Due Diligence

Monday, October 3, 2016

Due Diligence is the legal and commercial process of examination of a transaction, including the entities involved and the related documentation.

It is an essential part of a purchaser’s risk management strategy and it allows the purchaser to understand the risks associated with the purchase, incorporate these into the determination of the purchase price and deal with them as required. Through this process, issues can be dealt with and negotiated by the purchaser and vendor and if the issues cannot be resolved, the purchaser can then withdraw from the transaction and save costs.

The commercial reality is that most of the risks in the sale and purchase of a business or an asset fall on the purchaser. This is largely because the purchaser will not have available to them all of the pertinent information relating to the acquisition that the vendor has to hand. But through the process of Due Diligence, the purchaser can lessen the risk by accessing the information that will better allow them to make an informed decision on whether to complete the purchase.

Due Diligence should preferably be undertaken before a purchaser commits to the sale contract. This is preferable to entering into a sale contract and relying on vendor warranties because if something is discovered not to be right without a contract then the purchasing party can just move on without having to take steps to get out of the contract. In any case, the purchaser should retain the vendor warranties in case something is not detected in Due Diligence.

When performing due diligence it is critical that all issues of confidentiality are respected by the prospective purchaser. The general duty of confidentiality arises where information is made available and the party receiving the information should reasonably know that it is confidential. The issue of confidentiality arises when due diligence is undertaken because the members of the due diligence team will be exposed to very confidential and sensitive information (e.g. information about a competitor that is being acquired, production or processing information about very lucrative product or service) and if the sale does not proceed, then the purchaser has acquired some very valuable information. The Heads of Agreement may contain a confidentiality undertaking, otherwise the parties may sign a confidentiality or non-disclosure agreement.

With the sale and purchase of any business, the following should be included as part of a due diligence check:

  1. Corporate structure
  2. Licensing
  3. Key contracts
  4. Employee issues
  5. Intellectual property
  6. Financing commitments
  7. Litigation
  8. Insurance
  9. Financial issues / accounts
  10. Tax

1. Corporate Structure

Firstly, the purchaser should carry out an ASIC company search. This search will reveal the corporate structure behind the business, the directors of the company and registered charges over assets. It is important that if there is a charge over the company’s assets, further information is obtained especially concerning whether the company is in breach of its obligations.

It is also important that the purchaser check the constitution of the company against the ASIC record. There may be provisions contained the company’s constitution that are adverse to the purchaser’s interests, or others that constitute formalities required before a sale can proceed. The purchaser should also check for agreements with shareholders or obtain a statutory declaration that the company relies on the replaceable rules.

Of concern to a prospective purchaser is that in respect of private companies, shareholder agreement may give pre-emptive rights to existing shareholders giving them first option to purchase any shares in the company being sold. If these pre-emptive rights do exist, then it is important that the purchaser ensure that shareholders waive their pre-emptive rights.

The Purchaser should also check the following for compliance:

*    Appointment of Company officers

*    Issue of shares

*    Signed consents by officers before appointments

*    Appointments minuted and notified to ASIC

*    Minute books and share registers up to date

*    Register of substantial shareholders up to date

*    Share allotments notified to ASIC match register

*    Whether share register contains duplicate share certificates

*    Whether register of charges is up to date

2. Licensing

It is important that a purchaser is aware of any licensing requirements that are associated with the business to be purchased. These licensing requirements may relate to business names and premises, local government zoning and liquor. It would be prudent for the purchaser or there legal representative to examine Federal / State / Local legislation governing the operation and licensing of the type of business to be purchased.

The purchaser should also inspect all current licenses associated with the business and check:

*    For any conditions attached to the license

*    Whether there has been any past breach of conditions

*    That current license fees are paid

*    Whether extra licenses will be required in future, e.g. if business operations change.

3. Key Contracts

It is important that the purchaser review all key contracts including those concerning supply, distribution, employment and leasing. The purchaser should also inspect the signed original contracts and consider each of the material terms contained in these contracts e.g. duration, renewal, execution, payments, reviews, restrictions, default provisions, ability to assign and procedures to follow when assigning.

It is important for the purchaser to obtain confirmation from the vendor that:

*    There are no outstanding claims in relation to key contracts

*    Consent to assignment has been obtained (if required)

*    There is no variation to the contract

4. Employee Issues

Firstly, it is important that a purchaser identify core employees within the business and ascertain what their current arrangements are and whether formal contracts are in place. The purchaser would also want to ascertain what commitments the company has made to non-core employees.

A purchaser would also want to know the following:

*    What employee liabilities the vendor has paid to date e.g. Wages, leave pay, severance pay etc.

*    Whether Workers Compensation Insurance is in place- What is the cover for current claims? Does the vendor have recourse to another source of indemnity if the insurer will not cover claims that arise.

*    The Superannuation obligations to employees- have all compulsory contributions been paid and are the funds administered by the company compliant with the relevant legislation.

*    The relationship between the business and its contractors- What are the terms of these agreements? The purchaser would also want to ensure that no liabilities are outstanding to these contractors.

5. Intellectual Property

The purchaser will need to identify the nature and source of all intellectual property rights claimed to be owned by the company.

The purchaser will also have to consider:

*    What contract based and statutory based rights exist in relation to intellectual property.

*    What intellectual property rights exist in relation to the trading name of the business? Is the trading name registered in the name of the vendor?

*    What intellectual property may exist in any domain name and/or website for the business.

6. Financing commitments

The purchaser will have to examine closely the books of the business to determine the extent of its liabilities. The purchaser will also have to check the books for secured liabilities which may give rise to a future claim over the assets of the business in the event of default.

7. Litigation

The purchaser must ensure that when purchasing the business, the company controlling the business or any of its officers are not the subjects of any litigation that involves the business.

Consideration must also be had to the following:

*    What is the potential exposure for the purchaser?

*    Any prospective claims / pending claims must be verified

*    The purchaser should search court registers for the status of any proceedings already on foot involving the company.

*    Whether an undertaking of assistance is required from any person with knowledge of a claim against the business.

8. Insurance

The purchaser should check certificates of currency of cover for:

*    Public Liability

*    Workers compensation

*    Stock, plant and equipment

*    Real estate owned by the company

*    Product liability

The purchaser should also obtain a schedule of current insurances and check the claim history. This will also reveal whether the insurer has denied liability on current / previous claims.

9. Financial issues / accounts

The purchaser will need to thoroughly check each of the following for the business:

*    Management accounts

*    Annual accounts

*    Asset valuations

*    True extent of liabilities (including anticipated liabilities)

10. Tax

The purchaser will need to inquire as to what the tax liabilities are in connection with the business.

In particular, they will need to check the following:

*    GST registration / Australian Business Number

*    BAS (Business Account Statement) returns

*    PAYG (Pay as you go) liability

*    Federal tax liability (group tax, income tax, Capital Gains Tax)

*    State tax liability (land tax, payroll tax)

Liability limited by a scheme approved under Professional Standards Legislation.

Back to News

promo-footer.jpg