Due diligence refers to an investigation which is carried out before a substantial legal transaction. It is particularly important in a business acquisition. The investigation will aim to uncover any hidden liabilities or potential problems with the target business. Due diligence helps to improve the quality of information available to buyers which then contributes to informed decision making.
In a legal M&A context, due diligence will normally take place before a buyer invests in or acquires a business. The aim is to give the buyer a concise, well-focused report which is then used by the buyer to decide whether or not to proceed with the transaction. It can also be used as a negotiation tool should any underlying issues be identified that need to be addressed.
The buyer will be acquiring an entity along with its assets and liabilities; it is therefore important that the buyer seeks to identify what those assets and liabilities are and that the seller is able to transfer legal title to them. This allows for a smooth transaction with the risk of any problems materialising post-completion being reduced.
Why is due diligence important?
The due diligence process is the first step in the buyer seeking to protect itself from unknown liabilities which may exist within the target business. Due diligence may throw up potential problems and the buyer may be dissuaded from continuing with the transaction if the target company looks less desirable than first thought. Due diligence also helps to identify the most beneficial structure for the transaction.
The process can also give the buyer reason to negotiate; this could be a renegotiation of the purchase price or it could lead the buyer to request extra protection in the form of indemnities or warranties in the purchase agreement.
Spotting a potential issue during the due diligence process will allow the buyer to get it sorted before completion. If the issue is only discovered post-completion, then a claim against the seller for breach of warranty may be the only answer. But this is something the buyer will want to avoid as it will be both time consuming and costly, and there is no guarantee of any award.
