Key Aspects of the Due Diligence Process and the Importance of a Comprehensive Disclosure Letter.
In any corporate transaction, the buyer will want to be sure that the seller, or the target company, has good title to its assets and has no outstanding claims that could affect the business’s operations. To give this comfort, the buyer will undertake due diligence.
A solicitor will help streamline the due diligence process, which can help in hitting a completion date. If acting for the sellers or the target, a solicitor will respond to the due diligence enquiries. Where acting for the buyer, a due diligence report will follow, which will flag up any areas of concern. A purchase price can be subject to the results of any due diligence.
Key Aspects of Due Diligence
Due diligence is broadly split into financial due diligence, i.e. the target’s outstanding liabilities and liquid assets, and legal due diligence, i.e. employees and intellectual property.
With regards to legal due diligence, the enquiries to raise will depend on the target’s market. However, broadly speaking, the following seven enquiries should always be raised:
- Contracts: if the target offers a service, then are there watertight terms and conditions for the target’s engagement to provide services? What are the risks of these terms and is there any exposure? If the target sells goods/products, then does the target have standard form sale contracts? If so, are these contracts compliant with the implied statutory provisions, and/or the regulations of the EU?
- Employment: does the target have employees? If so, have they all been provided with written terms of their employment? If the buyer is acquiring assets, then TUPE will likely apply. In the last twelve months, have there been any dismissals/redundancies, and if so, how have these been dealt with? Another key area is employment policies, and whether they are in place, e.g. bribery policy, and grievance procedures.
- Disputes: is the target subject to any ongoing dispute with a supplier, client, or customer? If so, will completion be conditional on the resolution of any dispute subject to the satisfaction of the buyer? The seller should take steps to resolve disputes out of court, as litigated matters in the courts can become protracted.
- Intellectual property: from a seller’s perspective, it always pays to have the business’s intellectual property rights adequately protected. If the target has a revenue stream through a licensing model, then a review of the licence agreement can help address any areas of concern.
- Assets: how is the purchase price arrived at? If the seller owns a large portfolio of fixed illiquid assets, then the seller will want the business valued using EBITDA. That is to ensure that the value is not diminished by amortisation and depreciation. A target with consistent cash flow and a high level of goodwill will likely wish for a valuation based on EBITDA. A buyer should look to the terms of any property lease, which may have change of control provisions that can be triggered on a business sale.
- Compliance: many tech-driven businesses rely on software usage and large quantities of data. How is that data protected? Is the business registered with the Information Commissioner’s Office (ICO)? Does the target ensure that the business only transfers or processes data to recognised entities having appropriate protection in place? Transfers of data outside the EEA bring special considerations.
- Ownership: bespoke articles and/or shareholders’ agreement will usually contain provisions relating to share transfers. Do the majority shareholders have the right to “drag” the minority into a sale? Likewise, do the minority shareholders have the right for their shares to be bought out by the buyer? This will depend on how the purchase is structured.
The Importance of the Disclosure Letter
On completion of the due diligence exercise, the buyer will likely insist on warranties and/or indemnities from the seller. Those warranties and indemnities will address any issues that the buyer discovers during the due diligence exercise, e.g. warrant that the business does not control or transfer personal data if the buyer discovers the target is not registered with the ICO.
A seller will then have to fully fairly and accurately disclose against any warranties that the buyer requests. For example, the buyer may request that the seller warrants that “there have never been any employment claims against the target company”. The seller then discloses against this warranty in the disclosure letter, similar to “the target has had a claim from one employee for constructive dismissal in 2010, which was dismissed by an employment tribunal”. The seller would then disclose the tribunal’s judgment as an annexed document.
Therefore, the disclosure letter is extremely important as it will qualify any warranties that the seller is required to make. It can help protect the seller in the event a claim is made by the buyer against the seller for breach of warranty. A seller should disclose as much information as possible, so as to flush out any warranties.
Protecting Sellers in the Purchase Documents
A seller should look to cap liability for warranty breach within the purchase documents.
The usual way to do this is to cap the seller’s liability to the buyer in the event of a warranty claim at an amount equal to, or a percentage of, the purchase price. The actual level of liability cap will depend on negotiations, due diligence, the seller’s exposure, and the buyer’s assessment of the target’s risk.
Gannons are a boutique firm of corporate and commercial solicitors based in central London. Gannons have an extensive track record of handling sales and purchases of private limited companies. Helen Curtis is a partner in the corporate and commercial team at Gannons. Helen can be contacted on 0207 438 1065, or firstname.lastname@example.org