Mergers and Acquisitions: the due diligence process

Buying a company is a difficult, but potentially rewarding process, which may take days or weeks depending on the complexity of the company structure. This is not entirely dependent on the price being paid. Because buying a company will involve investing a significant amount of money and time, it is essential that the purchaser gathers enough information about the company to ensure that following purchase there are no nasty surprises. This process is commonly referred to as conducting due diligence.

In most company purchases, the purchaser will want to learn everything possible about that company before signing the purchase agreement. Alternatively, if there isn't time to do that, then the purchaser will want to make sure that the representations of the vendor concerning the company are quite comprehensive and that the definitive agreement allows him to back out of the deal if the due diligence done after signing the agreement is not satisfactory. However, the latter process is not really desirable to either party. The damage to the company by the change of leadership or a potential leadership vacuum is likely to be permanent.

Why do due diligence?

Conducting proper due diligence will help the purchaser to avoid the following problems:

· Discovering that the purchase price of the business is too high

· Misunderstandings as to the type and condition of the company being bought

· Bad financial situations

· Bad management

· Pending litigation

· Contingent liabilities

· Situations likely to lead to increased tax burden

And indeed to fully understand what it is that the purchaser are buying. The purchaser’s ability to run the company post purchase needs to be informed and this is in part done through the due diligence process.

What are warranties?

Warranties are statements made by the vendor to the purchaser regarding the status of the company and the existence of any issues that may be of concern to the purchaser. The purchase agreement will contain a schedule of warranties covering almost all parts of the company’s business. The warranties usually include statements about the following items (but others will be included where particular to the company or industry):

· Vendors ability to sell

· Accounts

· Employees

· Property

· Litigation

· Pensions

· Insurance

· Tax

· Environment

· Regulatory matters

If after completion it transpires that a warranty untrue, a purchaser may have a claim for damages for the loss it has suffered. However, litigation is a destructive process and should be avoided wherever possible. As a result warranties are not a substitute for detailed and in-depth due diligence. In effect the warranties deal with those items drawn out by the due diligence that are key to the purchaser in the purchase of the company.

To avoid the warranties becoming extremely complicated and lengthy, a vendor will qualify those warranties in a separate document known as the Disclosure Letter. Where disclosures reveal a liability that the purchaser would assume they can request an indemnity from the vendor in respect of that liability.

What are indemnities?

Indemnities are promises made by a vendor to meet a specific potential legal liability which a purchaser may incur following an acquisition. An indemnity would entitle the purchaser to a payment if the event giving rise to the indemnity takes place.

It is important to be aware of the difference between a warranty and an indemnity. A warranty is a contractual statement made by the vendor regarding the state of the target company and an indemnity is a promise to indemnify, i.e. to reimburse the purchaser in respect of a specific liability if it arises.

Limiting the Vendor's exposure

The problem with these items is that the vendor’s exposure to warranty and indemnity claims is unlimited. That is not a reflection of a fair position. The company is an asset and the company either has value or it does not. If in the worst possible situation the company has no value that the Vendor should have been paid nothing for it. This scenario informs the process of limitation of liability. The Vendor’s exposure to these claims should be no more than what he was paid for it.

Allowing Purchaser sufficient information

The Purchaser must use the exercise to create an understanding of thecultural issues in the target and the requirements for integration. It is often the case that transaction fail because of some significant issue raised in the due diligence process but there is very little failure as a result of the challengess presented by culture to integration. Purchasers need to take more heed of these issues rather than treating the purchase of the target as a trophy.