In almost all sale and purchase transactions, buyers will seek to conduct extensive due diligence on the target business from a commercial, financial and legal perspective.

This blog focuses on what legal due diligence is, how to conduct due diligence and some examples of issues that may arise during the legal due diligence process. 

What is legal due diligence?

Formal legal due diligence will generally arise once a buyer has made an initial offer after conducting initial diligence from a commercial and financial perspective. It will generally take the form of a preliminary questionnaire prepared by the buyer’s lawyers and sent to the sellers’ lawyers, prior to the main legal transaction documents being drafted. 

Alternatively, in auction sales, the initial legal due diligence is typically carried out by the sellers’ lawyers in order for potential bidders to make a more detailed assessment of the target to prepare their bid (known as ‘vendor due diligence’).

Initially, it is an information gathering exercise across various elements of the target business, seeking comfort for the buyer as to what it is buying and also identifying any potential risks from a legal perspective. 

The findings from the legal due diligence process will drive the detail of the warranties that the sellers are required to give to the buyer in respect of the target business in the main sale and purchase agreement.  It is a crucial step in the transaction process and, together with disclosure, will typically be the area that that incurs the most time from a legal process. 

What areas of a business will be covered by legal due diligence?

The buyer will generally seek a full assessment of the target business. This can be broadly broken down into the following areas:

• Share capital (particularly in share sales) and information on the Seller(s).
• Finance, accounts and assets.
• Key corporate and commercial agreements.
• Intellectual Property, Information Technology and Data Protection. 
• Property and Environmental.
• Employees, Immigration, Pensions and Health and Safety. 

Conducting the legal due diligence process

As touched on above, typically the process will start by way of a preliminary questionnaire sent by the buyer’s lawyers to the sellers’ lawyers. This will consist of some standard questions and requests for information covering the areas of the target business outlined above. 

Once the initial responses are sent to the buyer, there will generally be further rounds of additional questions and requests for information, focusing on more specific areas identified by the buyer as a result of those initial responses. 

How to go about conducting the process really depends on the sellers’ circumstances. For example, particularly with smaller, owner-managed businesses, they may be inclined to keep the process between the sellers, at least initially, due to confidentiality issues, or the assistance may just not be available within the business. For larger businesses, assistance may be available from specialists departments within it. 

Costs will also be a key consideration. Particularly in the early stages of the potential transaction, sellers may wish to keep their legal costs lower in the event the transaction doesn’t complete. This may impact the level of support provided by the sellers’ lawyers. 

Sellers will typically have a “first go” at responding to the initial requests, as the reality is that they are the ones that know the business inside and out. From experience, the more input the sellers’ lawyers have from the outset, the smoother the process will be as the lawyers will have been through this process many times before, and will generally know the information the buyer is looking for. 

As the process continues, the sellers may require more input from their own teams as well as their lawyers. 

Issues that may arise during the legal due diligence process

It is important to mention that, although issues may – and almost inevitably do – arise during the legal due diligence process, this does not necessarily mean that it is a deal breaker. The buyer will typically be trying to understand what any actual or potential issues are and seek clarity on how best to resolve any issues, to the extent that they can be resolved. 

The nature of any actual or potential issues will largely depend on the nature of the target business. For example, where a business has a large number of employees, employment and pension arrangements may be a particular area of focus for buyers. Similarly, for businesses with numerous premises, property due diligence may be a particular focus. 

In general, any specifically identified issues that arise from the process will be dealt with in one of three ways (or potentially a combination of them): (a) the sellers resolve the issue prior to completion; (b) the buyer seeks protection from the sellers in the form of an indemnity; or (c) the buyer negotiates the price down. 

Examples of issues that may arise during the process using the areas identified above may include:-

• Share capital: there can be particular issues where a target business has carried out share buybacks and/or has employee share schemes in place due to the strict legislation surrounding these areas.
• Assets: there may be particular issues where a company uses assets on lease and/or hire purchase arrangements. 
• Commercial agreements: many commercial agreements include “change of control” provisions which may give the other party the right to terminate following completion of the acquisition. Typically the buyer will want to assess the risk of these in the contracts of the most importance to the target business. In asset acquisitions, the buyer will want to ensure that these key contracts will be assigned to the buyer. 
• Intellectual Property and Data Protection: issues can arise with a target’s legal ownership of the IP rights it uses as the laws around IP rights in England and Wales are different to many other jurisdictions. Particularly since the introduction of GDPR in 2018, buyers will want to ensure that the target business is fully complaint from a data protection perspective. 
• Property: a target business may have carried out alterations to its premises without proper consents. There can also be issues with registrations at the Land Registry or unusual terms in leases.
• Employees and Pensions: there can be robust rights for employees in England and Wales. There may be issues with specific employees within a target business, and the buyer will want to seek clarity on the risks that may pose to it following its acquisition. Issues with pensions may also include compliance with auto-enrolment obligations. 

Summary

Legal due diligence is a critical stage of any acquisition. The process tends to vary depending on the nature of the transaction and the target businesses. No two deals are ever the same.

Depending on the level of detail, legal due diligence can be a painstaking process for sellers to go through, particularly for owner managed businesses that may not have the assistance of various teams to help them through the process whilst trying to run the business simultaneously. 

For both buyers and sellers, our recommendation would be to get on top of the process as early as possible. Indeed, for businesses with longer term plans to sell, it is recommended to prepare and to start the process prior to a transaction. 

Contact us

Moorcrofts has a wealth of experience advising both buyers and sellers on all types of acquisitions. 

For assistance, please get in touch with our corporate team and we would be happy to help.