Conducting a legal due diligence is usually the preliminary step
taken by an investor intending to enter into an asset or share sale
transaction. The purpose of a legal due diligence is to assess the
potential risks of a transaction by investigating the obligations
and liabilities of the target company. This provides objective and
reliable information to a potential purchaser as to whether to
proceed with the transaction or ring fence, exclude or limit the
risks, and negotiate warranties or the purchase price.
The scope of the due diligence is usually determined by the type
of business conducted by the target company and the size and the
type of acquisition envisaged (such as whether it is a sale of
shares or a sale of business). Depending on the requirements of the
specific due diligence, the due diligence team could be
multi-disciplinary, including financial and technical experts (in
addition to legal experts).
A purchaser should always ensure that there is a condition
precedent in the sale agreement regarding the successful completion
of a legal due diligence to the satisfaction of the purchaser. This
will ensure that the purchaser has an exit opportunity from the
sale agreement if the legal due diligence results are not
satisfactory to the purchaser. A seller will usually expect a
non-disclosure agreement to be signed by the potential purchaser
prior to the legal due diligence being undertaken.
A legal due diligence generally covers an investigation of the
following areas: corporate, commercial contracts, employment,
intellectual property, information systems, environmental, health
and safety, regulatory compliance, competition, litigation,
property and tax. A due diligence should also provide a framework
to understand the jurisdiction in which the target company is
Whilst a full and detailed due diligence on the target company
is always recommended, with limited exceptions only, a high-level
due diligence will achieve similar results. In the latter case, red
or yellow flags highlighting "deal-breaker" or
"commercially negotiable" issues respectively will be
indicated. Documents are usually provided by the seller in response
to a specific due diligence questionnaire prepared by the
purchaser's lawyers. It is also useful to have face-to-face
interviews with key management of the target company to obtain
first-hand information or clarification in regard to specific
A prudent purchaser should utilise the results of a due
diligence investigation as a negotiation tool in the transaction.
For instance, any potential liabilities discovered (such as tax
liabilities, litigation, outstanding amounts due by debtors,
fines/penalties imposed) can be used as a pricing chip to reduce
the amount of the purchase price.
Where risks have been identified, the seller could provide
warranties or indemnities to protect the purchaser from any future
liabilities which may arise from these risks. Where consents and
approvals are required, to assign contracts or licences or in
relation to change of control provisions or pre-emptive rights,
these can be incorporated as conditions precedent in the sale and
purchase agreement. Furthermore, where specific issues require
action by the seller prior to the implementation of the
transaction, these may also be added as conditions precedent in the
sale and purchase agreement.
The more thorough the due diligence is, the more specific the
ensuing contractual protection can be. Although a due diligence may
not uncover or quantify every risk in the transaction, it provides
a comprehensive platform from which to negotiate the transaction,
especially in instances where there is full disclosure by the
seller. It gives the purchaser a bird's eye view of the target
company's business in order to make an accurate assessment of
the pertinent issues and limit any potential future exposures.
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The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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