Kerry Brooks of O’Connors
By Legal Futures Associate O’Connors [1]
The American writer and biochemist, Isaac Asimov, was not a fan of the concept of ‘let the buyer beware’. He said he preferred the idea of ‘let the seller be honest.’ If only life were that simple, there would be little need for anyone to do due diligence before they buy anything.
When it comes to buying companies, the legal due diligence process can sometimes appear chaotic and leave buyers wondering if the benefits of it really outweigh the expense.
So, why is legal due diligence in an M&A transaction important and how can you, as a buyer, control the cost of it?
Legal due diligence
Legal due diligence is the investigatory part of a company acquisition. It is an exercise in gathering and verifying information about a target company. This information is then used by a buyer to decide whether to proceed with the acquisition, renegotiate the deal or withdraw from the transaction altogether.
Let the buyer beware!
Under English Law, buyers must rely on their own investigation of a target company prior to buying it, and a key element of this is the legal due diligence exercise.
Relying upon contractual protections in a sale agreement, as a substitute for a thorough legal due diligence exercise, is a poor strategy. Most contractual protections are limited by disclosure and are generally given on a conditional basis. Even when a breach of a contractual protection is deemed valid, damages for the breach can be difficult to calculate, and difficult to recover. Buyers tend to underestimate the time and cost involved in pursuing a warranty or indemnity claim against a seller and the impact it can have on the parties’ relationship, especially if the seller is to remain with the company post-completion. Warranty and indemnity claims are notoriously difficult to pursue, and judgments can be difficult to enforce.
Controlling the cost of M&A legal due diligence
Controlling the cost of legal due diligence is an understandable concern, given how heavily weighted the due diligence exercise can be in the overall transaction costs.
So, what are the some things that increase the cost of legal due diligence and what can you and your legal team do to control them?
- Information dumping – In a bid to avoid the risk of non-disclosure, some sellers dump vast amounts of irrelevant information about the target company on a buyer. You should insist that only documents you have specifically requested are provided.
- Poor data room organisation – You should insist that each document provided by the seller is clearly referenced to a specific enquiry raised by you so it can be readily identified and reviewed in the light of the response to the enquiry. Documents that are not referenced can take longer to review which increases costs.
- Scope creep – Parties can sometimes agree changes to a transaction during negotiations, causing legal due diligence work to fall outside of your legal team’s original scope and budget. This can be controlled by ensuring close communication with your legal team to minimise any extra work and agree an acceptable variation to the budget.
- Time pressure – Often a seller will try to pressurise a buyer to start negotiating the sale agreement before replies to the legal due diligence enquiries have been provided. This usually results in the sale agreement being dealt with piecemeal, which adds to the number of draft exchanges. You should insist on a complete set of replies before the first draft of the sale agreement is prepared.
- Communicating through third parties – Ideally, all legal due diligence should be managed direct between your legal team and the seller’s legal teams. Where a third-party consultant is involved, give your legal team permission to liaise with them directly. This is the most cost-efficient way to do it as it tends to avoid duplications and confusion.
Some other practical tips to increase efficiency
As a buyer, you can help to reduce transaction costs related to legal due diligence by:
- Carrying out your own basic checks on the target company prior to the preparation of the heads of terms, to flag up any showstoppers before the legal teams get involved in the legal process.
- Having a frank conversation with the seller about what is expected of them during the legal due diligence exercise. For example, a discussion over cost-sharing might assist in deterring a seller from tackling the due diligence exercise in a lazy manner.
- Agreeing with your legal team the scope of the legal due diligence process required, so that time can be allocated to the issues which are of most concern to you. For example, where a target is regulated, you may want to weight legal due diligence towards regulatory compliance, insurance, and litigation.
- Being clear with your legal team as to the type and format of legal due diligence report you require – a verbal key issues report will usually cost less than a full written report.
- Providing your legal team with a list of issues that could be showstoppers for you. This is incredibly helpful as it means your legal team will ‘down pencils’ immediately should they come across any listed issue and inform you immediately.
An effective due diligence exercise will feed into the drafting of the sale agreement and other important transactional documents, assist you in negotiating valuable points during negotiations and alert you to any practical considerations for running the company post-completion. As you will have gathered, the key to controlling cost is in proper planning and in good communication between you and your advisers.
For further information, please contact Kerry Brooks [2] or call 0151 906 1000.