The Essentials of M&A Due Diligence

Peter Howson

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351606066
• Edition: 1
• Topic: Business
• Subtopic: Mergers & Acquisitions
• Index: Business

How can you be sure you are buying the company you think you are? Are you sure it is as good as the seller says? How can you be certain unexpected costs and obligations will not suddenly appear once you are the owner and responsible for them? How best can you arm yourself for the negotiations? Have you worked out precisely what you are going to do with it once it is yours? How do you set the priorities for change to recoup the premium you have paid for it?

The answer to all these questions, and many more, lies within a series of three comprehensive yet concise volumes by Peter Howson.

The Essentials of M&A Due Diligence, the first in the series, is a must for anyone who needs to master the essentials of due diligence with the minimum effort and in the minimum amount of time. Straightforward and unbiased, it sets out the fundamentals of pre-acquisition investigations, showing which are appropriate and why.

1 Introduction

Due diligence is the process of finding out about what you are buying. It is often criticised as a way of spending a lot of money to tell you what you already know – which is exactly what it should do, preferably without costing too much.

Due diligence comes just before the final negotiations. By then sellers have nothing to gain by giving a buyer time to probe and find reasons to chip away at the agreed price. This means the buyer has a short time to collect and digest a lot of information, often with imperfect access. Without building up a prior body of knowledge on the target, sufficient to highlight the ‘known unknowns’, a buyer puts itself at a disadvantage.

After that, it is all about project management. The last thing a buyer needs is expensive advisers doing their own thing or falling over each other. Focus is key. This book is about helping to decide what information is and where and how to get it so making due diligence manageable and cost effective. And if it only confirms what you already know, so what?

When is it done?

Acquisitions come about in different ways, from long courtships with lots of goodwill built up on both sides to controlled auctions where a buyer hardly gets a look in before the final stages. At some point towards the end will come Heads of Terms/Heads of Agreement/A Letter of Intent. Whatever called, it is a (non-binding) document which sets out the main points agreed (price, timing, etc.) and the basis on which the two sides are prepared to proceed. It confirms that the parties are serious and signals that (formal) due diligence can begin. Until then, the buyer will have relied on public information, information released to help the transaction – an information memorandum, partial access to a data room, vendor due diligence and maybe even management discussions – but has not yet had the opportunity systematically to research the workings of the target and verify the accuracy of the data it has been given.

Why do it?

It is possible to buy a company without doing any due diligence; it is not a legal requirement in acquisitions, so why bother? What persuades the sceptical CEO to spend money verifying what management has already told him?

First of all, without making the enquiries you will not know where the risks are, meaning that you can only negotiate standard warranties. There is nothing wrong with that if the deal is small and/or the buyer’s knowledge of the target is very good.

Second, due diligence can unearth problems no-one really knew existed. Sellers, usually quite genuinely, believe their companies to be problem-free. Often they will have lived with what outsiders would see as ‘problems’ without any harmful effects.

Another benefit of due diligence is avoiding litigation. Litigation is expensive and uncertain. Comparatively speaking, due diligence is cheap. Buyers should be much more comfortable knowing about problems beforehand, rather than being left with the possibility of making warranty or indemnity claims or having to sue the seller.

Third, knowledge is power. Due diligence gives the buyer knowledge. The more that is known about a seller’s business, the better the buyer is equipped for the negotiations which lie ahead.

Fourth, as a defence against charges of negligence in a transaction. The US courts, for example, have found that it is not reasonable to rely exclusively on the target’s management. What they tell you must be double-checked through an independent investigation.

Once completed, due diligence findings feed into the final negotiations by identifying risks against which the buyer should negotiate some sort of protection or guarantee with the seller.

Last and by no means least, due diligence should have an important part to play in the acquisition making a decent return. A buyer will always pay more for a business than a seller thinks it is worth. To make a return on the transaction, a buyer must either know more than the seller does or be able to do more with the business than the seller can. Due diligence findings should therefore also assess the strategic rationale of the deal, the business’s standalone value and growth prospects and the size, timing and achievability of synergies. Findings should feed into the post-acquisition integration plan.

Under English law, the principle of ‘caveat emptor’ or ‘buyer beware’ means that virtually no terms are implied in favour of a purchaser of shares in a company. Consequently, protection must be dealt with by express contractual provision. The usual form of protection is through warranties and indemnities, but a purchaser should use all means of protection available: due diligence, warranties, indemnities, reductions in the purchase price, retentions from the purchase price, earn outs, guarantees, insurance, the exclusion of certain assets and remedial work at the seller’s cost.

Warranties

A warranty is, in effect, a ‘guarantee’ by the seller that a certain state of affairs exists. Warranties are statements of fact which the seller confirms to be true. An example might be that the target company is not involved in any litigation. If the seller knows that this is not true, it discloses the real facts (e.g. the details of the actual litigation) in a disclosure letter. By disclosing exceptions to the warranties, the seller will have no liability for the matters disclosed. If a buyer tries to claim for one of these items, the seller can hold its hands up and say, ‘but I told you about that’.

Warranties have two functions as far as a purchaser is concerned. The first is that the disclosure letter usually contains a lot of useful information about the target. It may even flag up liabilities which were previously unknown, in which case the purchaser may try to negotiate a price adjustment. The second is contractual. Any breach of the guarantee given by the warranties which has a bearing on the value of the target entitles the purchaser to a retrospective price adjustment. That is to say, where there is a breach of warranty, a buyer who can prove loss is entitled to damages to put itself back in the position it would have been in had the warranty been true.

Great, except that there are problems in relying on warranties. It can be difficult (and costly) to prove that there has been a breach, that there has been a loss resulting from the breach and how much less the target company is worth as a result of that loss – especially several years down the line, when all sorts of other things have changed, too.

Indemnities

An indemnity is a guaranteed remedy against a specific liability. The buyer is entitled to it regardless of whether or not the value of the target is affected or whether the liability was disclosed in the disclosure letter.

Indemnities enable the purchaser to adopt a ‘wait and see’ policy, especially if there is uncertainty about the size of the liability and/or whether it will crystallise. The sale and purchase agreement can provide that if the liability crystallises, the purchaser will be compensated an amount to cover the loss suffered. One of the most common indemnities is an indemnity against tax liabilities. Here the vendor promises to meet a liability should it arise.

The value of an indemnity (or a warranty, for that matter) depends on the financial worth of the seller. If the seller is not particularly creditworthy or, for example, has moved its assets to an offshore jurisdiction or into his wife’s name, some security may be called for. This could take the form of a deposit of funds in an escrow account, a third party guarantee or even retention from the purchase price for a stipulated period after completion.

Like warranties, difficulties of proof may make indemnities difficult to rely on. They may also be time limited and financially capped.

The different due diligence disciplines

There are a number of different types of due diligence which can be carried out. Table 1.1 summarises the three main areas, while Table 1.2 shows the other usual due diligence topics. It looks like a forbidding list. In any deal, some of these will be more important than others. Some will be carried out as topics in their own right, and others subsumed under other headings. For example, human resources, IPR and property could be covered by legal due diligence; tax, insurance, IT, operational and pension by financial due diligence and management and technical by commercial due diligence.

All the above, except property and operational, are covered in later chapters. Property is covered under legal, while operational is so highly tailored to the target company it is difficult to generalise about it much beyond what is said in Table 1.2 and in the appropriate headings in the chapter on financial due diligence.

Table 1.1 The main due diligence topics

Due diligence topic	Focus of enquiries	Results sought
• Financial	• Validation of historical financial information, review of management and systems.	• Confirm underlying profit, provide a basis for valuation, determine cash free/debt free adjustments.
• Legal	• Verification of assets, confirmation of title, contractual agreements, problem-spotting.	• Priorities for warranties and indemnities and other means of legal protection, validation of existing contracts, drafting of sale and purchase agreement.
• Commercial	• Market dynamics, targ...