Due Diligence in M&A Transactions
What is Due Diligence?
Due diligence in a catch-all term alluding to the process that buyers undertake to familiarize themselves with the business and assets they are considering acquiring from a seller or target. Depending on a variety of factors, the scope of due diligence can be minimal to exhaustive. The size of the target business, the industry in which it operates, and the structure of the business will all bear upon the scope and depth of the due diligence that is undertaken.
The bottom line with any due diligence undertaking is to minimize risk prior to making an acquisition, investment, refinancing, restructuring, and public listing or similar transaction. Due diligence helps an acquirer to understand how the business of the target is conducted and how it may be able to be integrated into an existing group of companies. In addition to it revealing the information required to assess possible financial, legal, and regulatory issues, the process provides valuable insight into a Target’s structure, culture, operations, human resources, supplier/customer relationships, competitive positioning and future outlook.
Aspects of Due Diligence
Within the life cycle of a merger and acquisition, due diligence follows the drafting of a confidentiality agreement, valuation and letter of intent. Whether a share transaction or an asset transaction, a buyer’s legal due diligence will typically involve the following:
- A review of the corporate records of the target corporation
- A review of the intellectual property of the target corporation
- A review the encumbrances and litigation of the target corporation
- A review of government records pertaining to employment, environment, and tax, which can only be accessed with the target corporation’s consent
- A review of the material contracts and agreements to which the target corporation is a party such as distribution agreements, supplier agreements, warehousing and logistics, licensing agreements, franchise agreements etc.
- A review of the financial health of the business which includes reviewing the financial statements, T2 Income Tax Returns, balance sheets and general ledgers
- Other due diligence pertaining to the nature of the target corporation’s business
With respect to corporate records, this will involve a review of the board of director’s minutes and other records pertaining to the number and type of shares of the target corporation and any liabilities that are not immediately disclosed.
The result of one’s due diligence will lend insight into whether the transaction should proceed or be abandoned, and provide information for risk reduction and price negotiations.
There are different types of Due Diligence which generally fall into the following categories:
Legal Due Diligence
The process of legal due diligence involves reviewing any legal risks associated with the target including assets and property ownership, Intellectual property, loans, securities, corporate governance, employment, customer and supplier disputes, and any pending litigation. Consideration during the legal due diligence process will be paid to the structural ownership of the target, existing contracts with customers, suppliers and management; adherence to regulations including a history of any breaches, and any insurance claims.
Legal due diligence also typically involves the running of various public record searches to verify if there are any liens against the business, if the corporation is involved in litigation, if there are outstanding executions or writs against any target or if the corporation has filed for bankruptcy.
Legal protection should be used in instances of uncertainty or for risk mitigation. Warranties and indemnities are all common outcomes of the due diligence process. Typically these will be included in any Share Purchase Agreement (SPA) with the Target providing representations at the point of sale. Should the Target refuse such provisions, the acquirer may have to be prepared to walk away from the transaction.
Fundamentally, legal due diligence involves a review of the material contracts of the Target with an eye to the onerous provisions that will bind the purchaser.
Lawyers typically assist with legal due diligence.
Financial Due Diligence:
The scope of the transaction will depend on the availability and quality of the financial information, typically contained in a target corporation’s monthly or quarterly management accounts. The acquiring corporation will look at the target’s historic financials including the balance sheet, profit and loss, cash flows, projects and contracts, earnings, assets, and liabilities, and future financial projections.
An accounting firm typically assists with financial due diligence. Lawyers cannot make inquiries or comments on financial matters.
Commercial Due Diligence
Commercial due diligence involves reviewing factors such as market structure, size and conditions specific to the sector, legislation specific to the sector, competitor analysis, and customer and supplier feedback. This is typically undertaken by the acquisition team which is comprised of business advisers or M&A specialists.
Operational Due Diligence
Operational due diligence refers to the appraisal of key systems and processes, including IT systems, key management team and senior staff, staffing and other HR matters, and insurance and risk assessments. This is also undertaken by specialists in the industry as opposed to lawyers or accountants.
Human Resources Due Diligence
When conducting due diligence in a target’s human resources, the acquiring business should review the target’s compliance with employment laws, employee contracts, and employment related liabilities. Consideration should also be given to post-deal matters and the integration plan from an HR perspective in terms of retention of key talent, communication and integration of company cultures. HR specialists and employment lawyers typically assist here.
Conclusion – Due Diligence
The above constitute the most important and common areas of due diligence, which should lead to answering the following key questions:
- Are there any problems with the target that would lead you to abandon the deal?
- Are there any issues that would lead to a change in the structure, terms, and price of the transaction?
Clearly, conducting due diligence is a critical aspect of the process when considering a merger or acquisition of a target. Effective due diligence requires an experienced legal team which knows what it is looking for. If the purchaser 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 purchase is at its own risk in the absence of an express warranty in the contract.
Contact one of our M&A lawyers to assist you in conducting a due diligence process that is comprehensive and informative, leading to a sound and solid business transaction.
-Shira Kalfa, BA, JD, Partner and Founder
-Shira Kalfa, Founder & Partner
Shira Kalfa is the founding partner of Kalfa Law. Shira’s practice is focused in corporate-commercial and tax law including corporate reorganizations, corporate restructuring, mergers and acquisitions, commercial financing, secured lending and transactional law. Shira graduated from York University achieving the highest academic accolade of Summa Cum Laude in 2012. She graduated from Western Law in 2015, with a specialization in business law. Shira is licensed to practice by the Law Society of Ontario. She is also a member of the Ontario Bar Association, the Canadian Tax Foundation, Women’s Law Association of Ontario, and the Toronto Jewish Law Society.
© Kalfa Law 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.