In any sale transaction whether it is a business sale or sale of shares, an important step is the due diligence process for both vendors and buyers. While, in our experience, purchasers are increasingly shifting their focus towards protection through comprehensive warranties in sale agreements, particularly given the growing trend of deferred consideration, the significance of thorough due diligence cannot be understated.
The Importance of Due Diligence
Due diligence is a comprehensive appraisal of a business conducted by a prospective buyer to establish its assets and liabilities and evaluate its commercial potential. This process is pivotal as it provides the buyer with crucial information to make informed decisions and mitigates risks associated with the acquisition.
For buyers, due diligence is essential to:
- VERIFY the financial health of the business: review and confirm the accuracy of financial statements, including balance sheets, income statements, and cash flow statements. Identify any discrepancies or hidden issues, such as debt, tax liabilities, or legal obligations, and assess key metrics like revenue trends and profit margins to ensure stability and profitability;
- ASSESS the legal and compliance risks: Conduct a thorough review of the business's compliance with all relevant legal and regulatory requirements. The assessment should be proportional to the nature and value of the assets involved, such as intellectual property registrations, which need to be verified for validity and ownership. Additionally, buyers should review freehold and leasehold interests to confirm that there are no encumbrances, disputes, or compliance issues related to property rights; and,
- IDENTIFY potential liabilities: Examine the company's financial and legal documents to uncover any pending litigations that could lead to future legal disputes or financial losses. Evaluate debt obligations to understand the company's current and future financial commitments, and examining contingent liabilities—potential obligations that may arise depending on the outcome of specific events or conditions. By identifying these liabilities, buyers can gauge the true financial health of the business and negotiate terms to address or mitigate these risks before finalising the acquisition.
For vendors, thorough compliance with due diligence is equally important as it positions them advantageously during negotiations. By being transparent about these obligations and other critical factors, vendors can effectively address any issues or concerns, thereby negotiating from a position of strength.
Red Flags for Vendors and Buyers during Due Diligence
During due diligence, both vendors and buyers must be vigilant for certain red flags that could indicate underlying problems.
Inconsistent financial statements can signal financial instability or fraudulent activities, undermining trust and the transaction's viability. Legal and regulatory issues, such as pending lawsuits, non-compliance with regulations, or unresolved legal matters, can pose significant risks, potentially leading to financial losses and operational disruptions.
Employee and HR issues, including high turnover rates, unresolved employee disputes, or unclear employment contracts, may indicate internal problems that could affect the business's stability and performance.
Customer and supplier contracts also require close examination. Unfavourable terms, reliance on a few key customers or suppliers, and short-term contracts can affect the business's stability. Further, change of control provisions in these contracts also need to be closely examined to assess whether a supplier or customer would have the right to terminate the contract if the acquisition were to proceed.
The Shift towards Warranty Claims
Warranty claims in sale of business agreements are assurances provided by the seller regarding certain facts about the business, which if proven false, entitle the buyer to seek compensation or remediation. In recent years, we have seen there has been a notable shift among purchasers who are placing less emphasis on due diligence and more on warranty claims. This trend is driven by the increasing prevalence of deferred consideration structures in business transactions.
One common structure of deferred consideration is having monies held in an escrow account for a specified period (e.g. 12 months post-completion) to cover any claims or discrepancies that arise, providing a financial cushion for potential issues that may surface after the sale.
Another approach is straight deferred consideration, where a portion of the purchase price is deferred (e.g. 50% at completion, 25% after 12 months, 25% after 24 months). This payment structure helps manage cash flow and provides a safety net for buyers.
Earn-out amounts are also gaining popularity. These are additional payments based on the business's performance (e.g revenue or profits) during specified periods post-completion (e.g. 12 or 24 months). Earn-outs align the interests of the seller and buyer by linking part of the payment to future performance.
These structures provide a safety net for buyers, allowing them to claim on warranties if the business does not perform as expected. However, this approach should not replace due diligence completely, as relying solely on warranty claims can lead to protracted disputes and potential litigation.
Key Points:
- Due Diligence is Essential: Comprehensive due diligence is crucial for buyers and vendors to assess the financial, operational, and legal aspects of a business, helping to mitigate risks and make informed decisions.
- Increasing Focus on Warranty Claims: Purchasers are increasingly relying on warranty claims and deferred consideration structures, such as escrow accounts and earn-outs, rather than solely on due diligence although due diligence remains important.
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.
