Due Diligence

Introduction

Time and again, we see the term ‘due diligence’ used without any understanding of the term and the implications of the process. ‘Due Diligence’ is simply a phrase used to describe what are generally, ‘business investigations’. It is commercial jargon for the detailed analysis and risk review of an impending commercial transaction.

While due diligence can be used in a wide variety of situations, the emphasis in this article is on due diligence arising in the context of a Business purchase, given that this is the most common form of due diligence. Due diligence is commonly undertaken by a prospective purchaser prior to acquiring a business, or the shares in a target business. One of the main keys to a due diligence exercise is the proper scoping of inquiries to meet the decision-making criteria of the prospective purchaser.

Why is Due Diligence Important?

Due Diligence is viewed as the fundamental step in the purchase process and is seen as crucial in establishing a plan when looking at acquiring a target business. In essence, it is like an insurance policy, whereby the purchaser pays a premium (the cost of due diligence) by engaging the appropriate experts (i.e. lawyers, accountants, financial advisors and/or others) to perform an investigation into the contracts, books of account and other relevant materials pertaining to the target business. The premium is to insure against information that is least known and most risky in respect of the target business.

By undertaking due diligence, the prospective purchaser is attempting to minimise or unveil any post settlement ‘surprises’ and thereby reducing any uncertainties prior to deciding whether to acquire the target business. In deciding whether or not to perform due diligence, the purchaser needs to appreciate that the ‘cost’ of reviewing ‘now’ and renegotiating the terms of the transaction would be far less than sorting out any problem arising ‘post’ settlement.

Where the vendor often provides certain warranties and indemnities in the agreement for the sale and purchase of the target business, these warranties and indemnities often have to be enforced. A vendor rarely rolls over and pays up on a failed warranty. The purchaser often has to bear the time and cost burden of such enforcement. The increase in exposure of the prospective purchaser to liability under certain legislation is also of concern when carrying out due diligence. The likes of ASIC, the ACCC and the ATO impose sizable penalties for breaches. Due diligence would investigate such critical areas to identify any breaches by the target business, depending on the activities carried out by that target business.

Due Diligence Process

In carrying out a business purchase due diligence, the prospective purchaser will normally carry out some form of negotiation in respect of the purchase, whether it be the assets or shares in the target business. The prospective purchaser will usually rely on limited information regarding the target business in order to determine its offer price and finalise the terms and conditions of the proposed purchase. Following the initial ‘scoping investigations’, the prospective purchaser will typically conclude a conditional agreement, with the vendor, under which the purchaser has a limited period to undertake due diligence.

It is important to review the due diligence clause in the conditional purchase agreement prior to execution, to ensure that the required business investigations are able to be performed within the period before the agreement is deemed unconditional. The prospective purchaser will need to have full access to all relevant materials to carry out its inquiries and investigations. From the vendor’s standpoint, where the business owns information relating to trade or industrial secrets pertaining to its operations, a confidentiality agreement should be entered into with the prospective purchaser, to protect the vendor’s interests. This will ensure against the situation where the prospective purchaser decides against acquiring the target business, yet uses, or discloses such secrets, to the detriment of the vendors business.

Objective of Due Diligence

From the purchasers standpoint, the main objective of due diligence is to ‘extract’ knowledge from the important areas of the proposed transaction. By being able to obtain more detailed information relating to the affairs of the target business, it is hoped that the due diligence exercise will not only reveal any potential risk areas that require further investigation, but also any potential benefits for the prospective purchaser, arising from the proposed transaction.

Therefore, due diligence will assist in providing for a greater degree of certainty over the expected future performance and earnings of the target business. In instances where a price has not been agreed between the parties prior to undertaking due diligence, a key objective of due diligence will be the determination of a proposed price along with other relevant terms of the proposed transaction.

On the other hand, where a price has been conditionally agreed upon prior to due diligence, then such an exercise can be used as a vehicle to try to justify the agreed price. Importantly, due diligence may often result in:
A. The purchase price being affirmed or re-negotiated;
B. The value of the assets being reduced;
C. Additional terms and conditions being added to the agreement for sale and purchase;
D. Assets of the business being purchased instead of shares; and/or
E. Improved structuring of the purchase price.

Further Considerations

In reviewing the value to be assigned to either the assets and goodwill of the business, or the shares in the company, it is important to be aware of the vendors’ intention in determining the purchase price. The vendor typically aims to apportion a high value to goodwill, giving the vendor a non-taxable capital gain. The vendor will also look at apportioning a low valuation for plant, equipment, and stock in trade, as this reduces any depreciation to be claimed and any gains on sale of these items, which are taxable.

From the purchasers standpoint it is important to renegotiate, to reduce the value of goodwill and increase the value of plant, equipment, and stock in trade, in order to increase the depreciable value of capital assets; and reduce the profit on sale of the plant, equipment, and stock, both of which will reduce the taxation of profit in acquiring the business.

The Costs of Due Diligence

Like many aspects of business, due diligence can be an expensive exercise. At the end of the day, it is a commercial decision to be made by a purchaser in respect of any transaction. Embarking on due diligence must deliver benefits that outweigh the cost: otherwise there is no added value to the prospective purchaser in engaging in due diligence.
The cost/benefit rationale is based on the notion that the cost of review & renegotiation ‘now’ is far less than sorting out post settlement ‘surprises’ following completion of the transaction.

Conclusion

No matter how thorough the due diligence process, risks still exist in purchasing a business and detailed warranties and indemnities need to be obtained from the vendor that are enforceable in the agreement for sale and purchase, to protect the purchaser from making an ill informed decision.