Due Diligence in Business Acquisition

Legal Insight

March 2023

George Psarakis LL.M. (mult.), PgCert

(republished from Moneyreview.gr)

Summary: In this article we explain the usefulness of due diligence in the acquisition of a business, the alternative contractual arrangements that work to the benefit of the seller or buyer and the scope of the due diligence. We conclude that the ultimate purpose of due diligence is to provide as much insight as possible into the material and serious problems that may arise, in order to assist in determining the sale price on the one hand, and in allocating liability between the parties when the time comes to draft the SPA.

In previous articles we have dealt with NDA/CAs and MOUs in business acquisitions (see here and here). Today we will look at the next stage in the acquisition process, which is due diligence.

Due diligence ("DD") of the target company is one of the most important stages of the procedure. It is where the potential acquirer gets a better understanding of what it intends to buy, learns about potential problems, defects, weaknesses, etc. The DD usually follows the signing of the MOU (memorandum of understanding) and lasts, in most cases, from 1-6 months, depending of course on the volume of data and the capacity of the team that will be in charge of it. The longer the duration of the DD, the greater the likelihood that the valuation of the business will change and therefore that disagreements will arise, possibly resulting in new negotiations.

The problems of DD start from the fact that a business is not an object that can be examined by a layman with a simple external review; hundreds of hours of work are required by expert consultants (financial, legal, etc.) to carry out a proper audit so that the potential buyer can know as accurately as possible what he is buying.

The DD includes mainly the control of a) corporate documents (documents relating to the establishment, representation and management of the company), b) affiliated companies, c) customer list, d) branches, e) lawsuits and possible litigation, f) amount and changes in share capital, g) company assets (real estate, equipment, cash, etc.  ), (g) collateral (pledges, mortgages, mortgages, etc.), (h) tax and insurance compliance, (j) contracts (e.g. commercial agency contracts, leases, financial and non-financial leases, any change of control clauses, etc.), (k) labour relations, etc.

The DD results are important for two reasons:

First, they largely determine the price. If problems are identified during the audit, then the price may be reduced or subject to contingencies, etc.; if risk hotspots are identified, then the risk-taking by the buyer may influence the pricing to be combined with performance clauses, etc. (see decision 493/2021 of the Athens Court of Appeals: "For this reason, moreover, in order to formulate the purchase price of the shares, they carried out, through the company ..., a pre-contractual financial due diligence in order to ascertain the financial situation of the company they were going to acquire. Consequently, the value of the shares purchased was established on the basis of the audit carried out in March 2001 by the above-mentioned auditing firm, which recorded both the current assets and all the liabilities of the company being transferred in terms of suppliers, creditors, tax liabilities and liabilities to insurance companies").

Secondly, they shape the contractual terms of the SPA (share sale agreement) as the buyer's fears, stemming from the DD findings, are translated into an attempt to transfer risks to the seller through contractual terms in the sale agreement.

The DD also determines to a large extent the seller's liability after the completion of the acquisition. This is because the buyer's knowledge of possible defects in the business prior to the sale of the business results in the seller being relieved of any liability. In other words, the seller is relieved of any liability if the buyer became aware of the defect prior to the sale. This makes sense in principle: you cannot, while knowing about the defect, come back after the transaction and point it out in order to reduce the price or claim damages. If you knowingly buy a defective business, you assume the risk and you have obviously 'passed on' the defect in question in the agreed price. For this reason, a "disclosure letter" is usually delivered by the seller to the buyer listing all the documents that have been disclosed to the seller or it is agreed that all documents posted in the Virtual Data Room are deemed to have been disclosed to the buyer and the latter is aware of their contents (Disclosure Letter - see e.g. the decision of the Athens Court of First Instance No. 6285/2013: "In addition to the general knowledge of the plaintiff of the inaccuracy of the balance sheet concerning the plaintiff's general financial situation, as proved above, it was proven that the plaintiff's licensor consortium, despite having carried out the legal-financial audit under time pressure, had been informed of the existence of the debt of its counterparty to the Dutch Company and was aware that the balance sheet was inaccurate with regard to the specific Claim [... ] In view of the facts established above, and in particular the fact that the applicant consortium's licensor was aware of the existence of the abovementioned debt of the Dutch company and that it was not included in the balance sheet of 31. 5.5.2001, which constitutes knowledge of the lack of the agreed status within the meaning of Article 536, the defendant's liability to pay compensation for that lack of agreed status is excluded, the objection raised by the defendant in its submissions in respect of the assessment of their content being accepted'; see also See also the judgment of the Athens Court of First Instance No 6119/2011: "However, until the signing of the share purchase agreement of 11/10/2001, the licensor of the first of the defendants in the action No 3 in question, the Consortium of Companies ........./........, was aware of the actual situation regarding the dire financial situation of ................. ", as reflected in the published balance sheets of ".................", and the delays in the execution of the programme contracts with ......./.........., since, on the one hand, the data room data verification process (verification period), in which it participated, represented by qualified financial advisers from the auditing company "....................", was in progress. and by legal advisers of '.................', namely ............. and ................, and also received information from the joint venture partners of '.................', as the first of the defendants itself admits...').

In order to deal with the above issues in the context of a takeover contract, there are various contractual configurations to reflect the will of the parties each time:

Α. It is possible to agree that the DD has no relevance as to the seller's liability. In other words, even if the buyer has been made aware through the DD of certain defects in the business, the seller will normally be liable as long as he has promised a business free of defects (sandbagging clauses). This clause is intended to protect the buyer from e.g. last-minute provision of documents for which there is no time to process or from failure to calculate the impact of certain issues on the financial agreement and thus referring this issue to be decided at a later stage at the level of damages. In practice, of course, this clause can be used by a buyer who, while knowing about a defect, wants to "throw ashes in the eyes" of the seller (hence the term sandbagging) in order to agree a price that will ultimately be reduced even further after a claim for damages has been made.

Β. It is possible to agree that in order for the seller to be relieved of any liability, the buyer must have knowledge of the problem in a specific way. That is, a defect must not be inferred from a document, e.g. a document that he has read in passing, but must be directly deduced from it. Often the prospective buyer and his advisers are confronted with a large number of documents, contracts, financial statements, etc. Each document or even the absence of a specific document/contract may give rise to an assumption; for example, a contract with a supplier of the acquired company may have been disclosed, but it may contain an invalid clause which may give rise to a claim for damages against the acquired company. If that claim is ultimately asserted after the acquisition, it is a question of whether the seller can base its discharge of liability on the fact that the seller had knowledge of that contract. Usually the parties will draft the relevant terms so that the seller will only be relieved of any liability if the issue raised arises directly and immediately from the notified document; i.e. in our case the notification of the contract would not suffice but would have to have been notified by, for example, an out-of-court letter or a lawsuit by the supplier.

In conclusion, DD is a laborious task which almost never manages to give the perfect picture to the buyer. This is because, firstly, this is not feasible in the few months of its duration, and secondly, it would require the payment of large sums of money to specialist consultants to examine each issue raised individually. For example, it cannot be the case that every dispute that may have arisen is examined by a specialised lawyer, because this would require armies of legal advisers and would entail very high costs. The ultimate purpose of the DD is to give as good a picture as possible of the material and serious problems that may arise, in order to assist in determining the sale price on the one hand, and in allocating responsibility between the parties when the time comes to draw up the SPA on the other.