Welcome to MJ Hudson’s first monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions. This month we focus on due diligence, with 10 handy dos and don’ts on how to run an efficient process.
Make sure you have a clear idea of your objectives and that you resource your legal due diligence accordingly. Focus in particular on any arrangements or circumstances that appear non-standard, and ensure you have a thorough understanding of all areas that underpin the business’ value (e.g. key assets, key trading relationships, business-critical licences). Always cover, in sufficient detail, any areas that an internal or external interested party (e.g. investment committee, or funding bank) may require in order to proceed.
Publicly available sources can reveal key information about a target. For example, a company’s accounts can show material liabilities that would shape the scope of the due diligence review and influence transaction terms, e.g. latent pension scheme liabilities. In the case of UK companies, Companies House records will identify the ultimate beneficial owners and will also reveal any secured creditors.
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Agree a clear due diligence scope, including a materiality threshold, with each professional adviser at the outset. Make it detailed. For example, “review of IP for material issues” could prompt a lawyer to review every aspect of a company’s intellectual property, prepare a long report and distract attention from the company’s true, value-driving assets. Specify the outcome – is it a summary of terms, a list of onerous contracts, a commentary on likely financial exposure? Make sure the scope has been signed off by the right people internally and externally (i.e. those who will rely on it), especially any financing bank. This will help deliver focused, efficient and cost-effective due diligence.
Face to face meetings between a buyer’s advisers and target’s management will always expedite due diligence, and save inboxes. Where permitted by the sellers, arrange for your legal advisers and any other key advisers to meet with the target’s management team sooner rather than later to identify and discuss key due diligence issues. Opening communications channels and building trust between your advisers and target management will save time and ensure your advisers have a solid understanding of how the target’s business operates.
After closing, you should be able to launch straight into implementing your 100 day plan. That is, if you’ve prepared one (do it). Your plan should pick up on all those niggles and non-show-stopping issues raised during the due diligence process. It should also include an assessment of the target’s finances, key trading relationships and any other assets critical to operations and revenue. The plan and a post-acquisition audit should flush out any potential warranty claims and, if you plan to make multiple acquisitions, will be important learning for future transactions. Keep good notes.
Deal costs should never be a surprise; know who’s being paid what, by whom, from the outset. If, as a buyer, there is no scope to agree a seller contribution to your costs up front, could you at least agree to recover some costs if exclusivity is breached? If the buyer is ultimately shouldering costs, is there a clearly itemised budget for due diligence, including contingency for inevitable overrun? Don’t forget to agree costs and abort costs with legal and other professional advisers before work starts.
Where budget or resources are tight, a buyer could be tempted to forgo legal due diligence and instead rely on warranties and indemnities in a sale agreement. Bad idea. Not least, financial recovery may be insufficient to compensate a buyer for a breach of warranty. Bringing a warranty claim can be costly both financially and in terms of any ongoing working relationship with the sellers. Better to discover and price any risks upfront.
Key contracts –
Director and employment contracts –
Cyber security – …
Many due diligence processes are stuck in the 90s and purely asset-focussed, but in the 2010s, risk takes virtual form too. It’s worth understanding how secure customer data and business-critical software is. Take a look at global hot topics for inspiration, too – business regulation, corruption, fair business practices all loom large in the media and politics, so they might need to feature in your due diligence process too.
A deal is for life, not just for closing. Start planning for the future when the acquisition is first tabled, not in a flurry once closing is secured. Your plans for the target company will impact on due diligence scope (please tell your advisers what those plans are…), valuation and the legal documents. In particular, consider which services, if any, the target will require from the seller or the seller’s retained business after closing, for how long, and whether these are currently provided at market cost or below (is the target’s cost base artificially low?). This can be a critical workstream if the target is heavily IT dependent.
Don’t take it for granted that your advisers are talking regularly, flagging issues and noting documents of interest to each other. Any truly ‘material’ due diligence issue will have implications spanning at least two areas of professional expertise – e.g. tax and legal, legal and financial, financial and commercial – and you may run out of time if due diligence is carried out in separate professional silos. You won’t be able to fully assess, and react to, critical due diligence issues unless you examine them from all relevant perspectives.
Still have questions? Want to know more about improving your legal due diligence? Expert legal advice is on hand from MJ Hudson’s M&A practice. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
Next Month: How to and not to structure your earn-out
MJ Hudson’s M&A and Private Equity transactions team advised a German multi-family office on the bolt-on acquisition of a leading UK manufacturer and distributor of medical sterilisation and decontamination products, drawing on specialist medical devices regulatory advice and racing against the clock to achieve a challenging deadline for closing.
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