Welcome to part three on this series of articles discussing everything (legal!) you need to know about selling your business.
In the first article I provided an overview of the entire selling process, if you missed it you can have a read here.
I then went on to look at pre-sale considerations and you can check that article out in full here.
That brings us nicely on to part 3. In this blog episode, I’ll be concentrating on due diligence.
Most people have heard of this part of the process, which is arguably the most important in the entire sale.
Clients will usually carry out some initial due diligence themselves, or with the assistance of their accountant. This kind of initial due diligence usually (understandably) concentrates on the financial position of the business being sold. In other words, working out whether it is worth the asking price. This is one of the key focuses of both buyer and seller.
Your accountant will assist you in reviewing the last 3 years (or more) accountants of the business, to give you a good idea of how it is performing financially. They will analyse all aspects of its financial performance, as well as help you to ascertain whether or not you would be able to improve that post-purchase.
However, whilst important, there is a lot more to due diligence than finances. In the sale and purchase contract, a large part will be dedicated to warranties that the seller will give to the buyer.
What are warranties? Are they necessary?
Warranties are essentially promises or assurances that the buyer gives to the seller that certain things are true about different aspects of the business and company being sold. So why are these needed? In English law there is a legal principle that you may have heard of. In latin it is ‘caveat emptor’, or ‘buyer beware’. This means that a buyer purchases with full risk of any inherent issues or defects. If you do not inspect a product that you purchase and do not ask for any assurances about it, then you cannot expect/assume those things to be present in the product. This is why certain characteristics in consumer sales are implied by statute, such as ‘satisfactory quality’ ‘fit for purpose’, etc. However in a commercial sale, the burden is on the buyer to ask questions about every aspect of what is being purchased. Given that a business is a complex thing, covering everything from contractual terms to employees, disputes, property matters, IP, IT and many more, a lot of questions will need to be asked to ensure that there are no unpleasant surprises for the buyer post-sale, which at worst could mean that they have paid far too much for a business which in fact becomes a liability rather than an asset.
The process:
It is clear then, that the due diligence process is very broad. It is usually broken down into the following stages:
- The due diligence questionnaire
Submitted by the buyer to the seller/their advisers asking questions about all aspects of the business being sold and for disclosure of evidence in support.
- Due diligence replies and document disclosure
The seller’s replies to the questionnaire.
- Review and report on information disclosed
The buyer’s advisers review the seller’s replies and disclosure. This is similar to the Report on Title a conveyancer produces in a residential property purchase. It essentially confirms the positive aspects of the business, bearing in mind those that are non-negotiable either legally or for the specific buyer. It also points out any problem areas. The buyer may consider re-negotiating the deal for the purchase if unexpected risks are found.
- Drafting of warranties in the sale contract
The warranties in the sale and purchase contract will then need to accurately reflect the business being purchased. Whilst there will be a raft of fairly standard warranties, some of these will need to be tailored specifically to the sector and individual business in order to ensure that the assurances that the buyer requires are meaningful. Further disclosure by the seller in the light of the wording of the warranties may be required.
- Preparation of the Disclosure Letter and Bundle/Data Room
The due diligence replies and any further information disclosed will then need to be collated into a Disclosure letter and Bundle (usually electronic nowadays) or Data Room. This information and documentation needs to specifically relate to the warranties that are set out in the sale and purchase contract.
As can be seen, this aspect of the sale process is not only extremely important, but very labour intensive. It will make up the bulk of the time spent on the sale and of your adviser’s costs of the transaction. Whilst some elements, such as the collating of the documentation, can be done by clients, in the main, your legal adviser will be the person charged with this process. Indeed without their detailed involvement in the due diligence process, you run the risk of not being fully advised on any liabilities of the business you are buying. On occasion, during the due diligence process, a buyer may decide not to proceed, or a funder may pull out. Whilst this will mean costs have been spent on an abortive transaction, it is a small price to pay for being fully forewarned of any potential risks and problems.
If you would like to discuss any aspect of the sale of your business, contact me at karen.blakesley@cognitivelaw.co.uk.