Due diligence is the process of obtaining and verifying information about a company or person in preparation for a business transaction, such as an acquisition, merger, or potential new business partner.
Generally, due diligence provides information about the company being considered for purchase and its operations, with an eye toward risks that could cause future problems. Obtaining details about pending lawsuits, contractual disputes, tax problems, and other issues uncovered by due diligence helps a potential buyer to understand a company’s value and enables the buyer to make informed decisions during negotiations and before entering into agreements.
Reasons for Due Diligence
Business involves risk-taking at every level, but there is a big difference between taking an informed risk and recklessly rolling the dice.
In the context of a business transaction, due diligence is an in-depth investigation into a business that can reveal potential legal red flags, including, but not limited to, the following:
- Lawsuits
- Debts
- Assets
- Contracts and agreements
- Intellectual property
- Employees
- Regulatory violations
- Business licenses and permits
For example, due diligence could show that a company targeted for acquisition has human resources issues with outgoing employees, contractual disputes with suppliers, or is facing costly litigation. These potential problems will often become the responsibility of the buyer after the deal goes through, so it is important for the buyer to make an informed decision after reviewing the information obtained during the due diligence process.
Not every red flag is a deal-breaker: Some can be corrected as a condition of moving forward with the business transaction. Others can be the subject of negotiations aimed at mitigating risks for the acquiring business.
What the purchasing company chooses to do with the results of its due diligence is up to it. Depending on the types of risk uncovered, it could use this information to negotiate an adjustment in the purchase price, obtain indemnity from certain liabilities and costs arising subsequent to the date of the sale, or identify steps that must be taken before closing. The buyer could also conclude that an identified risk is too great and forego the deal.
If a company is preparing for sale, it should consider self-auditing prior to negotiations. This can expose risks that might be detrimental to the deal and give the seller time to address them, providing an opportunity for the seller to enhance the value of the business.
How to Conduct Due Diligence
Legal due diligence is generally divisible into three main stages: preparation, investigation, and presentation:
- Preparation for due diligence depends on your goals for the transaction. Knowing what you want to get out of the deal will help to frame the scope and direction of the investigation. Your company probably does not have unlimited time—or resources—to perform due diligence. It is important to focus on obtaining the information that is most crucial and then set priorities, timelines, and budgets.
- Investigation produces documents that will enable your accountant and attorney to evaluate the target company or asset. In this phase, contracts, leases, intellectual property, financial reports, tax liabilities, pending litigation and judgments, warranties, and organizational documents such as company bylaws, certificate of incorporation or articles of organization, credit reports, and a company’s owners and directors may be reviewed.
- Presentation of results is the final step in the legal due diligence process. After all the necessary information has been gathered and analyzed for accuracy, your attorney and accountant will provide you with their findings. They may also provide an opinion about whether the transaction is advisable.
The due diligence process may only take one or two months. However, if the transaction involves a large or foreign company, the process could take longer due to greater complexities.
Due diligence demands the skill set of an experienced attorney who can bring all the facts to the table in a professional, unbiased manner. You get what you pay for in business, and if you cut corners on due diligence, you could end up paying a much higher price later in the form of an undisclosed risk that should have—and could have—been identified by an experienced advisor.
To learn more about how we can advise you in any planned business transactions, please schedule an appointment.
