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Due diligence: red flags and red lights

Professionals involved in large corporate transactions are generally familiar with the so-called “due diligence exercise”. How necessary is this exercise? Is it just an extra expense or could it prove beneficial to a deal?

While carrying out a due diligence process has become more or less standard practice for entrepreneurs interested in a specific company, it is still often bypassed when it is the underlying asset owned by the company which is the primary target. In fact, businessmen interested in purchasing a specific property are very often landed with the incidental purchase of the shares in the holding company related to that asset. The interest in the asset itself very often becomes so overriding that the purchase of the shares is done quickly in order to secure closing.

The purchase of shares, however, not only implies ownership, wholly or partially, of the profits or assets of the target, but also responsibility for the liabilities of the company acquired.

It is nowadays therefore a sine qua non with the vast majority of substantial acquisitions that a thorough investigation into the potential target is carried out before any stipulations are made and any money is exchanged. Setting out to purchase a majority of shares in a company should require the buyer to carry out his preliminary research into the viability of the acquisition.

Professionals entrusted to manage and handle M&A transactions are therefore often also given the task to review the target company from every angle in order to ensure that there are no major obstacles to the acquisition.

A contemporaneous assessment is thus made by the financial and legal advisers primarily with a view to giving the red light (or the red flag) for the transaction to proceed. The vendors, at the request of the potential buyers, would typically set up a data room, physically or virtually, comprising of the salient legal and financial documents pertaining to the target company. The lawyers and auditors, together with the buyers and anyone else privy to the data room, would bind themselves to keep the contents of the documents to themselves and not to disclose their contents other than for the purpose of the transaction at hand.

Following the signature of a non-disclosure letter, the due diligence process would then commence. Professionals are normally given a time frame within which to review the documents and assess the situation.

The legal team made up of lawyers, with different areas of expertise, would set out to sift through the data room with a fine tooth comb in order to be in a position to highlight any areas of note and of concern for the potential buyers for them to bear in mind in the process of negotiating share purchase agreements and, in particular, the price of the acquisition. The indemnities and warranties included in such agreements would ordinarily reflect the findings from the due diligence exercise.

No one due diligence exercise is like the other

The process is not for the faint-hearted. Lawyers are often faced with volumes of paper work to order, read and review with the task of reporting on all or some of the documents, depending on the preference of their clients, often, because time is of the essence in concluding a deal, also within a very short time frame.

Hours of professional time are spent investigating the legal implications of the various contracts entered into by the target company and provided for review in the data room. It is often the case that, apart from the data room documents, lawyers would also be required to carry out and to review independent searches at various institutions – typically the Registry of Companies, the Courts of Law and the Public Registry. Trademark searches are also carried out in connection with the name/s ordinarily used by the target company. For those companies which have a long history, a cut-off date is common – thus limiting such searches to a stated amount of years.

A typical legal due diligence exercise would see the documents divided into a number of salient categories of review – typically: corporate, material commercial and financing agreements, property, employment, litigation, intellectual property, environmental, government consents and insurance. Tax and accounting matters are often left to the financial advisers to deal with, with input from the legal team only where required.

Each section of the data room would include the documents pertinent to that category. It is often an arduous task for the less organised entities to set up the data room in an orderly fashion. It is at this stage that the keeping of good company records throughout the company’s lifetime bears it fruit – a prompt and structured set-up of the data room often leaves a very good first impression on potential buyers and advisers alike and is a good first indicator of the target company’s state of affairs.

No one due diligence exercise is like the other. Each company has its own history, its own idiosyncrasies and its own particular personality, as it were. Shareholders often have rights, negotiated at inception or during the lifetime of a company, related to an acquisition. Thus options to acquire shares or to tag or drag along a sale of shares may prove to be a bone of contention during negotiations.

Typical red flags also include onerous commercial contracts, significant potential or pending litigation, financial agreements indicating substantial loans or property leases with impending expiry dates. The possibilities are endless – however, the diligent lawyer will know how to extract the substantial from the run-of-the-mill and to provide a comprehensive final report to the client to be used for an effective structuring and closing of the acquisition.

“Diligence is the mother of good luck”: no successful entrepreneur should ever start a new venture without carrying out his ground work. With the assistance of competent professionals in the field, the potential buyer will be in a position to embark on the desired course with the peace of mind that the undertaking is a sound one and that no stone was left unturned in anticipation of the deal.

Krista Pisani Bencini is a senior associate at Fenech & Fenech Advocates.

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