Deep Dive: The Due Diligence Process

Asset 21

There are many stages in the purchase or sale of a business. Part of a new series on our website, this article provides an in-depth review of the due diligence process so that you can know what to expect and how we can help.

For a more cursory overview of due diligence, we invite you to read our related Business 101 article on Due Diligence, which serves as an introduction to the ideas explored here.

 

Stages to Due Diligence:

In short, the due diligence process can be summarized into the following steps:

  1. Buyer and Seller enter into an agreement in principle (e.g., Letter of Intent);
  2. Buyer enters into a non-disclosure and/or confidentiality agreement with the Seller;
  3. Buyer sends a due diligence checklist outlining any information to be provided by the Seller;
  4. Seller provides requested information;
  5. Buyer reviews information;
  6. If applicable, the terms of the Agreement of Purchase and Sale are amended to reflect information discovered during the due diligence process; and
  7. Deal closes.

 

Scope of Due Diligence:

While every purchase and sale transaction will include some form of due diligence, the scope or focus will vary significantly depending on many factors, including:

  1. Relationship between the Parties: Where the deal is between closely related individuals (e.g., parents selling to their children), or where the Buyer is already familiar with the business (e.g., where the buyer is a long-standing employee), the due diligence process will likely be much more brief, as there is not as large of an information gap between the Buyer and the Seller. On the flip side, where the Buyer is completely new to the business or the industry, due diligence will necessarily be more complex and in depth, as the Buyer has a much larger information gap which needs to be bridged.
  2. Deal Structure: Asset vs Share purchase
    • In an asset deal, the Buyer is only acquiring specific assets of the Seller, and assuming only certain liabilities. Therefore, the due diligence will be limited and focused only on matters relating to the assets being purchased, rather than on the entire business itself.
    • In a share deal, the Buyer is acquiring the entire business of the Seller, including all of the opportunities, risks, obligations and liabilities associated with it. The scope will therefore be much more extensive than an asset purchase, as the Buyer needs to know exactly what they will be taking on once the deal closes.
  3. Industry: The industry of the business, and the Buyer’s existing knowledge of the industry, may influence the areas of due diligence focused on. For example, due diligence for a gas station will likely include obtaining environmental assessments, something that likely would not be addressed in, for example, an e-commerce business.
  4. Cost: To reduce expenses, the Buyer may wish to limit the scope of due diligence investigations (e.g., by choosing not to obtain a stage 2 environmental assessment). The Buyer may also limit initial due diligence efforts until after the likelihood of the deal closing increases or key information has been confirmed.
  5. Time Constrains: The parties may wish to complete the transaction by a certain date (e.g., fiscal year end), the business may have enough bargaining power (e.g., where it is a very large selling company), or the situation be such that there is a limited time allowed for due diligence (e.g., in an auction situation).
  6. Risk Tolerance: Depending on the Buyer’s existing familiarity with the business, or the purchase price, the Buyer may be willing to purchase the business without engaging in meticulous diligence review.
  7. Shift of Risk: Instead of completing certain searches (which may be either time consuming or expensive), the Buyer may be willing to accept representations and warranties from the Seller regarding certain issues (e.g., the Seller may provide written assurances that there have been no gas spills on the property, and agree to indemnify the Buyer should anything be discovered after closing).

 

Buyer’s Considerations and Objectives:

In short, the purpose of due diligence for the Buyer is to minimize risk, determine whether the purchase should proceed or be abandoned, and to provide information for risk reduction and price negotiations. It can provide a Buyer with valuable insight into a business’s structure, culture, operations, human resources, supplier/customer relationships, competitive positioning, and future outlook.

 

Generally speaking, the goal of the Buyer should be to develop more knowledge about the material aspects of the business and how it has been operated in order to draft a comprehensive agreement of purchase and sale that protects the Buyer’s interest. For the Buyer, some of the key objectives of due diligence may include:

  1. Confirming the Seller has capacity to sell the business or assets (i.e., they actually own the business, and either do not require additional approvals or can obtain the necessary approvals), and that the business or assets will be sold with clear title (i.e., there are no liens, registrations, or other security interests granted to third parties);
  2. Ascertaining whether the business is sufficiently health and/or free from major risks to warrant moving forward. This may include considerations of the economics and health of the business, identifying opportunities for synergies with the Buyer’s existing business(es), the business’ prospects for growth, and the people involved in the business; and
  3. Determining any potential liabilities or risks associated with the business.

 

Overall, the due diligence stage is very important for the Buyer, as with the information learned, the Buyer can leverage information obtained to negotiate certain contractual provisions or abate the purchase price, or, in extreme situations, may even be able to abandon the transaction entirely.

 

Seller’s Considerations and Mitigating Risks:

For the Seller, there are some important risks to be aware of when it comes to due diligence processes, including:

  1. general disruption to the business/operations;
  2. potential for premature disclosure of information if the deal does not close and disclosure of information which may compromise key assets or relationships, including pricing, personnel, landlord/tenancy relationships, suppliers, customers, production/distribution network, etc.
  3. resources necessary to close in light of scale or magnitude of the transaction;
  4. particular disclosure and approval requirements for regulated industries, and other regulatory considerations (e.g., pre-notifications or consents);
  5. consents of other shareholders, especially where there is a shareholder agreement in place;
  6. legal risks (e.g., loss of solicitor/client privilege through disclosure, possible breach of privacy legislation, breach of contracts with other parties in respect of information disclosed during diligence).

 

To help mitigate some of the risks, it is often advisable to have the Buyer sign a non-disclosure and confidentiality agreement before any information is exchanged. Other strategies a Seller may engage include:

  • responding only to written due diligence requests;
  • addressing any adverse facts with the Buyer before it is discovered;
  • excluding specific assets from the transaction;
  • requiring the Buyer to assume specific liabilities;
  • staggering disclosure to prevent premature disclosure of sensitive information, or limiting who disclosure requests can be received and responded to by; and
  • negotiating carve outs.

 

What to Request:

Though the specific due diligence items will vary in every purchase, below are some of the key items which are often included in a due diligence request list:

  • Constating documents (e.g., articles of incorporation, by-laws, etc.), and the corporation’s minute book and registers;
  • Ownership of intellectual property;
  • Leases and other agreements with third parties;
  • Material Contracts and Agreements (suppliers, key customers);
  • Financial documents (balance sheet, income statement, cash flow, projections for future years, etc.);
  • Tax records (T2 tax returns, payroll deductions, HST remittances, etc.)
  • Existing security agreements and encumbrances;
  • Parcel registers for any real property owned, property tax and utility bills;
  • Employment contracts; and
  • List of physical assets and equipment.

 

Impact of Due Diligence on the Deal:

Information discovered during due diligence can have significant impacts on the deal. Ascertaining how certain components of the business or matters discovered during due diligence review will impact the deal is very important. Some impacts may include:

  • Reductions to the purchase price or changes to the how it will be paid (holdback, escrow, earn-outs, etc.);
  • Changes to the overall deal structure (share vs asset deal);
  • New terms in the purchase agreement to address risk factors that have been uncovered (e.g., what representations or warranties are needed, what covenants are needed, any third-party consents required to close, indemnification in the event of a breach of a representation or warranty, etc.); and
  • in extreme situations, termination of the transaction entirely.

 

Your Due Diligence Team:

Typically, the due diligence team for both the Buyer and the Seller will include personnel from three main areas: legal, accounting, and business.

How your lawyer can help: conducting searches on the business and the Seller, reviewing copies of legal agreements and other documents disclosed (such as leases, supply agreements, loan documents, etc.), requesting and keeping track of disclosures, setting up data rooms, building in representations, warranties, covenants and indemnities into the purchase agreement to combat information discovered, negotiating confidentiality agreements, and more.

Outside of a lawyer, other members of your team that should be involved in due diligence may include be a broker, real estate agent, financial advisor, accountant, contractor, and key members of your existing business.

 

Conclusion:

Conducting due diligence is a critical aspect of the process when considering a merger or acquisition of a business. Effective due diligence requires an experienced legal team which knows what it is looking for. If the Buyer does not conduct adequate due diligence, a court of law will not be sympathetic to a claim for recission of the contract due to the longstanding common law principal of caveat emptor. Caveat Emptor stands for the proposed that a buyer must exercise its due diligence before a purchase otherwise the buyer is at its own risk in the absence of an express warranty in the contract.

If you are thinking about buying a business or have already started the process, get in touch with one of our experienced team of business lawyers at CARREL+Partners today.

 

Stay tuned for more articles in our Business Transactions Deep Dive series!

Buying a business can be complicated. While none of these tips will guarantee you a successful purchase, they will increase the chances that your deal will run smoothly and close on budget. If you are thinking about buying a business or have already started the process, get in touch with a our experienced team of business lawyers at CARREL+Partners today.

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Disclaimer:

This publication is for general information purposes and is not to be taken as legal advice. The information within is current only to the date of publishing. If you have any questions regarding article content, please contact the author(s) directly.