The Role of Due Diligence in Structuring M&A Transactions: Legal, Financial and Corporate Risks

Mergers and Acquisitions (M&A) – mergers and takeovers. These are among the most complex corporate transactions. Under such a transaction, the buyer acquires corporate rights in the company; however, the scope is much broader: the buyer also takes on the entire history of the business, including legal disputes, contractual obligations, employment relationships and risks. This is precisely where the value and key role of due diligence lie during the preparation of an M&A transaction, as its purpose is not merely to review documentation, but to provide the buyer with an objective understanding of the actual state of the business and the associated risks.

Due Diligence helps answer three important questions:

• Is it worth entering into the transaction at all?
• If so, at what price?
• What safeguards should be included in the contract?
• So what exactly is due diligence, and how does it differ from an audit?

Due Diligence is a comprehensive review of a company, an asset or corporate rights prior to concluding a transaction. Its aim is to identify risks: legal, financial, tax, corporate, operational and reputational. In practice, due diligence is often mistakenly equated with an audit. However, there is a significant difference between the two: an audit is primarily aimed at verifying the accuracy of financial statements for a specific period, whilst due diligence has a broader scope, as it assesses and verifies not only the financial statements but also the overall risk profile of the business, and determines whether the business is worth acquiring or investing in, and whether it is safe for the buyer to enter into a partnership.

Key areas of due diligence in M&A

Legal Due Diligence: this involves reviewing the company’s corporate structure, its constitutive documents, decisions of governing bodies, key contracts, permits, licences, intellectual property, and the seller’s rights to a stake or shares in the company.

Financial and Tax Due Diligence: an examination of financial statements, income, expenditure, cash flows, debts, accounts receivable and payable, as well as tax history, the existence of tax arrears, risks of penalties, and discrepancies between tax returns and the company’s actual operations.

Corporate Due Diligence: verification of the ownership structure, beneficial owners and the powers of the management team.

Operational Due Diligence: analysis of business operations following a change of ownership, including a review of the management team, the CEO’s role, the owner’s involvement in operational processes, as well as the business’s dependence on any single individual, key employees, customers and suppliers.

Compliance/KYC Due Diligence: verification of sanctions, AML, anti-corruption and reputational risks, as well as the integrity of counterparties.

Stages of the Due Diligence Process

Due Diligence typically takes place in several consecutive stages:

The first stage involves defining the scope of the review. The parties determine exactly what is to be reviewed: the entire company, a specific asset, corporate rights or a group of companies.

An important aspect at this stage is the signing by the parties of an NDA – a non-disclosure agreement – as during the due diligence negotiations the seller discloses significant amounts of confidential information to the buyer: financial statements, customer base, contracts with customers, details of the team and workforce, commercial terms, internal business processes, and information on assets and liabilities. This is the purpose of the NDA – it is intended to protect the seller from the unauthorised use of such information, whilst enabling the buyer to gain lawful access to the necessary documents in order to assess the risks.

The second stage involves preparing a request for documents. The buyer or their lawyers draw up a list of documents to be provided by the seller. This list may include corporate documents, contracts, financial statements, licences, etc.

The third stage is the analysis of documents and verification of information. Due diligence should not be limited solely to the documents provided by the seller. Information must also be verified against public registers, court databases, sanctions lists, enforcement proceedings databases, etc.

The fourth stage is risk classification. The identified risks should be divided into several categories: – critical risks that render the transaction impossible; – material risks, which affect the price, structure or terms of the transaction; – information risks – these do not prevent the transaction, but the buyer should be aware of them.

The fifth stage is the preparation of a due diligence report. The report should include not only a list of the identified issues and risks, but also their legal rationale and commercial significance for the transaction.

Read the full article on the LIGA.net website: here.