When initially deciding on the acquisition of a particular target company or business, buyers will often rely only on available public information, limited information released by the sellers and any knowledge of the target’s business that they have acquired from previous dealings.
Before entering into a binding commitment to acquire a target, it is essential that the buyer carries out a full investigation of the target. A thorough investigation will reveal areas in which the buyer may be at risk, and where it will be necessary to include relevant warranties and indemnities in the acquisition agreement as a measure of protection, and will maybe lead to the re-negotiation of the purchase price.
The investigation of a target company in a share acquisition will need to be more extensive than that undertaken when acquiring a business. This is because buyers of shares will be acquiring all the assets and liabilities of the target company, rather than those selected to be included in a business acquisition, where the investigation will be more specialised.
Apart from the commercial investigation carried out by the buyer, it is usual for the investigation to consist of financial due diligence, carried out independently by a firm of accountants, and legal due diligence. In particular cases it will be necessary to examine other aspects, such as information technology, environmental issues or pensions. All will be central to drafting the acquisition agreement and protecting the respective parties.
Legal Due Diligence: the nature of information required
The preliminary enquiries of buyers will cover commercial, employee and property concerns, together with company searches, property searches, intellectual property rights searches and bankruptcy searches against the names of individual sellers.
It is important for the buyer to obtain full details (and copies) of contracts which the target has entered into. This will ensure that the buyer is aware of expiry dates, change of control provisions, opportunities of renewal and onerous terms. In a business acquisition, the buyer will need to examine key commercial contracts to see whether they require consent to assignment or contain any other restrictions on assignment.
Buyers should also investigate the loan arrangements of the target and the existence of any charges. This will ensure that the buyer is aware of any onerous provisions in the loan agreements, perhaps requiring immediate repayment of the loan on a change of control, and will confirm which charges will need to be discharged before completion of the acquisition. It is also essential that the buyer ascertains whether the seller of shares has guaranteed any obligations of the target, such as the repayment of a fixed term loan. It may be necessary to obtain releases and provide substitute guarantors in this respect.
Intellectual property rights may also be crucial to the business and it is important to ascertain whether rights are adequately protected, what agreements and licences are in place and, on a share purchase, whether a change in control will affect such arrangements. On a business acquisition, the buyer may have to approach third parties with a view to renegotiating licences or agreements entered into with the seller. It is also essential for buyers to obtain details of the computer systems and software packages used by the target to check they are licensed and to enable the buyer to integrate these with its own systems.
Where the target is a member of a group, the buyer should also request information on goods or services supplied on a non-arms’ length basis to other members of the group, since it is unlikely that such arrangements will continue once the group relationship is broken. It is also possible that individual shareholders of the target have been supplying, or receiving, goods or services to or from the target either directly or through companies in which they have an interest. The buyer’s analysis of the target’s profit figures may be very different in the light of arrangements such as this that will cease on completion of the acquisition.
Warranties and Indemnities
The scope of the due diligence will determine, at least in part, the extent to which the buyer needs to safeguard itself by including warranties and indemnities in the acquisition agreement.
A large part of the acquisition agreement will usually consist of warranties by the sellers in favour of the buyer covering a whole range of aspects of the target’s business, many of which are reviewed in the due diligence process. Warranties are representations by the sellers that a particular state of affairs exists. The sellers will disclose any qualifications to the warranties in the form of a disclosure letter, thus providing the buyer with a more accurate picture of the target’s business. If the buyer subsequently discovers that any of the warranties provided by the sellers are untrue, it must establish loss to be able to claim damages. Sellers will invariably negotiate limitations on their liability in this respect.
Indemnities are also included in acquisition agreements, usually on a less extensive basis as they are more burdensome on the sellers. Indemnities are essentially promises by the sellers to reimburse the buyer in respect of a designated type of liability which may arise in the future. The buyer will simply receive an amount equal to the liability, together with related costs and expenses. It is the usual practice on the purchase of shares in a private company to seek such an indemnity against tax liabilities.
Issues revealed in the due diligence process will highlight where particular warranties and indemnities should be sought to protect the buyer.
Due diligence is a vital part of any acquisition, both in terms of clarifying the target’s business and protecting the buyer in the binding contract. It also provides the sellers with an opportunity to provide a fuller picture of the target and to justify a qualification of any of the warranties. The process should not be compromised even for a smaller, or less complex, acquisition, though it should be more straightforward in such cases.