Due diligence in corporate transactions series: process and review areas

Legal due diligence is the process through which the buyer and its advisers investigate the target business for acquisition and verify the information provided by the seller to identify matters that could affect the proposed transaction.

In the first of our Due diligence in corporate transactions series, we explored the foundations of due diligence. In part 2, we provide a guide to a typical due diligence process and identify key business areas that frequently come under review.

What is the due diligence process?

While the precise process will depend on the size and complexity of the transaction, a typical legal due diligence exercise includes the following stages:

• Confidentiality arrangements: Before any sensitive information is shared, the parties will usually enter into a non-disclosure agreement governing how information may be used and disclosed.
• Establishing a data room: The seller will establish a secure electronic data room through which documents and information can be provided to the buyer and its advisers.
• Issuing the due diligence request: The buyer’s legal advisers will prepare an information request or due diligence questionnaire setting out the documents and information required.
• Uploading information: The seller and its advisers will gather the requested documents, upload them to the data room and prepare responses to the buyer’s enquiries.
• Reviewing the documents: The buyer’s advisers will review the material supplied to verify information about the target and identify legal or commercial risks.
• Raising follow-up enquiries: Further questions are raised where information is incomplete, documents are missing or a matter requires clarification. This is often an iterative process, as one response may lead to further questions.
• Preparing the due diligence report: Once the review is sufficiently advanced, the buyer’s advisers will report on the principal findings, their potential impact and any recommended action.
• Addressing the findings: The parties will determine how identified risks should be dealt with in the transaction documents or otherwise resolved before or after completion.

Principal areas of review in a due diligence process

The scope of due diligence should be proportionate to the size, nature and risk profile of the target business. However, the principal areas of legal review will commonly include the following business areas:

Corporate

The corporate review seeks to confirm that the target has been properly incorporated, establish who owns it and assess whether its corporate affairs have been appropriately managed.

The buyer’s advisers will typically review the targets:

• constitutional documents;
• statutory registers;
• Companies House filings;
• option arrangements; and
• key director and shareholder approvals.

Potential issues which may arise include discrepancies between Companies House filings and the statutory registers, missing approvals, undocumented transfers, incomplete minute books, unidentified options or warrants and uncertainty over ownership of the shares being sold.

As ownership of the target is fundamental to a share purchase, deficiencies in this area need to be rectified before completion.

Employment

Employment due diligence will usually include a review of:

• employment contracts;
• directors’ service agreements;
• consultancy arrangements;
• bonus schemes;
• benefits;
• incentive arrangements; and
• any existing or threatened employment claims.

The buyer may also need to understand whether the business depends heavily on particular founders, directors, employees or consultants and whether suitable arrangements are in place to retain those individuals’ following completion. Restrictive covenants may be reviewed to assess the protection available if a key individual leaves and seeks to compete with the business or solicit its customers.

Where the proposed transaction is structured as an asset purchase rather than a share purchase, consideration will also need to be given to the Transfer of Undertakings (Protection of Employment) Regulations 2006, commonly known as TUPE.

Intellectual property

For many businesses, intellectual property is central to its value. The review will seek to establish what intellectual property the target uses, whether the target owns it and whether any third party has competing rights.

Relevant documents may include trade mark and domain name registrations, software development agreements, copyright assignments, patent records, licences and agreements with employees or external contractors who have created intellectual property for the business.

A common issue is that intellectual property has been developed by a founder, consultant or external developer but has never been formally assigned to the target. If ownership has not been properly documented, the buyer may not receive the rights it expects when it acquires the company.

Litigation

The buyer will want details of existing, threatened or anticipated claims involving the target, including court proceedings, contractual disputes, and regulatory investigations.

The review should assess the likelihood of liability arising, the possible financial exposure and any operational or reputational impact. The significance of a dispute will depend on its value, the parties involved and its wider effect on the business.

Property

Property due diligence will identify the premises owned, leased or occupied by the target and consider whether those arrangements are properly documented.

The review may cover matters such as title, lease terms, rent and service charges, break rights, repairing obligations, permitted use, alterations, planning, environmental issues and property disputes.

The key question is whether the target can continue to occupy and use the premises required for its business following completion, on terms acceptable to the buyer. A short remaining lease term, an existing breach or a requirement for landlord consent could have material operational or commercial consequences.

In the final part of our Due diligence in corporate transaction series, we dissect the key elements which comprise a due diligence report and the potential outcomes following its findings.

How Hamlins can help

Our Corporate team acts for entrepreneurs, SMEs and larger organisations, providing corporate, commercial advice and business expertise, both in the UK and internationally.

We have extensive experience supporting clients with the sale of their business or the purchase of a target, including managing the due diligence process which accompanies these transactions. We work with clients to identify the issues that matter, assess their commercial significance and ensure that they are appropriately addressed in the transaction structure and documentation.

If you would like to explore an opportunity in respect of purchasing or selling a business, please get in touch to find out more.