M&A due diligence process for buyers
The following is a summary of the due diligence part of a merger or acquisition (or "M&A") process, specifically the legal due diligence undertaken by the buyer (and/or its advisors) when assessing a potential target company (share purchase) or business (asset purchase). We do not discuss the specifics of other types of due diligence the buyer might undertake such as financial, commercial, tax, environmental, IT/cyber, and HR due diligence that are standard in M&A transactions.
There are many other crucial steps that come before and after the legal due diligence process which are outside the scope of this article. These steps include (but not limited to) acquisition strategy and criteria, valuing and evaluating a target, management presentations and Q&A sessions, as well as post merger integration of the target company or business.
Why is M&A legal due diligence important?
M&A legal due diligence is the process of reviewing documents and assessing the legal risks, liabilities, and compliance issues associated with a target company or asset that might affect the proposed transaction. While the seller and buyer can undertake legal due diligence, the focus of this article is on the buyer's legal due diligence.
The main reasons why legal due diligence is performed are:
- helps uncover any potential legal risks, litigation/lawsuits, disputes, or regulatory issues that could impact the target company or business. This includes reviewing contracts, intellectual property rights, employment matters, and pending litigation by conducting court searches.
- evaluates whether the target company or asset is compliant with relevant laws, regulations, and industry standards. This may involve reviewing corporate governance documents, licenses, permits, and adherence to environmental, labour, and tax laws.
- aims to identify any undisclosed liabilities, such as outstanding debts, liens, or legal judgments against the target company or asset.
- verifies the accuracy of legal representations made by the target (or its management), such as ownership of assets, validity of contracts, and compliance with laws.
- helps structure the proposed transaction in a way that mitigates identified legal risks and ensures compliance with applicable laws and regulations.
- assists the buyer evaluate the proposed merger or acquisition as well as valuing the target company or asset.
- helps identify any necessary conditions that might need to be included in the sale and purchase agreement (for example, counterparty consent to a change of control of the target company for a share sale).
M&A legal due diligence process
The process description suggests a linear flow, but in practice, due diligence activities often occur simultaneously.
Seller (or company) sets up the data room
- The seller selects a data room to securely share documents with the buyer, the buyer's internal team and the buyer's professional advisors. Stay tuned for a future article on what to look for when selecting a data room.
- The seller can start preparing the data room by uploading some documents. Otherwise, the seller can wait until the buyer prepares the Information Request List (or "IRL") requesting documents and information from the seller.
- If the buyer is a competitor of the seller, the seller may elect to limit disclosure of information by providing a "vendor due diligence report" (or "VDDR") which is generally prepared by the seller's advisors. In this case, the information provided in the data room (at least at the early stages of the M&A process) will be limited to the VDDR.
Information Request List (IRL) or M&A due diligence checklist
When representing the buyer in an acquisition, one of the key initial steps is to prepare the Information Request List of documents that should be requested from the seller. As an advisor, here is how you might approach preparing the Information Request List:
- Understand and gather information about the proposed transaction type (asset sale or share sale), information about the target company or asset including the industry of the target.
- consult with the buyer's internal team, and other professionals involved in the transaction to understand their specific areas of interest and any particular concerns they may have.
- Use a M&A due diligence checklist to develop a comprehensive list of documents and information to request from the seller. Organize the M&A due diligence checklist in a structured manner, categorizing requests by subject matter or importance.
- Click here to download free M&A due diligence checklists
- confirm with your client (the buyer) that there is nothing missing from the IRL.
- work with the seller and their advisors to understand the best way to send them the Information Request List (usually via the seller's data room).
- once the Information Request List is finalized, formally submit the list to the seller's representatives, ideally through a data room.
Agree on the scope of the buyer's due diligence
Spending time on the scope of due diligence is often an overlooked area, but in some ways, it is the most critical area. Scoping a due diligence accurately helps to ensure that the advisor completes the due diligence on time and within the agreed budget.
- After the seller provides the documents requested in the Information Request List and makes them available in the data room, the buyer can start reviewing the documents within the data room itself or by downloading the documents and storing them in their own data room (if the data room permissions allow). Even if the seller has set up a data room, it might be necessary for the buyer to set up their own data room so they can project manage the due diligence and successfully close the transaction.
- Confirm the proposed transaction type (e.g. share sale or asset sale) as this will influence what contract provisions are reviewed in the due diligence. Sometimes the buyer might not know the proposed transaction type at this early stage so you might need to consider a couple of options.
- The buyer will agree with its advisors what documents they want reviewed, the nature of their review (e.g. ‘red flags’ only or a more detailed review) and the type of due diligence report to be delivered to the buyer (e.g. exceptions only due diligence report or a detailed due diligence report).
- Ask the buyer whether they have a "materiality threshold" to apply to the due diligence. This might be a quantitative and/or qualitative materiality threshold. This helps you determine what documents or contracts are material and therefore within the scope of due diligence. Spending time on documents that are not material, may affect your ability to recover time spent (and legal fees) on this transaction.
Project managing a due diligence
- The buyer’s advisors assemble teams of M&A due diligence document reviewers, normally consisting of subject matter experts such as employment, tax, cyber/privacy, property leasing, etc.
- The legal advisor classifies the documents by document type in the data room and assigns the documents to the reviewers based on their area of specialisation.
- This helps the M&A due diligence project manager know the review status of documents and can re-assign documents to reviewers that have spare capacity to speed up the review and ensure the due diligence is completed on time and within budget.
M&A due diligence and document review using checklists
- Always use a M&A document review checklist to review documents.
- The checklist should be customised based on the document type and the agreed scope of work (as above).
- Download free M&A due diligence review checklists to review documents
- The buyer's team of document reviewers review the assigned documents, identifying any red flags and preparing document summaries of key terms in each contract or document.
- The buyer's advisors compile the individual document reviews, comments, and findings from the review teams into a cohesive report.
Prepare and finalise M&A due diligence report
- The buyer’s advisors prepare a draft report using a due diligence report template. See here to download free due diligence report templates.
- The due diligence report typically summarizes the findings from the due diligence, key risks (or red flags), and recommendations for each key risk (where applicable). Key risks are often presented as a traffic light system: high risk (red), medium risk (amber) and low risk (green) which seeks to help the buyer prioritise the risks and recommendations identified in the due diligence.
- After review and input from the buyer on the draft due diligence report, the buyer’s advisors finalize the due diligence report, incorporating the buyer's feedback.
- Often finalising the due diligence report is an iterative process as when the draft report is initially provided to the buyer, often there are outstanding requests for information or RFIs asked of the seller in the Q&A process that need to be answered and incorporated into the final due diligence report.
- As such, it's important to document when the review cut-off date is so that you are not responsible for missing information that the seller disclosed after the review cut-off date.
Recommendations to be incorporated into the transaction documents
Sometimes there are key risks identified in the due diligence that need to be dealt with in the transaction documents (e.g. the sale and purchase agreement). One common example in a share sale is change of control restrictions. Change of control restrictions of the target company are typically treated as conditions precedent in the sale and purchase agreement. It is the responsibility of the M&A project manager to ensure that relevant findings from the due diligence are appropriately captured in the transaction documents.