Franklins First for Your Success…Legal Due Diligence

“I’ve looked at the accounts and everything seems to be okay”. Unfortunately, when discussing the prospect of legal due diligence this is often the response that I receive.  The caveat “buyer beware” applies to your transaction and the onus is on you to undertake detailed enquiries and ensure that you know what you are buying, warts and all.

Due diligence is about identifying risks and mitigating them so that not only do you have a successful transaction, but a successful business to trade moving forwards. Analysing the Company’s accounts is crucial to confirming the value of what you are buying and understanding its income, liabilities and cash flow (amongst many other things) all of which will have an impact on your ability to profit from the deal and ensuring that you can meet the repayment terms of any funding. However, the company’s accounts are only one part of the story.

Contracts

You’ve analysed the accounts and the seller has disclosed that the company is turning a healthy profit and has multiple returning clients. The regular business results in a healthy cash flow that supports your funding requirements for the deal. This is all excellent news.

However underpinning every business relationship is a contract. It does not need to be in writing to be binding, however having written terms certainly gives you comfort as to the terms of service. If there are no written terms, reasonable notice can be given to terminate a contract. So here is the question: what if the customers are unsettled by the change in ownership and give notice to terminate? That income that you were relying upon may dissipate quickly.

It’s not just the customers that you need to think of – what about suppliers? What happens if the change of control triggers a right for them to terminate or change terms of business? You could lose your supply chain that not only could this be disruptive to the business, but could also result in you needing to find alternative suppliers or negotiate new terms, which may be less favourable.

Business, after all, often comes down to relationships. People deal with people and ownership changes can be unsettling. Undertaking legal due diligence can identify the risks specific to the business you are acquiring, the potential impact that a change of team may have and allow you to put a mechanism in place or have comfort in the contractual terms to ensure a successful business post-completion.

Litigation

The accounts may make provision for a potential claim against the company, however founded or unfounded that it may be. That may give you an indication as to what the seller considers the value of the potential liability to the company in monetary terms, but it does not give you an understanding of the likelihood of success of the claim or the broader impact that it may have.

The question is, what is the claim? Is it faulty goods that have been provided – if so has the problem been rectified or could potential claims follow? The risk to the company could be far greater in terms of cost that the initial claim itself and may need rectifying and indeed an indemnity from the seller in respect of any other claims that could arise.

Another key question is reputation – is the claim likely to be public and could it mar the company’s reputation? Take data breaches for example. Personal data is highly sensitive and not only are the sanctions costly, but if made public can damage the company’s reputation and impact its business and therefore income. Identifying the risks of this in due diligence can allow you to put a plan in place to manage the risk and damage to reputation and mean that you are proceeding with your eyes open rather than being blindsided post-completion!

Property

This is one of the highest areas of risk in any transaction as the property may not just be somewhere that the company trades from but also an investment in itself. It’s a great asset to have on the balance sheet and is often leveraged as a part of the transaction in favour of your funders. Although you may not be directly acquiring the property as it is already owned by the target, nevertheless indirectly you are taking on both the asset and associated liabilities and if that asset is compromised; not only can it compromise your security but the investment and business trade itself.

There are a multitude of issues that can arise in relation to property that could be costly:

• Covenants and restrictions on certain types of trade or activities could impact your business growth and development plans or access to the premises could be an issue not originally picked up.
• If leasehold, the term of your lease and whether or not you have security of tenure is vital to your continued occupation and ability to trade from the premises. If the lease is due to expire with no right to hold-over shortly after the acquisition, this will have a significant impact on the business.
• If the property is in a bad state of repair the cost can be significant and the question is, who is going to bear the burden of that cost? If you don’t undertake due diligence and thorough investigations this could be a liability that you suffer even if it happened in the seller’s period of ownership.

The above are just a few examples of property issues that can be detrimental to the business that you are acquiring. You would be amazed at the skeletons that are in the closet that we have encountered, from unpaid Stamp Duty Land Tax to issues with the scope of property ownership and access. Thorough due diligence gives you the opportunity to consider the risks and address them prior to completion or in the sale contract itself by apportioning liability. Without due diligence, you may not become aware of the underlying concerns and put yourself at risk post-completion.

Accounts vs Legal Due Diligence

I don’t deny that accounts due diligence is fundamental to a transaction – indeed in every transaction I work closely with my client’s accountants and tax advisors to ensure that they are also satisfied from a tax and accounting perspective and that the sale contract addresses any underlying concerns. However, it is only by working together that we can protect you.

The above are only examples of a few areas that are covered by legal due diligence and it is only by undertaking thorough investigations from both perspectives that you can ensure that you have fully appraised the opportunity and proceed with the transaction with confidence.

If you would like to know more about legal due diligence please contact our Business Services team on 01908 660966/ 01604 828282 or email ddaudit@franklins-sols.co.uk.