Undertaking due diligence is a crucial step in the process of acquiring a business. The due diligence process generally involves a detailed investigation to thoroughly assess the target business’ assets, capabilities, and financial performance, and identify potential problems or unexpected liabilities. It is a valuable risk management tool that allows the buyer to make informed decisions and avoid unpleasant surprises.

Due diligence allows the buyer to identify and mitigate potential risks and liabilities that could impact on the target business’s value or return on investment. It helps the buyer and seller establish a realistic valuation of the business, and assists the buyer to gain a comprehensive understanding of it. The results of due diligence inform the terms of the transaction, including price, warranties, and payment terms.

For a buyer undertaking due diligence, it is essential that the process be conducted thoroughly yet efficiently. Here are our top tips for conducting effective due diligence:

Tip 1: Negotiate an exclusivity period with the seller - an exclusivity period will ensure that the buyer can devote time and resources to undertaking due diligence without being concerned that the seller is, at the same time, trying to solicit other offers for the target business.

The majority of M&A deals have a buyer exclusivity period during which the seller agrees to discontinue marketing and stop actively looking for buyers. Also known as a “no shop” period, the seller agrees to deal exclusively with the buyer during this period, preventing the seller from soliciting, negotiating or entering into agreements with other buyers.

The due diligence process takes time. It is important the buyer allows sufficient time for thorough due diligence to be undertaken as part of the transaction timetable and that this is reflected in the exclusivity period.

Tip 2: Engage experienced advisers – a buyer should engage advisers (including lawyers, accountants and tax advisers) experienced in advising on M&A transactions to assist in conducting (and reporting on) due diligence on a target business.

Experienced advisors will know what issues to focus on (or look out for) during the due diligence process. They will assist the buyer in developing a comprehensive due diligence plan, conducting research required to uncover potential risks, and providing recommendations for dealing with due diligence findings.

Tip 3: Tailor the scope of due diligence - before obtaining detailed information from the seller, the buyer and its advisers (legal and financial) should tailor the scope of due diligence to fit the target business. The scope of the due diligence review will depend on factors such as the nature of the business, its size and value, the industry it operates in, and the risk appetite of the buyer. Materiality thresholds are often adopted to enable the buyer’s due diligence team to focus (and report) only on matters of sufficient materiality. This can improve the efficiency of the due diligence process and ensure relevant issues are not overlooked.

Tip 4: Obtain relevant and detailed information about the target company – it is standard practice to issue the seller with a due diligence questionnaire that has been customised for the specific nature of the transaction and target company’s business. The purpose of the due diligence questionnaire is to gather relevant information about the target business to assess its value and potential risks.

The seller should also be collating due diligence materials in an online data room. Materials in the data room typically include:

• financial information including financial statements such as the income statement, balance sheet, and cash flow statement, as well as tax returns and any other documentation required to provide a comprehensive picture of the target company’s financial performance;
• corporate governance and ownership materials such as constitution, shareholders agreement, share certificates, and member registers;
• legal contracts that are important to the business such as sale, supply, service, and distribution agreements, and leases;
• intellectual property records including details of patents, trademarks, copyrights, and other intellectual property the target company owns or has licensed;  
• information technology materials including details about the target company's technology infrastructure, such as software, hardware, and data storage;
• human resources information such as organisational charts, policies, and employment contracts;
• litigation or regulatory filings including information regarding any current or pending cases or investigations; and
• environmental information including any environmental assessments, permits, regulatory approvals or other documentation related to the company's environmental impact.

Tip 5: Conduct a detailed and targeted review - Once the seller has completed the questionnaire and uploaded documents to the data room, the buyer and its advisers will review these materials. Typically, a due diligence review is divided into several separate components, each conducted by the relevant experts:

• Legal due diligence: this includes a review of the corporate structure and records of the target company, material contracts, results of searches of registered intellectual property, business names, registrations of personal property securities and other securities, current proceedings, and transfers of employees and their entitlements;
• Commercial due diligence: this includes a review of real property/premises, plant and equipment, stock and inventory, systems and processes, employees, customers, products and services, suppliers, assets, insurance, market trends and issues;
• Financial due diligence: this includes a review of financial performance, financial position, maintainable earnings, debtors, creditors, work in progress, salaries and wages, superannuation, finance facilities, guarantees and bonds, pre-payments, tax returns, liabilities, notices, disputes, penalties; and
• Tax due diligence: this includes a review of tax returns, liabilities, notices, disputes, penalties, etc and the tax impact of the transaction (as structured) on the buyer.

Tip 6: Review and act on due diligence findings - once the buyer’s advisers have completed their review of the due diligence materials, they will report their findings in writing to the buyer. Reporting is often done on an “exceptions basis” only (unless the buyer requires otherwise).  This means due diligence reports will only mention issues with a value or impact over a certain materiality threshold. The reports will contain recommendations for managing the issues uncovered during the due diligence process that will inform the buyer’s actions.

Provided the buyer wishes to proceed with the transaction, the next step is to negotiate definitive transaction documents. Issues identified in due diligence and the corresponding recommendations of the buyer’s advisers will frequently translate into protections sought by the buyer in the transaction documents. These could include the completion of certain actions as conditions precedent to completion, pre or post-completion undertakings, warranties addressing specific or general areas of concern for the buyer, or indemnities to protect the buyer from specific risks.  

If you have any questions on buying a business, undertaking legal due diligence or would like assistance with conducting legal due diligence on a target business, please do not hesitate to get in touch with one of the Sierra Legal team.

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