Download What is due diligence? Due Diligence is the name given to the work

WHAT IS DUE DILIGENCE AND WHY DO IT?
· What is due diligence?
Due Diligence is the name given to the work done investigating a company or a
business by or on behalf of a prospective purchaser, investor or other interested party.
While the method of investigation and the personnel may vary, due diligence involves
information seeking, reviewing and reporting. A purchaser or a third party investor
will want to learn more about the business or company they are to invest in.
Put simply, a purchaser s aim will be through its due diligence to identify anything
which is (a) likely adversely to affect the business going forward and/or (b) likely to
have a material impact on its value. At its simplest, due diligence enables a purchaser
to satisfy itself that it is getting the assets it expects, and that it is not taking on
unexpected liabilities. However, the due diligence investigation will usually go further
than merely identifying assets and liabilities, and will review the business or company
in more detail.
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Reasons for due diligence
1. To learn more
A prospective purchaser of shares or a business will usually know little about the
target business or its assets or liabilities when negotiations begin or even when an
agreement for the acquisition is reached in principle. The purchaser may have
some published historic information, such as a copy of the latest audited accounts
relating to the target and perhaps other results of a company search, and it may
even have been supplied with some recent financial information by the target's
management. It is, however, unlikely to have detailed information.
2. To understand the target's business
Even if the purchaser and the target are in the same general area of business, the
purchaser is unlikely to have detailed knowledge of how the target operates.
Where the purchaser is acquiring the target to expand into a new field, the
problem will be even greater. Due diligence allows the purchaser to gather
valuable know-how to help prepare itself to run the target business from Closing
(i.e. after the acquisition is completed).
3. To reduce/avoid risk
Due diligence is also intended to identify and reduce or avoid possible risks for
the purchaser. In general, a purchaser cannot look for help elsewhere. Caveat
emptor is the governing general law principle. A prudent purchaser will not rely
only on contractual provisions for protection. Investigation is its other way of
ensuring that the target is as it expects, that pit-falls are avoided, and that there are
no unwelcome surprises. More importantly, a careful due diligence operation may
be a purchaser's only real protection where meaningful contractual warranties
relating to the business cannot be obtained e.g. where the proposed acquisition is
from a receiver.
4. To value the target
In addition to fact finding, due diligence has a more fundamental purpose. Once
more detailed information has been discovered, the purchaser can arrive at a more
informed and accurate valuation of the target. Due diligence therefore allows the
purchaser to arrive with greater confidence at its final offer for the target, or to
seek a reduction in the price for previously unforeseen risks or problems.
5. To decide whether to proceed
Another, related purpose of a due diligence investigation is to enable the purchaser
to decide whether it wants to proceed with the acquisition at all. A purchaser may
be interested in acquiring the target, but only if it can be satisfied as to a particular
aspect of the target's business (e.g. the duration or other terms of its contract with
its principal customer).
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Relationship with Warranties and Indemnities
In addition to conducting a due diligence exercise, a purchaser will usually seek
protection by obtaining warranties. Warranties have several functions. If they prove to
be untrue a purchaser may be able to secure compensation for breach of contract.
Many warranties are designed to elicit information concerning the target during the
disclosure process. Consequently, usual or standard form warranties can be a useful
checklist in due diligence for the areas of concern to the purchaser.
Prevention is better than cure
A due diligence investigation does not remove the need for warranty protection - an
investigation of the target cannot hope to discover conclusively all matters of concern,
especially where they involve third parties. However, the level of warranty protection
to be obtained, and the level of access to suitable information for due diligence, are
each related to the particular circumstances, and particularly the relative bargaining
strengths of the parties and their desire to do the deal. If a problem can be identified at
an early stage, so much the better:
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(a) if an investigation reveals a concern early in the negotiations, there will be a
greater opportunity to explore the circumstances in detail, to evaluate any risk before
exchange of contracts and, as the case may be, to include certain representation &
warranties;
(b) to discover a real problem at an early stage can therefore save time and expense
(i.e. professional fee expenses);
(c) to have to withdraw from the contract before closing because a matter amounting
to a serious breach of warranty is only discovered after exchange, can be difficult and
embarrassing commercially, perhaps even more so for a seller;
(d) litigating a claim for breach of warranty can be difficult, time-consuming and
expensive. Even if litigation is successful, a seller may be unable or unwilling to pay,
or may no longer exist or cannot be traced.