Whether considering an investment opportunity, buying an existing business or even considering a proposal to associate with a business or businesspersons not otherwise known to you, such proposals can in many circumstances come with substantial financial and reputational risk. While appropriately documenting any representations, promises and agreements made in the course of negotiations with the assistance of experienced legal counsel should be a given – undertaking appropriate due diligence in the course of any discussions or, at the very least, prior to (and as a condition of) the creation of any substantive legal obligation (such as the payment of money) should be standard practice.
What is Due Diligence?
Due diligence is a process, typically undertaken by a party to a transaction as well as that party’s financial and legal advisors, that looks into various legal, financial and operational matters related to a particular transaction prior to entering into formal agreements or legal obligations. At its core, due diligence seeks to:
verify any representations made by the other party in the course of early discussions or negotiations;
identify any potential obligations, liabilities or risks that could undermine the expectations of a party related to, for example, a return on investment or ability to continue to conduct a business, with respect to a proposed transaction; and
identify any government, shareholder, landlord, creditor or other third party consents or approvals that may be required in order to ensure that any timeline expectations can be facilitated or otherwise satisfied;
create an basic knowledge background in order to appropriately structure a proposed transaction and document any related expectations and agreements; and
meet fiduciary obligations (as directors or officers of a corporation, general partner of a limited partnership or trustee of a trust) with respect to a duty of care owed to shareholders, limited partners or beneficiaries, respectively.
It should first be understood that there is no “one” due diligence plan or process. Any due diligence should be determined and carried out in consideration of the industry involved, the parties’ circumstances, the size of the transaction, the proposed deal structure and the cost (usually in terms of money to be paid but also in terms of obligations or liabilities assumed) of the proposed transaction.
Why “Do” Due Diligence?
A thorough due diligence plan, appropriate for the circumstances, can pay dividends in terms of proper valuation of any proposals made (and ensuring you do not over pay) as well as uncovering potential business or legal issues to permit you to make a fully-informed decision as to whether to proceed or not and, if proceeding, on what basis. Information obtained and any business or legal issues identified as a result of that due diligence can also inform your accounting and legal advisory team as to legal structures and deal terms in order to appropriately allocate any valuation, business and legal risks among the parties in line their respective expectations.
Due diligence is particularly important for the buyer who will inherit certain risks and liabilities associated with the target, such as its material contracts, environmental obligations, legal liabilities and employee severance obligations. In this regard the price to be paid is not indicative of the need to conduct proper due diligence as it is very much possible that by acquiring an existing business even for a nominal purchase price a purchaser may concurrently be accepting liability for existing environmental liabilities; holiday pay and severance obligations; or outstanding tax assessments.
In larger value and often somewhat more sophisticated scenarios – such as public company M&A, investment funds or large trust administration – due diligence is not only a prudent transactional matter but is also a potential shield from shareholder, limited partner or trust beneficiary litigation for alleged failures by directors, officers, general partners or trustees (as applicable) to meet the an appropriate standard of care in exercising their respective fiduciary duties. Note here that these duties are not necessarily dependent on the size or context of the transaction, but the resulting litigation – due to the cost of litigation – often is.
By failing to conduct appropriate due diligence prior to committing to a transaction, and investor or purchaser risks overpaying for a particular investment or acquisition opportunity or at the very least making a poor decision based on an inaccurate or incomplete picture of the legal status, financial health and/or prospects of the target. Directors, officers, general partners and/or trustees may face allegations for breaching their fiduciary duties by failing to apply an appropriate standard of care before entering into a particular commitment. Failing to undertake any due diligence may also limit the ability of the legal counsel to identify and address such issues in transaction documentation to protect an investor or purchaser, to the extent possible, through appropriate transaction structures or provisions in the applicable documentation such as representations and warranties, covenants, rescission rights, indemnities and/or holdbacks.
True Story: A purchaser acquired a property with an operating business on the assumption that they would continue the business that had been operating there for several years. In determining the purchase price, the purchaser agreed to pay a premium on the property on the basis of a valuation attributed to the future income of the business. The transaction was documented, to an extent, and executed without legal counsel or due diligence. Once in possession the purchaser discovered that the business that had been operating on the property never had a business license and that the premises was not zoned for – and would never obtain zoning for – that particular business. The purchaser had already overpaid for the property, had no written representations as to the business that operated on the property, and now faced a decision as to whether to litigate over alleged verbal representations or implied representations regarding the business.
How is a Due Diligence Process Conducted?
A due diligence process can often be divided into three general categories:
Business Due Diligence. Usually conducted by the investor or purchaser directly or with the assistant of specialized advisors (such as leasing or insurance agents of business consultants), this form of due diligence usually goes to the operational matters of a target such as human resources, customers, supply-chain issues, real property (such as leases or real estate) and personal property (such as equipment and inventory). While certain issues may cross-over to the two categories below, often the operational assumptions made by an investor or purchaser are best verified directly by that investor or purchaser who, very often, has specialized expertise in the particular business being considered.
Financial. Usually conducted by an investor’s or purchaser’s accountants and/or financial advisors, this investigation looks to the financial health of the target review of financial statements, tax filings and other relevant financial information such as financing documents, accounts receivable and accounts payable. Often this form of due diligence is prudent simply to establish or at least verify valuations or assumptions regarding return on investment.
Legal. Usually conducted by an investor’s or purchaser’s lawyers, this form of due diligence can vary significantly with the size and context of a proposed transaction but will at least review the legal status of the target and its assets and liabilities but can (and often should) include a review of any contractual relationships with customers, suppliers, lenders, landlords and employees. More comprehensive legal due diligence may also include searching applicable governmental or third party agencies (such as Canada Revenue Agency, applicable provincial taxation authorities, applicable workers’ compensation and employment standards agencies, specialized agencies overseeing environmental protection, licensing or regulation and the Courts) to determine whether there are any outstanding or pending obligations, claims or proceedings against the target.
Due diligence can take to form of somewhat casual inquiries to a formalized, transaction team driven process. Typically at some point prior to either the negotiation of a letter of intent or formal transaction agreement a form of non-disclosure agreement is entered into between the parties. Subsequently some sort of request for particular records or documentation (or access to persons, records or documents) deemed relevant by the investor or purchaser is made on the other party – together, if required, with a form or forms of authorization to permit representatives of the investor or purchaser to obtain information from third parties such as government agencies. More common in larger transactions but a good practice for any party anticipating that it will or may be subject to a due diligence process, the target may respond by providing access to a “virtual” data room that gives the representatives of the investor or purchaser electronic access to the target’s material records, documents and other requested information.
As stated above there are no hard and fast rules as to what particular due diligence is done in the circumstances and who should do undertake whatever due diligence is done – the takeaway is and should be that any material financial transaction is accompanied by some form of due diligence conducted prior to the creation of any substantive legal obligation.
True Story: An accredited investor was approached by a long-time friend with an investment opportunity to acquire limited partnership units connected to a real estate property development in a popular location in British Columbia. Considering the location of the proposed development, the state of the real estate market and the representation that the long-time friend had already invested, the investor proceeded to invest a relatively material amount of money in the limited partnership. Not soon after the investor was advised that issues had arisen with the project, litigation was pending and likely all of the investor’s investment was lost. Subsequently, among a number of other issues that may have affected the investor’s original investment decision, it was discovered that the long-time friend was compensated handsomely for identifying future potential investors; that the real estate project was subject to a number of prior mortgages and guarantees that were in priority to any claim by the limited partnership and greatly exceeded the value of the real property; and that the principal behind the real estate development had a history of failed projects and, in fact, had been ordered by a another provincial regulator to cease selling limited partnership units in that province. The investor was left with an option of likely further significant expense to seek whatever legal remedy was possible or writing-off the investment almost immediately.
When Should Due Diligence Begin?
It is advisable to begin the due diligence process as early as possible both so as to inform any ongoing negotiations (so as not, for example, to negotiate on the assumption that a proposed transaction will be share sale transaction only for it to be determined that the only way forward is by an asset sale transaction and potentially start negotiations from scratch) as well as to determine whether any shareholder, government or third party consents and/or approvals are required (in public company circumstances, for example, shareholder approval can take up to 60 days, or more, and government agencies can take several weeks to respond to a request for certain information.
While some investors or purchasers may be concerned with the potential costs and/or delays of initiating a due diligence process, most lawyers would no doubt respond to such concerns by noting the very real and material expense and reputational cost of proceeding with negotiations and formal documentation which subsequently fails to close or is delayed while parties take up legal and negotiating positions due to something material uncovered late in the process; or the very, very real and material expense and reputational cost of proceeding to close a transaction based only on a final transaction agreement only to find out that representations made are false, the investor’s or purchaser’s expectations will never materialize and the options on the table is litigation or writing-off the investment made.
True Story: A medium sized but growing technology company had entered into a number of memorandums of understanding with smaller, regional technology vendors to acquire them by way of several share purchase transactions. Time was of the essence and in all cases it was decided to proceed with preparation of a formal share purchase agreement in accordance with the respective memorandums of understanding and rely substantially on the representations and warranties contained in the proposed agreements as a back-up for a somewhat casual and limited due diligence process. With the formal share purchase agreement finally settled and ready to be signed, all of the ancillary closing documents on the table and a cheque ready for presentation, the vendors disclosed (in a disclosure statement delivered earlier in draft form but amended and delivered in final form at the formal closing mostly due to some questions raised by the purchaser the day prior to closing) that there were two potential claims against the target company – one with respect to a finders’ fee payable by the target company to, at that point unknown, finder with respect to any merger or acquisition transaction subsequently undertaken and the other with respect to one part of the target company’s intellectual property. Faced with the time and expense already invested to get to closing, and the perceived business opportunity and reputational risk of delaying and/or potentially collapsing the closing of the transaction, the purchaser’s representatives were faced with a decision as to whether to proceed then-and-there in the boardroom and forced to undertake a somewhat imperfect negotiation to attempt to mitigate the risks related to these two discoveries.
What if Due Diligence Puts a Potential Deal at Risk?
In many circumstances it seems there can be a motivation to proceed with transactions that have been already agreed to in principle at any cost. To be sure in a competitive market environment where a number of firms may compete for a limited number of potential targets; where reputations for being a “deal closer” are often held above reputations for prudent, but otherwise infrequent, acquisitions; and where almost every market participant seems to be concerned with missing-out on the next big thing; all relevant priorities and considerations need to be balanced.
As stated above, no one process or timeline needs to be adopted for every transaction. Due diligence, as a process, is complimentary and seldom a liability to subsequent or concurrent negotiations, structuring and documentation. When issues are identified in the context of a proper due diligence process, whether or not a proposed transaction proceeds on the terms originally discussed or at all largely depends on the investor or purchaser and the significance of such issues. This is, presumably, how it should be.
Smaller matters likely can be discussed a resolved informally. With respect to more substantive matters, there are always ways that the parties can bridge gaps in order to move forward including any or all of post-closing covenants, holdbacks, post-closing escrow, guarantees, appropriate indemnities or a restructuring of the proposed transaction to, for example, purchase a certain portion of a business or target company.
If the parties acting in good faith and are otherwise motivated to work towards the common goal of closing a proposed transaction, adopting a due diligence process that is appropriate in the circumstances and transparent to all parties from the beginning should not be a deal breaker. If it is, perhaps an investor or purchaser should best pass on the opportunity.
Endeavor Law can assist on all aspects of a proposed investment, business acquisition or other transaction including advising on, and undertaking, due diligence investigations and reporting. Endeavor Law will always seek to provide competitive pricing for any legal services requested and is pleased to discuss fee arrangements that suit any potential client.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.