What is Due Diligence in Law?

Introduction to Due Diligence in Law

Before entering into any important investment, whether it’s acquiring a company or its underlying business, purchasing real estate or intellectual property rights, or some other commercial arrangement, you should conduct due diligence. This entails investing time and effort into obtaining as much detailed information as possible in order for you to make a wise and informed decision before spending your hard earned money.

For the purposes of this article, we will look at the importance of due diligence in the context of a business acquisition, although its principles are applicable for a range of commercial investments.

The article will explain what’s involved in the due diligence process, its benefits, and dangers of failing to perform due diligence, so that you are well equipped to proceed with the business deal with confidence.

Definition of Due Diligence

Due diligence is a legal concept that refers to the efforts made by a party, prior to entering into a business transaction, to ensure that all necessary information has been gathered and assessed.

The due diligence process requires that all relevant parties involved examine and review relevant information related to the transaction, such as financial records, intellectual property rights, contracts and other documents. This helps ensure that any risks associated with the deal are properly identified and addressed at an early stage.

Due diligence is an important process for both parties involved in a business transaction. It ensures that all parties involved are fully aware of the risks associated with the deal before they enter into an agreement. Without due diligence, parties may be unaware of potential liabilities or risks until after the transaction has been completed.

‍

Examples of A Legal Due Diligence Process

The due diligence process typically involves investigating your target business in these six key areas:

Financial Due Diligence

• Obtain annual reports to assess company finances. If they are a limited company, they can be accessed freely on Companies House, though beware these could be out of date at the time of inspection.
• Reviewing financial statements, company accounts, its balance sheet, profitability forecasts, budgets and other financial-related documents.
• Identifying any charges or loan agreements associated with the company.
• Examining tax returns and any potential liabilities related to taxation.
• Conduct a shareholder value analysis: Identify the current shareholders, what percentage they own, the value of their shares and any shareholder agreement in place.
• Depreciation / amortisation issues.

Legal / Compliance

• Assessing any legal issues concerning the business such as contracts, compliance with regulations and pending litigation issues.
• Making sure that all parties have the necessary authority to carry out the transaction.
• Any permits or licenses required to operate the business.
• Records of regulatory matters and regulatory compliance.
• What insurance policies are in place. Have there been any historical claims?
• Health and safety procedures.
• Are environmental issues a concern in the business?

Operational

• Conduct a detailed review of the business’ products and/or services, profit margins, its sales processes, manufacturing process and any distribution arrangements.
• Reviewing key third party business contracts in the supply chain.
• Who are the key people in the business currently? Are they vital to retain to ensure its ongoing success?
• Ensuring the target company’s culture, values and current practices are a suitable fit for you or your current business.

Company Assets

• Assessing the value and status of any plant, machinery or other equipment.
• Reviewing any freehold or leasehold property the business owns.
• Investigating the status of IP assets such as trademarks, copyrights and patents.

Employees

• Conducting a detailed assessment of the current workforce. Number of employees, their job roles, salaries, employee benefits, etc.
• Experience of senior board members and leadership team.
• Arrangements with freelance business partners, contractors, external advisors, consultants and other third parties.
• Pension plan policies.
• Are there any ongoing or historical employment complaints, disputes, or compensation claims?
• Employee culture, job satisfaction, retention rates.

Marketing

• Reviewing the track record and effectiveness of any previous marketing campaigns.
• Marketing budgets.
• How much goodwill does the business have? What is the public’s perception of the company?
• Investigate any press releases or reports relating to the company.

Taking reasonable care to conduct a thorough and detailed due diligence investigation by addressing these aspects should provide you with a comprehensive picture of your target company. Though I must stress that due diligence can take many other forms; the list above is provided solely by way of example and is by no means intended as a complete due diligence checklist suitable for every situation!

The due diligence process should leave no stone unturned, and it will be the role of a corporate lawyer to compile the due diligence findings into a due diligence report.

Benefits of Undertaking Legal Due Diligence For Business Transactions

With your due diligence report in hand, you should now be in a position to assess risk and weigh it up against the benefits before committing to the purchase.

One key benefit of conducting your due diligence investigations early on in the negotiations is that if the due diligence process has identified particular problem areas, you will be in a stronger bargaining position to negotiate the purchase price down or secure promises from the seller in the in the form of warranties or indemnities to help manage that risk.

Other benefits of undertaking due diligence prior to making a business investment include: