Why is carrying out a legal Due Diligence investigation necessary during an proposed acquisition?

Merging with or acquiring another company is a high-stakes endeavour. For any potential buyer looking to acquire a business entity, either by a share or asset purchase, it is important to identify any potential risks and hidden liabilities that company might be carrying. To do so and depending on the size and sector the target is in, buyers will be advised early on that carrying out some level of due diligence in the financial/tax and legal areas, as well as undertake a preliminary commercial assessment of the target business, is crucial to mitigating risk and ensuring their investment is sound and if not, to consider appropriate protections or back out of the deal altogether. In this article we will delve into the purpose, process and understand some common areas of a legal due diligence investigation.

What is the purpose of Legal Due Diligence?

At its heart, legal due diligence is a comprehensive and systematic investigation into the legal health of the target company. The primary goal is to identify and assess potential risks and liabilities that could negatively impact the valuation or future operations of the company. It also helps the buyer focus on areas where it may need contractual protections put in place, for example, warranties and indemnities. It is also necessary to understand early on whether any consents or approvals are required from regulatory authorities (e.g., Competitive Markets Authority or a notification made under the National Security and Investments Act 2021), in order to proceed with the deal.

It is important to note legal due diligence will be more extensive on a share purchase as all liabilities will remain with the target once the buyer has acquired it. Legal due diligence will still be required on an asset purchase, predominantly focussing on the specific assets being acquired.

What is the process of Legal Due Diligence?

Due diligence as a whole, will not only be undertaken by legal advisors, but will also involve financial and commercial advisors’ involvement, to understand the target’s financial health and commercial viability as an investment prospect. All forms of due diligence will typically take place in tandem with the other, but some buyers may wish to hold off proceeding with certain areas to avoid incurring unnecessary professional fees, say for instance, the legals in order to focus on the financials or commercial viability of the company.

Desktop search

At the point the buyers instruct their solicitors to proceed with the due diligence exercise, the buyer’s lawyers will usually review all public records and information relating to the target business by doing a desktop search. A Companies House search for companies registered in England and Wales, will greatly assist with this step and it is free to access by the public. If there is a known property involved, then those property details can be requested from HM Land Registry for a small fee* and similarly details of any registered intellectual property, are also freely accessible. A quick Google search can also present information unavailable on governmental sites if the business or its directors have been in the news, for good or bad.

*£7.00 per each office copy entry at the time of writing, subject to change

Legal Due Diligence Questionnaire

Whilst desk top searches are easy to do, they present only a superficial layer of detail about the interested target company. What buyers are looking for is a holistic and well-rounded understanding of their targeted investment, so whilst desktop searches are being undertaken, the buyer’s lawyers will often prepare and circulate a detailed legal due diligence questionnaire (LDDQ) to the seller’s solicitors. This questionnaire will contain extensive questions on every element of the sale of the target, and tends to be quite lengthy, so it should be tailored to the particular business involved. The replies to these enquiries will form the buyer’s main source of information and a seller has very little to gain in giving evasive replies, and in the interest of the wider deal, should give full and frank replies to those enquiries.

Virtual Data Room

Any and all information and documentation arising out of the LDDQ replies will be provided by the seller or the seller’s advisers via a secure virtual data room (VDR). By doing so, the seller’s advisers will carefully consider what information should be made available or in the case of commercially sensitive information, what should be redacted and will provide access to the VDR only to a number of individuals (i.e., selected individuals of the buying entity (if a company), and their professional advisers). Whilst reviewing the contents of the VDR, where insufficient information has been provided, the buyer via their solicitors, will raise further additional enquiries of the seller.

Legal Report

It is common practice a legal report will be prepared by the buyer’s solicitors documenting their findings following undertaking their due diligence review. This report typically sets out legal concerns and detail risks to the buyers, using a traffic light approach, and then, depending on how severe the concern is, will suggest recommendations and contractual protections to proceed with the deal. This legal report is confidential and for the benefit of the buyer only and most reports will expressly confirm the same. It is also commonplace to see various drafts circulated by a buyer’s lawyer to their clients, during the course of the due diligence exercise, where updated information and advice (subsequently arising from the updated information) has been provided.

Examples of common areas of Legal Due Diligence investigation.

Corporate Information, constitutional documents, registers etc.

As mentioned above, a lot of useful information about the target company can be found by doing a search at Companies House. This service is free to use and easily accessible to the public. Some of the documents/information which can be found at Companies House are the target’s incorporation documents, Articles of Association (Articles), accounts, whether any charges over the company, and who the directors are. This is usually the first port of call for buyer’s solicitors undertaking their due diligence review. A company search is quite limited however and may only be reliable to the extent that information is correct as the onus is placed on the company and its directors, to file the correct information in compliance with the Companies Act 2006.

It is always sensible therefore to undertake checks and review of the company’s constitution (i.e., the Articles and or a shareholders agreement, if one is in place), to ensure the company has power to carry on the business and understand if there are any restrictions imposed on a sale or transfer of shares. For example, pre-emption provisions, obliging shareholders wishing to sell their shares to first offer those shares to existing members on a pro rata basis.

In a similar vein, buyer’s lawyers will almost always request to see full copies of the company’s statutory registers, which a company must retain and keep up-to-date as required by law. For example, a buyer’s lawyer would expect to see at the very least, the register of members, minute books, register of allotments, and register of transfers. For overseas companies, how those constitutional documents, corporate information or statutory books will look like, will vary country to country and it is advisable that local advice is that jurisdiction is sought.

Key contracts

One of the biggest advantages to a share acquisition is the lack of disruption caused to the company’s trade, given the contracts in place will typically remain unaffected by the acquisition, except where the change in ownership triggers a right relating to a change of control. This differs from an asset acquisition, as the benefit of existing contracts do not automatically pass to the buyer unless they are novated or assigned.

As part of the legal due diligence process, buyer’s lawyers will ask for full details and copies of fundamental contracts entered with the target company. Upon receipt, these are reviewed to see whether any require any consents, contain restrictions or if they are affected by the change of control provisions. It will also be necessary to investigate the contracts which are nearing the end of the term and depending on how vital they are to the business, seek a renewal with the third party. The process on how contracts are dealt with will also depend on whether it is a share sale or an asset sale.

Employees

From a buyer’s perspective, another key area of due diligence covers employment related matters. A buyer’s lawyer will request for a whole host of information relating to the businesses current employment team, including anonymised details of each employee, worker or consultant as well as full copies of their service contracts, confirmation of recent disputes, dismissals, and changes to terms and conditions. Of particular importance, where the buyer is looking to make major changes to the workforce (for example, a reorganisation of the business, redundancies etc.), depending on the situation, the target, seller or the buyer may be at risk of contractual claims from the affected employees, which will also need to be carefully considered.

Summary

The above are some of the core areas a buyer may wish to focus on, , along with intellectual property and real property matters, identifying charges/encumbrances over the company and what licences/consents/regulatory compliance is necessary. Depending on the type of business or objectives of the buyer, there may be additional focuses.

Understanding the company on a more holistic approach, will help buyers and their lawyers identify risks and liabilities, verify ownership of retained assets and also assists both the buyer and seller in making informed decisions and negotiate terms.

What might apply to some transactions, may not work for another so its vitally important you obtain the correct legal and financial advice before making any decision. At Clarkslegal, our specialists are well versed in advising on business sales or purchases, as well as owners of SMEs and owner-managed businesses. If you’re looking to purchase or sell your company, feel free to reach out to our corporate team and we would be happy to have an initial chat free of charge, to understand your requirements further.

Disclaimer – this article is provided for general information purposes only and does not constitute as legal or other professional advice, as it is not comprehensive, fitting for each circumstance and may not be up to date. Specific advice should always be sought in relation to any legal issue and Clarkslegal LLP does not accept any responsibility for any loss which may arise from reliance on any of the information contained on this site.