Introduction
This Practice Guide discusses the process of due diligence that is typically undertaken in connection with an M+A transaction and some practical tips in relation thereto.
What is Due Diligence?
Due diligence refers to the process undertaken, most typically by a proposed Purchaser under an Acquisition transaction, to obtain and confirm pertinent information regarding the other party (e.g. the target company). In most cases it involves a detailed financial, operational and legal review of information that is either publicly available or otherwise obtained on a confidential basis, relating to the business, assets, liabilities, obligations, condition and results of the operations of the other party. Often, this is broken down into a number of distinct areas: financial, operations, environmental, intellectual property, human resources, and legal. This typically includes review by business personnel of the Purchaser, as well as accountants, lawyers, tax advisors and other professionals, of financial statements, contracts and other material information. For example, legal counsel may review corporate records of the target company, and certain contracts, licenses, permits and executive or employment compensation arrangements, and business people and accounting and financial advisors may review financial statements, records, tax returns and reports and other information.
Due Diligence Period
Letters of Intent entered into in relation to a proposed Acquisition transaction (see the Letters of Intent Practice Guides) often expressly contemplate a specified period for due diligence, typically between the signing of the Letter of Intent and the parties entering into a definitive agreement. However, where a Confidentiality Agreement has already been executed by the prospective Purchaser, due diligence may commence prior to the Letter of Intent being signed.
Purchasers often continue to conduct due diligence after entering into a definitive agreement, to attempt to confirm that there has been no breach of any representations and warranties and, in some cases, may do so to satisfy any “due diligence out” condition that may be included in the Acquisition Agreement.
Purpose of Due Diligence
Due diligence may be largely “confirmatory” in nature, intended to permit the Purchaser to confirm (i) information (e.g. summary information) provided by the Vendor or target company or its agent (e.g. a financial adviser), (ii) the truth and accuracy of the representations and warranties, or (iii) whether any issues identified in prior phases of due diligence have been addressed or are properly reflected in the Acquisition Agreement. In other cases the Purchaser may use the due diligence process to obtain additional information regarding a target company and to confirm the suitability of the Acquisition and that is it comfortable committing to complete the purchase.
In general, due diligence conducted prior to signing of an Acquisition Agreement is not intended to permit a prospective Acquiror to ‘sandbag’ the Vendor by “keeping quiet” about any inaccuracies in the Vendor’s proposed representations and warranties, and then sue for a breach following Closing (although, depending on the terms of the Acquisition Agreement, it can sometimes be used for that purpose). Instead, in most cases, Acquirors share the results of deficiencies that they uncover with the target company and its legal counsel, and may, if the deficiency is material and significant, seek to negotiate a reduction in the purchase price before the Acquisition Agreement is signed. Similarly, if due diligence discovers deficiencies after signing, but before Closing, Acquirors typically share the information with the target company. In that case, depending upon whether the Acquisition Agreement includes or does not include “Sandbagging” or “Anti-Sandbagging” provisions, if the Vendor is not willing to renegotiate the purchase price the Acquiror may have to make a decision regarding whether to rely on a condition precedent permitting it not to complete the Acquisition, or complete the purchase. If the Acquiror elects to complete, depending on whether the Agreement contains Sandbagging or Anti-sandbagging provisions, the Acquiror may or may not have the right to close and then seek indemnification for the breach (See the Sandbagging and Anti-Sandbagging Practice Guide).
Due Diligence Checklists, Confidentiality Agreements and Data Rooms
Experienced buyers will often provide a target company with extensive due diligence checklists or questionnaires or requests that many target companies find overwhelming.
In negotiated transactions (e.g. private M+A transactions and friendly public M+A transactions), it is common for a target company to create a “data room” (usually a virtual data room on a hosted website) containing materials assembled in response to the requests (or anticipated requests) of a prospective Acquiror (or more than one) to review information, including confidential information, regarding the target company. Typically, access to the due diligence materials assembled in the data room is only granted after the prospective Acquiror agrees to confidentiality restrictions, which may be included as part of the Letter of Intent, or may be in a Confidentiality Agreement or Non Disclosure Agreement executed by the prospective Acquiror.
For public target companies, the Confidentiality or Non Disclosure Agreements often include “standstill” restrictions restricting the prospective Acquiror from acquiring shares of the target company or commencing a hostile take over bid.
Vendor Due Diligence
Where the proposed consideration for the acquisition of the target company shares or assets includes securities of the Acquiror, the Vendor may also need to conduct due diligence on the Acquiror prior to entering into a definitive agreement or completing the transaction. However, if an Acquiror is a public entity, the Vendor may conduct less extensive due diligence and instead be more willing to rely on information publicly available in relation to the Purchaser.
Prepare in Advance
In many cases, where a target company is anticipating potentially ‘shopping’ itself around or entering into discussions with one or more prospective Acquirors, it is advisable for the target company to conduct its own internal due diligence to attempt to identify (i) matters that may give rise to issues as part of prospective Acquiror’s due diligence requests, (ii) deficiencies that may need to be rectified, or (iii) items that may require disclosure, and try to assemble the materials in advance in a data room, rather than only doing so in response to requests by a prospective Acquiror.
As a general comment, if a target company is disorganized, has not assembled materials in a data room in advance, and only does so in response to requests from a prospective Acquiror, this can often affect the way the prospective Acquiror negotiates various provisions. The Acquiror may be less likely to (i) accept risks regarding potentially undisclosed items, (ii) accept knowledge or materiality qualifications to representations and warranties, (iii) agree to seller friendly or even middle of the road indemnification provisions, or (iv) waive conditions precedent to Closing and close on a more expedited basis.
How Much Is Too Much?
The level of due diligence information that needs to be provided can be the subject of negotiation. For example, in a transaction structured as an Asset Purchase, where the Purchaser only intends to assume specified “Material Contracts” or agreements or liabilities that they expressly agree to assume, and other contracts, agreements or obligations will remain with the target company, Vendors may resist having to go through the exercise of making available copies of contracts or documents that are not to be assumed. But Purchasers typically insist that they be provided with as much information as possible in order to decide what they wish to assume, and to more fully understand the business and protect against unforeseen surprises. For example, a Purchaser needs to determine whether and to what extent any contract not intended to be assigned or assumed may be necessary or material to the conduct of the business or generate revenue intended to be generated post Closing.
Publicly Available Information
If a target company is a public company and is a “reporting issuer” in Canada, material information regarding that party will be publicly available, which can reduce the information or documents that need to be separately made available in the data room, or otherwise under the due diligence process.
Lender Due Diligence
In some cases, e.g. where a Purchaser is obtaining financing from a third party for the transaction (for example, from an institutional lender, or private equity firm) those parties may have due diligence requirements which supplement those of the Purchaser.
Should a Purchaser Prepare a Vendor’s Response?
If a target company does not have a large staff, assembling the due diligence information, responding to due diligence requests, and preparing required disclosure schedules can be overwhelming. In such cases Vendors might argue that the Purchaser, and its representatives, have greater familiarity than the target company regarding the required disclosure as a result of all of the due diligence they are conducting. However, Purchasers will generally resist having their representatives prepare disclosure required from the Vendors, on the basis that this may potentially prejudice their right to seek indemnification in the event the disclosure is not correct.
Conclusions
Due diligence by a Purchaser in an M+A transaction is an unavoidable necessity. The process is unfortunately time consuming, can involve a significant amount of effort and may require significant time and attention of representatives of the target company. However, not being properly prepared for due diligence, or being unable to promptly and properly respond to due diligence requests can potentially delay Closing, adversely impact negotiation of certain provisions in the Acquisition Agreement and increase risks of the target company not uncovering any of its own ‘skeletons” on a timely basis (increasing the risk of claims for breach of representations and warranties or indemnification claims).
