyer may have a claim against the seller for breach of warranty.
Where a seller knows of information that makes a warranty untrue, they may provide a disclosure in a disclosure letter which will mean the buyer is considered to be aware of the disclosed information and can be prevented from bringing a claim (assuming the information has been properly disclosed).
As mentioned above, for significantly serious issues, the buyer may insist on an indemnity whereby the seller agrees to reimburse the buyer in respect of a specific future liability should it arise.
How might a buyer’s actual or deemed knowledge impact the claims it may pursue against the seller?
If a buyer was aware of facts, matters, or circumstances before signing the share purchase agreement that would contradict or lead to a breach of warranty when given, they may be prevented from successfully claiming a breach of warranty. This might be the case even where the matter was not explicitly disclosed by the seller during the disclosure process.
This remains a debated issue and as a result, a share purchase agreement would usually seek to specify whether the seller’s warranties will be qualified by the buyer’s actual or constructive knowledge.
The corporate and commercial team advises across a range of issues, including mergers and acquisitions, finance and corporate restructuring.
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