Due Diligence

The due diligence investigation

The moment it is decided to buy or sell a company, an audit will have to be conducted. If such an audit relates to a takeover or merger of a company (or a part thereof), this is referred to as due diligence. Although the due diligence refers to the audit, due diligence does, in fact, involve more than that. Due diligence also focuses on the legal, financial, tax and commercial aspects of a company. As such, this type of investigation extends beyond just a mere audit into the financial affairs of a company. How extensive a due diligence investigation should be will often depend on the type of company being purchased and on the financial weight of the transaction.

Investigation from different perspectives

Due diligence is generally initiated by the buyer, but not necessarily so. A seller too can arrange for due diligence (referred to as vendor due diligence). A vendor due diligence occurs in situations where the seller is actively offering himself or a part of the business for sale. To arouse the interest of prospective buyers, a ready-made due diligence report can contribute to a successful outcome. In addition to a due diligence being carried out in the case of acquisitions, due diligence investigations are sometimes also conducted into customers to properly estimate the risks of a collaboration in advance. Such an investigation is called a customer due diligence. The seller often does not agree to a due diligence investigation until the parties have signed a letter of intent (memorandum of understanding), after the buyer has already made a conditional takeover bid (non-binding offer) or after the parties have signed a non-disclosure agreement. During the investigation, the seller is expected to disclose highly confidential information. The seller will want to have this information secured. To give an idea of what such a due diligence process entails in practice and which investigations are possible, a brief explanation of a due diligence investigation is set out below, initiated both by the buyer of a company and by the seller.

Forms of due diligence

Buyer due diligence
The most common due diligence is an audit carried out by or on behalf of the buyer of a (part of the) company. The buyer’s board is also obliged to do so. A takeover without any investigation can lead to directors’ and officers’ liability. The buyer is therefore obliged to conduct an investigation in the event of an important investment decision. The board cannot simply assume that everything the seller has told them is correct and complete, on the contrary. Hence a due diligence investigation is essential; essential for internal decision-making and accountability. By conducting a due diligence investigation, all useful information is revealed, the information of the seller is verified, risks and opportunities are identified. All this information can be used as a basis for negotiations. If the due diligence investigation leads to a decision to acquire the company, the purchase agreement will also refer to the due diligence investigations. The guarantees and indemnities that a seller must provide in the event of a sale are brought in line with the results of the due diligence investigation.

Vendor due diligence
In addition to the obligation of the buyer to conduct a thorough investigation before deciding to make an acquisition, the seller has a duty of disclosure. The seller is obliged to provide all known relevant information in the sales process to the buyer. A vendor due diligence report can play an important role in this. Instead of waiting until a buyer has been found and waiting for this buyer to complete his due diligence investigation, the seller can have the due diligence investigation conducted early. This way, the seller is better prepared for any negotiations with prospective buyers. If a buyer is provided with a vendor due diligence report, a highly simplified due diligence confirmatory investigation is often performed in practice. This limited investigation serves to check whether the vendor due diligence report is complete and whether all opportunities and risks of an acquisition have been correctly assessed.

Customer due diligence
In addition to a due diligence investigation required for the sale of a company, the Dutch Money Laundering and Terrorist Financing (Prevention) Act obliges companies also to investigate customers whom they do business with. Such an investigation is also referred to as a customer due diligence. A customer due diligence investigation identifies the risks of doing business with a specific customer. A customer due diligence also examines the customer’s corporate structure. This can also include an investigation into the customer’s ownership structures. Such an investigation into the underlying owners is, in some situations, a legal requirement.

The purpose of a due diligence investigation

The purpose of the investigation is to determine whether the information provided and presented by the seller is correct and complete. The information provided identifies the risks and opportunities for the buying party, which are essential for the decision-making as to whether the acquisition or merger will, in fact, have the intended results. Hence the due diligence is indeed performed before the acquisition or merger; i.e. before the final decision-making. The importance of a thorough due diligence investigation is two-fold. On the one hand, to investigate whether a takeover will produce the intended benefits. The risks and opportunities of an acquisition are mapped out. On the other hand, to reach the right decision internally as to whether the investments are sound. From a buyer’s perspective, a due diligence investigation therefore aims to find out more about the company to be purchased. The buyer will try to determine whether the company is worth the purchase price and what risks are associated with the intended acquisition of the company. Whereas the seller has a duty to disclose information, the buyer has a duty to investigate. If the buyer does not comply with this duty to investigate, it may have consequences for his recovery options. If the buyer fails to fulfil his duty to investigate, there is a risk that any damage cannot be recovered from the seller. This will be the case, in particular, if the buyer could have revealed the injurious facts through a basic investigation. The buyer should, therefore, not blindly rely on the information provided by the seller and must investigate all matters important to him. The investigation must therefore be carried out in a professional manner. When a due diligence investigation is carried out, all parties benefit, both the buyer and the seller. The buyer, because the risks and opportunities are made transparent and the seller because he knows what guarantees and indemnities can be given.

Reasons to carry out a due diligence investigation are:

• To oversee the legal consequences. Know what you are buying and what risks may manifest themselves in an acquisition. Are the agreements between the acquired company and its customers and/or suppliers maintained? Or can they be terminated? • To avoid financial consequences. Is the purchase price representative of the purchased business or part of it? What are the debts and claims of the company being acquired? What is the financial situation of that company? • For economic reasons. In the case of a takeover or merger with another organisation, it is important to identify the strengths and weaknesses of this organisation and to verify the figures/data. Can synergy be achieved through the takeover? Or can the range of services and products be expanded instead? • To avoid corruption. Prevention of money laundering and bribery. Due diligence may be necessary to comply with local, as well as international legislation. Not only to prevent possible reputational damage, but also to prevent fines and sanctions.

The result of a due diligence investigation

The results of a due diligence investigation are recorded in a report. This report forms the basis for further discussions and negotiations between the buyer and seller. Based on the report, it is also assessed what securities and guarantees need to be included in a purchase agreement. In addition, on the basis of the report, the buyer can determine whether the purchase price is a reasonable price for the company or whether it needs to be (re-)negotiated, or that in view of the identified risks, the purchase is all-together decided against. Click here to read more about what Fruytier Lawyers in Business can do for your deal.