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Due Diligence
When a decision is made to purchase or sell a company, an audit must be conducted. If such an audit relates to the acquisition or merger of a company (or part thereof), it is referred to as due diligence. The meaning of due diligence is literally ‘appropriate care’.
What is due diligence?
What exactly is due diligence? Although due diligence refers to an audit, it encompasses more than that. A due diligence investigation also focuses on the legal, financial, tax, and commercial aspects of a company. This means that the investigation goes beyond simply examining the financial ins and outs of a company. The extent of a due diligence investigation will often depend on the type of company being purchased and the financial importance of the transaction.
Who conducts a due diligence investigation
In the case of mergers and acquisitions, due diligence is generally initiated by a buyer. However, this is not necessarily the case. A seller can also conduct due diligence (known as ‘vendor due diligence’). Vendor due diligence occurs in situations where the seller is actively offering itself or a part of itself for sale. A ready-made due diligence report can help to attract the interest of potential buyers.
Due diligence investigations are not only carried out in the case of acquisitions, but sometimes also in relation to customers in order to properly assess the risks of a collaboration in advance. Such an investigation is called customer due diligence.
Letter of intent phase
The seller often only agrees to a due diligence investigation when the parties are in the letter of intent (memorandum of understanding) phase, after the buyer has already made a conditional takeover bid (non-binding offer) or after the parties have signed a non-disclosure agreement. During the investigation, the seller is expected to provide highly confidential information. The seller will want to have this information secured.
To give an idea of what such a due diligence process entails in practice and what investigations are possible, a brief explanation of what a due diligence investigation involves will follow below. This applies to both the buyer and the seller of a company.
Why is due diligence important?
Conducting a due diligence investigation is particularly important for buyers. In order to make a good decision and a safe investment, it is essential that all important information from the selling party is available. This allows the buyer to check whether the information presented is actually correct. The audit is therefore not only a mandatory part of the purchase process, but also an indispensable step in preventing unpleasant surprises. The outcome of the due diligence investigation may influence the agreed acquisition price.
The investigation may reveal the following dangers, risks, and developments, among others:
- Excessive accounts receivable balance
- Incomplete accounting of liabilities
- Lagging margins
- Loss of important customers
- Adjustments to the cost structure
- Termination provisions in important contracts
Forms of due diligence
There are different types of due diligence investigations. The best-known form is the book review in the event of an acquisition. Due diligence in a company acquisition focuses on the financial, fiscal, and commercial aspects and the possible presence and scope of intellectual property. Another example of due diligence is due diligence in real estate, whereby the real estate that may be purchased is examined with due care. Both the buyer and seller can have this investigation carried out in the event of a company acquisition. The third form is legal due diligence. Here, a lawyer investigates legal matters such as legal disputes, contracts, personnel, and any licenses and patents.
Seller due diligence
The most common form of due diligence is a book review, which is carried out by or on behalf of the buyer of a company or part of a company. The buyer’s management is also obliged to do this. A takeover without any investigation can lead to director liability.
The buyer is therefore obliged to conduct an investigation when making an important investment decision. The board cannot simply assume that the seller has provided accurate and complete information. Quite the contrary. A due diligence investigation is therefore essential. Essential for internal decision-making and accountability.
Conducting a due diligence investigation brings all useful information to light, verifies the information presented by the seller, identifies the risks and opportunities, and allows this information to be used as a basis for negotiations.
If the due diligence investigation leads to a decision to acquire the company, the purchase agreement will also refer to the due diligence investigations. The guarantees and indemnities that a seller must provide in the event of a sale are tailored to the results of the due diligence investigation.
Seller due diligence
In addition to the buyer’s obligation to conduct thorough research before deciding to make an acquisition, the seller has an obligation to provide information. This is also referred to as the seller’s duty of disclosure. The seller is obliged to provide the buyer with all known relevant information in the sales process. A vendor due diligence report can play an important role in this.
Instead of waiting until a buyer has been found and this buyer has conducted a due diligence investigation, the seller can have the due diligence investigation carried out in advance. In that situation, the seller is better prepared for the negotiations with potential buyers. For example, by conducting a book review, the selling party can obtain clarity about intellectual property, including its value and rights.
If a buyer is confronted with a vendor due diligence report, in practice a greatly simplified confirmatory due diligence investigation is often carried out. This involves a limited investigation to determine whether the vendor due diligence report is complete and whether all the opportunities and risks of an acquisition have been correctly assessed.
Customer due diligence
In addition to a due diligence investigation prompted by the sale of a company, the Money Laundering and Terrorist Financing (Prevention) Act (WWFT) also requires companies to investigate the customers with whom they do business. Such an investigation is also referred to as customer due diligence.
A customer due diligence investigation identifies the risks of doing business with a particular customer. The customer due diligence investigation also examines the customer’s corporate structure. This may include an investigation into the customer’s ownership structure. In some situations, the law also requires such an investigation into the underlying owners.
Due diligence in real estate
This investigation is carried out when purchasing (commercial) real estate and concerns aspects such as an environmental investigation, exploring the zoning plan, a structural investigation, or a legal investigation. Due diligence in real estate ensures that the value of the real estate can be determined in advance, identifies potential risks, and provides insight into stumbling blocks or dangers at an early stage.
The purpose of the due diligence investigation
The purpose of the investigation is to determine that the information provided and presented by the seller is accurate and complete. The information provided is used to identify the risks and opportunities for the purchasing party, which are essential for deciding whether the acquisition or merger will actually deliver the intended results.
That is why due diligence is carried out prior to the acquisition or merger, i.e., prior to the final decision-making and transaction. The importance of thorough due diligence is twofold. On the one hand, it is to investigate whether an acquisition will indeed bring the hoped-for benefits. The opportunities and risks of an acquisition are identified. On the other hand, it is to reach the right internal decision as to whether the investments are responsible.
For the buyer, a due diligence investigation therefore serves to find out more about the company to be acquired. The buyer will try to determine whether the company is worth the purchase price and what risks are associated with the proposed acquisition of the company.
Whereas the seller has a duty to provide information and disclose facts, the buyer has a duty to investigate. If the buyer fails to comply with this duty to investigate, this may have consequences for their options for recourse. If the buyer fails to comply with the duty to investigate, there is a risk that any damage cannot be recovered from the seller. This will particularly be the case if the buyer could have ascertained the facts causing the damage by means of a simple investigation. The buyer may therefore not blindly rely on the seller’s statements and will therefore have to investigate all matters that are important to him. The investigation must therefore be carried out in a professional manner.
When a due diligence investigation is carried out, all parties benefit. Both the buyer and the seller. The buyer because the risks and opportunities are clear, and the seller because they know what guarantees and indemnities can be given.
Reasons for conducting a due diligence investigation include:
- To assess the legal consequences. Know what is being purchased and what risks may arise in the event of an acquisition. Will the agreements between the acquired company and its customers and/or suppliers remain in place? Or can they be terminated?
- To prevent financial consequences. Is the purchase price representative of the acquired company or part thereof? What are the debts and claims of the company being acquired? What is the financial position of that company?
- For economic reasons. In the event of an acquisition or merger with another organization, it is important to identify the strengths and weaknesses of that organization and to verify the figures/information. Can synergy be achieved through the acquisition? And what are the commercial aspects? Can the range of services and products be expanded appropriately?
- To prevent corruption, money laundering, and bribery. In order to comply with local and international legislation, it may be necessary to carry out due diligence. Not only to prevent possible reputational damage, but also to avoid fines and sanctions.
Due diligence checklist for company acquisitions
There is a lot involved in conducting a due diligence investigation. As the purchasing party, it is important that all important aspects are identified before and during the sales process. To give you an insight into what a book review entails and which aspects should not be overlooked when making a major decision, we have compiled a short checklist for due diligence when acquiring a company.
Our lawyers will be happy to provide you with more information about the content of the audit, so that you can be sure that you have all the essential information you need to make the right decisions during a purchase or sale process. Below is an example of a due diligence questionnaire, which gives you, as the buyer, an idea of what information is necessary for an audit in the context of a company acquisition.
Due diligence checklist:
1. General company information
– Personal details of shareholders, the relationships between shareholders, and the current valuation of the shares
– Names of directors and key managers
– Overview of stock options, convertible loans, and other rights that offer the possibility of acquiring shares in the company
– Information about (potential) subsidiaries and (tax) relationships
– Articles of incorporation, company statutes, and extracts from the Chamber of Commerce
– Minutes of shareholders’ meetings and documentation relating to important decisions concerning the management of the company
2. Financial data
– Personal details of the auditor, accountant/payroll processor
– Annual accounts (up to three years back), the current balance sheet and the interim profit and loss account
– Tax returns (up to three years back)
– Depreciation schedule
– Overview of debt
– All debtors and creditors
3. Assets and property
– Overview of all personal assets owned and leased items
– Real estate
– Contracts and agreements
– Stock lists and inventory lists
– Overview of bank accounts
4. Legal proceedings
– Current or future lawsuits or legal matters and proceedings
– Claims
5. Personnel data
– Employees, both those with employment contracts and freelance workers
– Employment contracts and terms of employment
– Remuneration schemes
– Pension schemes
– Insurance
– Training
– Partner agreements
6. Intellectual property
– Intellectual property registered in the company’s name (+ reports)
– Patents and patent applications
– Trade names
– Copyrights and trademarks
– Non-competition clauses and confidentiality agreements
7. Sales and marketing
– Customer overview (up to five years back)
– Competitor analysis and overview
– Market research
– Licenses, permits, and approvals
– Marketing materials, sample invoices, price lists
– Advertising agreements
– Distribution agreements
– Terms and conditions
When is it wise to seek legal advice during a due diligence investigation?
It is wise to seek legal advice before the due diligence investigation begins, so that it is clear which risks and points of attention apply specifically to your situation. But this also helps to determine the scope of the investigation; does it concern an investigation into all parts of the company? Only certain parts? And how far back in time does the investigation extend? During the investigation itself, an expert can help assess aspects that often have a direct impact on the value of the company and your negotiating position. Even if you, as the seller, have a vendor due diligence investigation carried out, legal guidance will prevent you from unintentionally making too many commitments or disclosing sensitive information. The experienced lawyers at Fruytier Lawyers in business can assist you throughout the process from the outset. This prevents legal issues from coming to light only after the deal has been concluded.
Frequently asked questions about due diligence
- What is due diligence?
Due diligence is an audit of a company’s books during a takeover. The due diligence investigation provides the buyer with information and background details for the purchase of a company or real estate. The investigation gives the buyer a good picture of the risks and opportunities involved in the takeover.
- Is due diligence mandatory?
Yes. Due diligence falls under the duty of investigation. When acquiring a company or merging, a buyer is obliged to gather all the information necessary for a fair acquisition. The due diligence investigation identifies risks, checks the information provided by the seller, and usually follows the negotiations between the buyer and seller.
- Who carries out a due diligence investigation?
The due diligence investigation is carried out by tax and legal specialists. The financial and tax part of the investigation is carried out by accountants and tax specialists. Lawyers are responsible for the legal investigation of due diligence.
- How long does due diligence (audit) take?
The length of due diligence depends primarily on the size of the company that a buyer wants to acquire. In addition, the provision of information and the availability of data also play a role. Usually, the buyer and seller agree on the maximum duration of due diligence before the audit begins.
- What should you pay attention to during due diligence?
During a due diligence investigation, the buyer collects information about the company or real estate that the buyer is acquiring. Due diligence is not just an audit, but also includes an analysis of the opportunities and (operational) risks of the company or property being acquired. The investigation must in any case contain information on these six components:
- Public company data
- Information from the company
- Tax, legal, and financial information
- Organizational overview and insight
- Working methods and corporate culture
- Public information (marketing & sales)
- What is technical due diligence?
Technical due diligence provides real estate buyers with factual insight into the opportunities and risks of purchasing (commercial) real estate. The technical due diligence investigation focuses on all technical aspects of a real estate object, such as the structural inspection, installation inspection, fire safety, and maintenance plan.
- What is due diligence legislation?
Due diligence legislation within the European Union stipulates that companies and investors are responsible for their own activities, but also for the business activities of their trading partners in the chain. By identifying business activities, preventing (or limiting) negative effects, and remedying disruptions or risks, companies work together internationally to create a better, safer supply chain in which forced labor, exploitation, and environmental pollution have no place.
- What does due diligence mean?
The English term due diligence literally means ‘appropriate care’. Due diligence is a term that applies to the process of selling, merging, and acquiring companies. Due diligence, or book inspection, is an investigation into potential dangers and risks, but also opportunities in a company takeover or real estate purchase.
Results of the due diligence investigation
The results of a due diligence investigation are recorded in a report. This report forms the basis for further discussions and negotiations between a buyer and seller. The report is also used to assess which securities and guarantees should be included in a purchase agreement.
In addition, the report enables the buyer to determine whether the purchase price is reasonable for the company or whether the price needs to be (re)negotiated. Or whether, in view of the identified risks, the purchase should be abandoned altogether. Are you looking for a due diligence specialist in Amsterdam? On the mergers and acquisitions page, you can read all about what Fruytier Lawyers in Business can do for your deal. Our corporate lawyers are true specialists in this field.
