One of the most important stages of selling a business is ‘due diligence’, along with its related process, ‘disclosure’. These are critical steps that often involve a substantial amount of work and will affect how key documents are negotiated and the respective bargaining positions of the seller and buyer.
This article outlines specific aspects of the pre-sale process and forms part of a series that examines the considerations involved when selling a business.
Although a seller may have been conducting informal discussions with a prospective buyer for some time, as soon as an agreement in principle is reached, the buyer will want to begin its formal investigations.
‘Due diligence’ is the name given to the buyer’s proper investigations. In the time available prior to the sale taking place, the buyer will want to obtain as much information as possible about the company or business to enable it to decide whether to proceed and, if so, on what terms. Any findings the buyer makes during its due diligence investigations may lead to it seeking to renegotiate the price, requiring specific indemnity cover or, occasionally, withdrawing from the process.
Good organisation is the key to successful due diligence. Business owners should consider how they would manage the diligence process, even if they have yet to seek potential buyers. It is a good idea for would-be sellers to do some of their own due diligence in advance to spot any issues that may be of concern to a buyer and which could be resolved beforehand. If possible, and subject to confidentiality concerns, an internal due diligence team comprising appropriate personnel should be formed, headed by a person with a good overview of the business.
The buyer’s solicitors will produce a detailed questionnaire which is intended to cover as many aspects of the business as possible. Before responding to this - or indeed providing any confidential information to the buyer - it is essential that the buyer signs a ‘confidentiality agreement’ (typically in letter form) which the seller’s solicitors will prepare.
The seller’s solicitors will usually co-ordinate responses to the questionnaire and should be sent a copy as soon as possible. The person in charge of the due diligence team should then divide the questionnaire up into its constituent parts (such as finance, employment, properties etc) and organise their team to begin working on the responses.
The replies and documents will typically be made available to the buyer and its advisers via a secure online data room managed by the seller or its solicitors. It is usually better to avoid using generic cloud document-sharing solutions as they may not be secure or offer adequate functionality, resulting in the due diligence process being more time-consuming and difficult for all parties.
Working in this organised way ensures that each side has access to a complete and well-presented set of relevant documents. Carrying out a controlled due diligence process also facilitates the subsequent disclosure exercise.
The buyer will require certain warranties to be given in the sale and purchase agreement. Warranties are contractual statements that amount to assurances over the condition of the company or business and, in particular, any existing liabilities.
Warranties may give rise to legal liability for the seller if they are not accurate and the purpose of the disclosure exercise is to ensure, as far as possible, that the seller is not exposed to this risk.
Broadly, a disclosure letter is a letter from the seller to the buyer which contains details of all matters which would or might give rise to a breach of warranty. The buyer will generally accept that the warranties contained in the sale and purchase agreement are qualified by matters fairly disclosed in the disclosure letter. This means that, provided an adequate disclosure is made, the buyer will have no claim against the seller regarding a matter which would otherwise have constituted a breach of warranty.
The disclosure exercise will be coordinated by the seller’s solicitors. They will put together a first draft of the disclosure letter containing certain standard or general disclosures. They will then need to meet with relevant personnel from the seller (typically the due diligence team) with a view to eliciting specific disclosures by reference to particular warranties. Depending on the number of warranties involved, this can be a lengthy process and the time necessary to complete it should not be underestimated.
Once the draft disclosure letter has been prepared, it will be sent to the buyer’s solicitors and is usually the subject of some negotiation. Items arising out of the disclosure letter frequently prompt additional enquiries from the buyer and it is usual for the due diligence and disclosure processes to continue right up until the time that the sale and purchase agreement is signed.
The disclosure exercise is a key part of any transaction. If the seller makes inadequate disclosures, it may find itself on the receiving end of a breach of warranty claim which it could have avoided. Similarly, if a buyer fails to review a disclosure letter properly, it may be in for some unpleasant surprises.
Having a team of well-selected and trusted advisers is therefore crucial for sellers and buyers alike to help navigate the due diligence and disclosure phases, advance their objectives and minimise their exposure to risks.
This article is an edited summary from Penningtons Manches Cooper’s Guide to Selling a Business. For a copy of our Guide please click the banner below or get in touch with your usual PMC contact.
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