Due diligence explained
Company takeovers often involve a due diligence investigation. What is due diligence? What are the responsibilities of the buyer and seller and what must each party be aware of? We will explain further below:
What is due diligence?
Due diligence is a risk estimation that, for example, can be related to finances, taxes or strategic and legal affairs. If you takeover a company without conducting a due diligence report and the company you purchase has an issue such as hidden debts, then it is possible that the seller does not have to pay damages. In other words, the buyer should have conducted adequate research.
As a commercial investor conducting a takeover you need to have answers to the following questions:
- Does the company meet the description of the seller?
- Can the company be used in the future in the manner that you intended?
- Are there any hidden missing figures in the (annual) figures?
How does due diligence work?
The seller creates a so-called ‘data room’ for the buyer. A data room gives visibility into important information that the buyer needs to get an overall view of the business. The buyer and seller agree on a variety of documents that should be made available in the data room.
It is up to the seller to ask for more information on any documents in the data room that have areas that might be unclear. This was determined by the ‘Hoog Catherijne’ ruling by the Supreme Court.
This disadvantage can be mitigated in the favor of the buyer by insisting on the inclusion of broad guarantees on the state of the company in the purchase agreement. In the negotiation process regarding the purchase, the seller will declare that they have provided all the information that is necessary for the buyer to obtain an accurate view, but parties will also agree that such guarantees do not apply to information published in the data room.
On the other hand, the seller will take the position that it is up to the buyer to identify any specific risks relating to the purchase.
The buyer should include indemnities for these risks in the agreement and also formulate them as broadly as possible.
Buyers obligations regarding due diligence
Purchasing a company involves an obligation to research that purchase. A long history of legal judgments has determined that a buyer must take measures within reasonable limits to prevent entering into a purchase contract on the basis of an incorrect representation of facts.
If a buyer does not carry out such a preventative obligation then they cannot later invoke wrongful misrepresentation.
As an entrepreneur, using the advice of experts when performing such a takeover leads to an increased responsibility to research the purchase. This cannot be evaded by not hiring experts. Current law regarding company takeovers generally requires the application of due diligence. Specialists can be considered a requirement for this, for example in assessing the specific tax risks where a tax advisor is necessary.
Duty of the seller to notify buyer during due diligence
A seller cannot sit back and let the interested buyer carry out all the work. The seller has a responsibility to provide information. This refers to another legal principle: Parties to a transaction have an obligation to act in ‘good faith’ and to take each other’s ‘legitimate interests’ into account.
Some matters might be obvious for the seller, but unclear for the buyer. Examples might include an irregular bank guarantee that is extended to a contracted partner, or a permit that the appropriate authority has declared will be cancelled. It would be strange if the buyer had to discover this information for themselves while the seller has this information readily available.
A seller must ensure that the buyer does not make the purchase based on an inaccurate assessment of the company. The data room can therefore be seen as an agreement by both parties regarding which information the seller must provide.
The composition of the data room is important in determining the extent of the obligation to provide information that applies to the seller. Information that has not been agreed as being required mostly falls outside the duty of the seller to notify the buyer. Conducting due diligence is also important for the seller as it reduces the risk of liability.
Help with due diligence
A great deal of discussion is possible and will from time-to-time occur regarding the extent of the seller’s responsibility for the specific condition of the company at the time of sale. Due diligence is an inseparable part of any negotiation into the conditions of a takeover. As the information above makes clear, the legal aspects of due diligence are complex.
Do you want to buy or sell a company? Our lawyers can provide advice. Crowe Peak has all the expertise in-house to give full or partial advice regarding due diligence, to coordinate the process or execute a due diligence process. Contact our advisors in advance of any planned takeover for professional assistance.