What is the due diligence exercise?
It is the investigatory part of a transaction, where the buyer gathers both operational and financial information about the business or company.The main purpose is to establish the business assets and liabilities and to evaluate its commercial potential. Of course any identified risk can be accounted for in the sale agreement.
The exercise from a buyer's perspective
The starting point for a buyer in any asset or share purchase transaction is the maxim, 'Caveat Emptor' (meaning 'let the buyer beware'). Since the seller is under no duty to disclose to the buyer any defects in, and liabilities of, the properties and business, the buyer will always need to conduct their own investigation into the properties and any potential liabilities. This process is known as due diligence.
From the buyer’s perspective, the purpose of due diligence is risk management, which allows the buyer to:
- Identify possible deal breakers at an early stage
- Establish areas of risk and assess how those risks are to be addressed
- Negotiate where ultimate liability for any known risks should fall (for example by requiring the seller to provide indemnities in respect of identified risks, or negotiating a price reduction)
Essentially, there are three options to mitigate potential issues:
Where a risk is identified and is quantifiable the buyer can insist on a price reduction
Where a risk is identified but not quantifiable the buyer can insist on the seller providing indemnities
In the situation that there is an unknown risk the buyer can insist on warranties
In a standard sale transaction the buyer’s solicitor will submit a detailed request for information known as a ‘due diligence questionnaire’ to the seller’s solicitor, which is intended to elicit material information about the business or company.
The seller’s solicitor will usually co-ordinate the responses to the questionnaire and will then index the documents supplied and give the buyer access to those documents
Depending on the responses provided by the seller in the original questionnaire, additional enquiries may be raised to allow for further investigation of a particular issue.
Due diligence report
The findings of the due diligence performed by the buyer's solicitor will be set out in a ‘due diligence report’. The nature of the report will depend upon the complexity of the transaction and may range from high-level reporting to an in-depth audit of the business.
The exercise from a seller’s perspective
The due diligence exercise is the ultimate protection for a seller against warranty claims. All information passed to the buyers during the exercise is brought together to produce a disclosure letter. The Disclosure Letter is a key document in a sale transaction. It is the seller’s opportunity to make ‘disclosures’ against the warranties listed in the sale agreement. If a seller makes inadequate disclosures, it may face breach of warranty claims, which could allow the buyer to recuperate some or even all the purchase price.
A disclosure letter for the main part attempts to impute certain knowledge on a buyer, such as matters of public record e.g GDC and CQC registers, Companies House, NHS vital signs reports which means that the buyer cannot rely on warranties in relation to facts which could have been verified from other sources. These disclosures are known as general disclosures. General disclosures are a minefield and may not hold water when the seller is faced with a litigious matter.
The most effective way to limit liability is to provide specific disclosures in the letter.
This is where items of information are made clear in the letter and are noted against specific warranties as listed in a sale agreement. For example, where a seller is warranting that the dental equipment is in good working order, if there is a fault with any piece of equipment it should be disclosed to the buyer within the disclosure letter, including a reference to that specific warranty. The buyer will not be able to claim against the seller post-completion for breach of this warranty as the breach has already been disclosed to them in the letter.
So as you can see, the due diligence process can be quite complex, despite it being an integral part of every practice sale. Whether you are selling or acquiring, making sure you understand what the process entails is crucial to ensure a somooth transaction and the support of specialists in this area can be of great benefit.