WHAT IS DUE DILIGENCE?

Due diligence is the term used to describe the detailed investigation and audit that you should undertake prior to exchanging contracts. Going back to the analogy in the introduction, it is akin to the survey you would carry out on a house prior to exchanging contracts, to ensure there is nothing untoward that might affect your decision to complete the purchase.

Having achieved agreement on the heads of terms, due diligence and the negotiation of the detailed sales contract will then tend to run in parallel, as the treatment of issues arising out of the due diligence process will need to be negotiated for inclusion in the contract.

Traditional due diligence has always focused on legal and financial matters, and generally is undertaken by your solicitors and accountants respectively. Over the last few years, however, a broader ‘commercial’ due diligence has increased in importance, normally covered by the work of your accountant.

There is significant crossover between these three broad areas, as indicated below.

The areas to be considered under each of these broad headings of due diligence headings are set out in this and the following

chapters, where you will see for example that both legal and financial due diligence will look to cover areas such as insurance. Since the topics that due diligence will cover are well known, these are obviously areas that a well advised and prepared seller should have addressed during their grooming of the business prior to putting it on the market, so that due diligence goes as smoothly as possible.

Attempting to undertake ‘DIY due diligence’ on any meaningful acquisition in order to save costs may be very dangerous in the long term, as you may not have the experience or the full range of skills required to assess the issues and you will have no recourse if it goes wrong.

LEGAL DUE DILIGENCE

Legal due diligence is broadly about:

• establishing the basic information surrounding the company and the legal status of its relationships with other parties so that problems can be spotted and adequate warranties taken
• ensuring the company’s compliance with the regulatory framework within which it needs to operate
• establishing the legal position in respect of a number of specific areas of assets and liabilities.

The main areas to be covered are set out below.

Ownership and structure

To prepare a sales contract you will firstly need to establish who the parties to the contract will be. Legal due diligence will look at the business’s formal legal structure – a partnership with a partnership deed, or a company with authorised share capital. If it is a company it will investigate the authorised issued share capital, who the shareholders are, whether there are any agreements between shareholders, whether there are any restrictions on the shareholders’ ability to sell shares, or restrictions in the company’s memorandum and articles of association that will impact on the ability to do the proposed deal.

You will also want to:

• know whether any of the shares, or the company’s assets, have been offered as security to any third party (for example, a debenture given to secure loans from a bank)
• check to ascertain whether the business is solvent and whether there are any insolvency or other legal proceedings pending and if so, the detailed status of each item
• ensure that there are no other bars to completing a sale, such as: Do any contracts, licences or agreements entered into by the company require the consent of any third party to the sale and change of ownership of the business?

Statutory compliance

Your solicitors will need to check that the statutory books and records are up to date, reflecting all the currently issued shares, meetings of directors, debentures and other charges, and whether the business has filed all necessary tax and/or company secretarial returns (such as filing of annual returns and sets of accounts at Companies House).

Funding facilities

Any or all loan and related security or guarantee documentation will need to be reviewed to consider:

• Are the business’s banking facilities in place with up-to-date mandates? Have the directors and/or owners personally guaranteed any such facilities? If so, how is it proposed that such facilities will be dealt with?
• Will the potential sale make any grants received liable to be repaid?
• Has the business given any guarantees or indemnities in respect of any third party’s obligations and do any third parties have any options over the company’s shares or any of its assets?

Liabilities

The solicitors will need to investigate whether there are any potential claims against the business not provided for in the normal accounts.

• A complete list of all disputes, claims, and any known legal proceedings will be required, together with full details of progress of the case and the company’s position.
• A full list of all contingent liabilities wil be needed, including employee claims, guarantees, warranties, produce returns, maintenance and support obligations, and any claims from suppliers for payment that are being disputed.

Contractual relationships

Your team will want to review all material agreements with suppliers or customers, such as any joint ventures or partnerships, any agents, licences, distribution agreements, franchising, or outsourcing arrangements, and any material supply contracts with customers or suppliers.

They will also need to review:

• any standard contracts for sale of goods or supply of services as well as standard purchasing documentation
• reservation of title clauses built into your terms of sale and the details and potential exposure under all warranties that you offer with your goods and services to see how effective they are likely to be
• a list of all material contacts to establish whether any of the business’s contracts are directly with either the individual vendors or related parties, and if so, whether any of these are undertaken on the basis of arm’s length transactions or on non-commercial terms.

Licensing and compliance

Your solicitors will need to check that the business meets all the necessary regulations and licensing requirements for carrying out its trade, and whether it is in default of any regulatory matters.

Where appropriate, a detailed health and safety review should be undertaken (which may involve the employment of a specialist), which will require the full disclosure of all health and safety meetings, recent reviews and inspections (including fire safety issues), and any disputes.

Similarly, you will need to take a view as to the extent to which any environmental due diligence is required. Given the strictness of current environmental legislation and the way that directors can increasingly be held personally liable for environmental issues, this is almost becoming inevitable in a business sale of any size. Again, a specialist consultant is likely to be required to consider the potential environmental risks of the company’s activities, review the necessary licensing and consents and review compliance with rules and regulations concerning waste discharges, spillages and so on.

And don’t forget to check to ensure the company is properly registered under the Data Protection Act and is complying with the requirements of the Act.

Intellectual property

A key part of the business’s value to you will be its ownership of any licences or intellectual property (IPR), such as trademarks, brand names, patents or designs. These need to be checked to ensure that all such intellectual property has been registered where applicable:

• with the relevant authorities, such as the trademark registry or the patent office, and
• that this has been done in the company’s name (and not the name of the business owner personally).

It is also worth considering if there is any intellectual property of significant value which has not been registered.

• Does the company trade under its own corporate name or under other trading names?
• If so have these been properly protected by registering as trademarks and possibly by registering dormant limited liability companies under these names at Companies House?
• If so, who owns these dormant companies, the business owner or the company?
• Have domain names been registered so as to protect its trading names in e-commerce? If so, who owns these?
• Is the business party to any confidentiality agreements?

Employees

Employees can be a major source of claims against a company. You will need a detailed list of all current employees, together with copies of their standard terms and conditions of employment.

• Do any employees have materially different terms and conditions of employment? If so, you will need to see copies.
• What are the procedures for dealing with complaints and disciplinary matters? Ask for full details and the records of such activities.
• Request details of all employees who have been dismissed over the last, say, three years. Are there any cases pending for unfair or constructive dismissal? Have any employees been dismissed within the last six months (which are still within the time limits for a claim to be lodged at an employment tribunal)? Are there any cases currently at an employment tribunal?
• Has the company engaged the services of a professional firm of employment advisers in order to ensure its procedures and practices match the requirements of current employment law?
• Are there are any profit sharing, bonus or option schemes for directors or employees? If so, what are the details?
• What pension arrangements are offered by the company to employees? If there are more than five employees, has the company instituted at minimum, a stakeholder pension scheme? Ask for full details of all existing pension schemes. If the company operates any form of final salary scheme (also known as a ‘defined benefits’ scheme) ensure you obtain details of the trustees as well as a copy of the most recent actuarial valuation. This is so that you can establish the degree to which the scheme is adequately funded, as if the scheme is underfunded this will need to be made up out of future profits – and increasingly legislation is making directors potentially personally responsible for protection of the pension fund. If you discover that a final salary scheme is significantly underfunded you should seriously consider pulling out of the purchase.
• Look particularly at all contracts of employment for directors (often known as service agreements). In addition to basic information about salary and notice periods, do such contracts include provisions for restrictive covenants preventing them from entering into competition with the company, specific bonus, profit sharing or option schemes and/or provisions specifically regarding the sale of the business (for example, a ‘golden parachute’)?
• Finally it is always worthwhile for your planning purposes to calculate the notice pay and redundancy that would be due to each employee if required. This quantifies the liability that you will be taking on under TUPE and allows you to plan any cost reductions required in your restructuring of the business.

Property

You will need a list giving the details (address, whether freehold or leasehold, and if leasehold, length of the lease and name of the landlord) of all properties used by the business (including details of any premises it has leased in the past), together with all the documentation needed to be able to establish that the business has good title to its current properties in order to be able to hand them over to you.

Your solicitors will need to investigate a range of commercial issues as regards all such properties, including the terms of leases; details of any specific rights or restrictions on your rights to deal with the property arising out of any transactions such as mortgages; and charges, easements, sub-tenancies or options that have been granted, either to or from the business. Often a surveyor’s report will be requested to provide a valuation of the property, together with a costing of any dilapidations that may exist and for which the business is liable under the lease.

Key issues will include:

• Are there any disputes with the landlord or owners of adjoining premises?
• What planning exists in respect of the properties, and have all the necessary planning permissions and building regulations necessary for the business’s required use been obtained?
• Is there any planning consent for use other than as currently that might have an affect on the property’s value?
• Who is responsible for insuring the property, the business or the landlord? If it is the company, obtain details of the insurance.
• Does any change of ownership of the company require the landlord’s consent?
• How long do any leases have left to run?
• What are the current rentals and when, and on what basis, are rent reviews conducted?
• Has the company previously rented property where it has then signed the lease to a third party? If so, does the company still have a contingent liability in respect of that lease?
• Are there any specific environmental risks associated with any of the properties such as a history of contamination or subsidence?

Insurance

Does the business have adequate insurance to cover its assets, as well as its trading activities (such as business interruption cover, and product liability insurance)? Obtain copies of all the insurance documentation together with details of any outstanding claims in progress.

See Appendix B, page 431, for a sample legal due diligence information checklist that illustrates the depth to which legal due diligence will look to go.