Indeed, the DD process often starts ahead of the preparation of the first draft of the SPA, so that the buyer can reassure themselves that they are confident the transaction will proceed and they are happy to invest in the legal fees associated with SPA drafting.

What is due diligence for?

The process of due diligence is extremely important for the buyer, as it enables them to properly understand exactly what it is they’re preparing to buy. They will want to take a good look at the company’s financials, to understand what its cost base, revenues and profits look like, and to ensure that the ‘top line’ numbers that have been shared with them pre-offer are supported by the more detailed figures.

They’ll also want to understand more about the company’s key suppliers and customers, and may want to see example contracts. And they’ll want to learn a bit about your staff, property and systems, too. Depending on the nature of your business, they may want to do in-depth research into your intellectual property – if you run a SAAS business, for example, they’ll want to know that you own the rights to your software, and are properly in control of any third-party or open-source components.

Before you share – NDAs for M&A

The information you share during due diligence can be extremely sensitive. Particularly when your acquirer is a competitor, or operates in the same vertical market as you, giving them access to the innermost workings of your business can be scary. This is why the non-disclosure agreement that you enter into prior to DD beginning is probably the most important one of your business career.

At Devant, we have developed an NDA specifically for M&A transactions, which is designed to give you the maximum amount of protection from a practical perspective. While NDAs are notoriously difficult to enforce, ours is carefully crafted to incorporate a number of practical steps that help keep your sensitive business information safe and discourage the buying team from making unauthorised disclosures. 

Over the years, we’ve seen many sellers preparing to share information based on the very basic NDAs prepared by their accountant, company sale agent or corporate financier. These rarely provide sufficient protection, particularly when you consider the potential risk if a deal doesn’t go through when you’ve shared all your secrets with the potential buyer. Devant has only had one company sale fall through at the last minute (when the buyer’s parent company got cold feet due to other acquisitions not performing well). In that instance, our client was very glad that we’d insisted on a detailed NDA that gave us confidence their information was securely deleted by the buyer!

How does due diligence work in practice?

DD is usually initiated by the buyer (or their solicitors) sending you a ‘Due Diligence Questionnaire’. This will set out all the information that they’d like to see, as part of their due diligence. If you’ve been through a Pre-DD process, you will probably have most of that information already assembled and ready to share. Some of the documents (like financial statements and management accounts, for example) may need updating, depending on how long it’s been since you did your Pre-DD. But the Pre-DD work will stand you in good stead, enabling you to provide information quickly and efficiently, knowing that everything is clean and tidy, and fit for viewing by a potential buyer.

For most of Devant’s transactions (all but the very smallest), we will set up a virtual data room (VDR). This uses third-party software to create a secure environment for sharing confidential information about your business. We use a tool that enables documents to be redacted when they’re first shared (with the most sensitive information, like client names and staff personal details, blocked-out), and then progressively un-redacted as the transaction proceeds, and you’re more confident that it will complete as planned.

This means that you can send information to us for uploading to the VDR, enabling us to sanity-check before making it available to the potential purchaser and their advisors.

The VDR allows us to carefully control who has access to which documents, and whether they’re able to view on screen, or to download. It also water-marks each document with the email address of the user, so that if any unauthorised screen-shots find their way into the wrong hands, it’s easy to see where they came from! 

Once the buyer and their team have been given access to the VDR, they will start examining the documents you’ve shared with them. At that point, you can expect to receive clarification questions, as they start to digest and understand the details of your business. It’s important that all of your responses and clarifications are also uploaded to the VDR, to ensure that all information shared is kept together in one place.

Over the course of the transaction, you may allow the buyer to see more and more of your information, by un-redacting some of your documents. It’s important to be aware, though, that there’s always the possibility that the deal will not complete. When sharing, think about how another potential buyer would feel, knowing that this information has been shared with a competitor. In the event the deal falls through, you may find yourself in exactly that position!

How do warranties and disclosures work?

When you first receive the buyer’s Share Purchase Agreement (SPA), it’s likely to include a long list of warranties. These can make up the majority of the SPA, running into many, many pages of detailed text. The warranties in an SPA are statements that you make about your business that you promise are true, and on which the buyer will rely when deciding to proceed with the purchase at the agreed price. This means they’re really important, and you need to pay careful attention to them. This can be hard when there are so many, and many of them may seem irrelevant to your business, but there’s no way round it – reviewing and understanding the warranties is one of your most important tasks in the process. 

Strangely enough, your buyer is less interested in the warranties that are true than in the ones that are not. This is where ‘disclosures’ come in.

As you read through the warranties in the SPA, you will see some that you know are not true. For example, there may be a warranty that says:

‘The vehicles, office and other equipment used by the Company in connection with the Business are in good working order and have been regularly maintained.’

If you are aware that one of your company vehicles has a mechanical problem that needs to be resolved before it can be safely used, you’ll know that this warranty is not true in all cases for your business.

It can be tempting, when you encounter a warranty that’s not entirely true of your company, to ask to have it removed. But that’s to miss the point of warranties – their main purpose for the buyer is to encourage you to disclose all the areas where they’re not strictly accurate. 

Disclosure is the process by which you inform your buyer of all the warranties that are not completely true, and tell them why not. In the above example, a suitable disclosure could be (properly cross-referenced against the clause number of the relevant warranty):

The Ford Focus used for delivering small orders to customers, registration [xxxxx] has a problem with its [whatever] and the vehicle cannot be used safely until this problem is resolved. 

By disclosing this point, you ensure the buyer knows that they’re going to have to spend some money getting the car fixed if they want to use it. 

As we go through the warranties together, we will do our best to identify any areas where the warranty is not completely true. We’ll then prepare a Disclosure Letter, noting which warranties are not true, and why. The Disclosure Letter will also refer to any relevant documents in the data room that help to shed additional light on the warranty issue, so that the buyers can quickly and easily assess the impact of each disclosure.

What happens if you disclose problems?

In the example above, depending on how important the vehicle is to the ongoing activities of the business, the buyer may ask to reduce the price they pay for the business as a result of your disclosure. Or they may request that you pick up the cost of the repairs out of your own money, after the sale is complete (using an indemnity provision, for example). Alternatively, they may not be particularly bothered, but will be pleased to have been told that the vehicle concerned should not be scheduled for work until it has been repaired.

What remedy would the buyer have under the warranties if you failed to disclose a problem which subsequently became evident?

If you were worried that the buyer would seek to reduce the purchase price as a result of the problem, you could simply fail to disclose the information at all, and give the warranty as though everything were fine. When the problem came to light, post-completion, the buyer may then have a remedy for ‘breach of warranty’, and be able to claim some compensation from you, on the basis that you gave a warranty that was not true.

As part of our negotiations on a Share Purchase Agreement, we’ll agree the ‘de minimis’ threshold and ‘bucket’ threshold for warranty claims. The first of these is the limit below which a claim cannot be made – so, for example, if the buyer identified a claim for £100 but your ‘de minimis’ threshold was £2,000, they would not be able to bring that warranty claim against you. If their claim was over the ‘de minimis’ threshold, but below your ‘bucket’ threshold (let’s say this was set at £10,000), they would only be able to bring the claim if it, together with any other claims that exceeded the ‘de minimis’ limit, jointly exceeded the £10,000 ‘bucket’ threshold.

This means that in the example above, if the claim relating to the car was worth £1,500, the buyer would have no remedy. If the claim was worth £11,000, they would be entitled to bring that claim against you, and you may be liable to pay the £11,000 to the buyer.

However, it’s worth understanding a little bit about how we determine what a claim is ‘worth’. In this example, the value of the claim is not simply the cost of putting right the problem with the vehicle. It’s the amount by which the value of the company has been reduced by the problem with the vehicle.

Does that seem like splitting hairs? If your company valuation was on the basis of a multiple of its last three years of profits, and this vehicle is not essential to the company continuing to make profit, then you could argue that the issue with the vehicle has no impact on the company’s valuation and therefore there is no claim – even if the cost of putting the vehicle into service again is significantly over your threshold for warranty claims. However, if your company had been valued on the basis of its assets, and the value of that particular vehicle was significantly reduced as a result of the problems with it, then the buyer could successfully argue that this issue has reduced the value of the company as a whole.

Warranty time limits

In the Share Purchase Agreement, we will usually agree a time limit during which warranty claims must be brought. This encourages the buyer to identify problems quickly, and also means that once the time limit has passed, the sellers can relax, knowing that they no longer need to put funds aside for any potential claims.

These time limits can be as short as 6 months, or as long as several years. 

Warranty claims, earn-outs and deferred consideration

If an element of the purchase price is to be deferred to a later date (see the next article for more info on earn-outs), then you may find that the buyer is entitled to deduct the amount of any warranty claims from those subsequent payments, rather than having to claim them from you directly.

While this gives the buyer more control, it also increases the risk that you will lose money to warranty claims. We would usually seek to limit this kind of deduction to only claims that have been agreed by both parties, or determined by a court, to stop the buyer using spurious claims to avoid paying you the remainder of the money they owe!