Due diligence as a guarantee of a successful purchase of a business

LEGAL DIGEST \ 19.07.2019

In a business world where deals are closed for high-value assets, an investor who is planning to acquire a controlling stake in a company or a large enterprise strives to forestall, to the maximum degree, the potential risks that are inherent in the business operations of such company or enterprise. Such risks include bad-faith counterparties, an inflated or volatile value of the target, high costs of litigation involving the asset, or other adverse consequences resulting in the actual value of the asset being reduced. A procedure known as due diligence is a key method to avoid most such situations or to mitigate the consequences of them.

Due diligence is comprehensive research into an asset that an investor wants to acquire and into the counterparty from whom the asset is being acquired. The research covers various aspects of audits that are aimed at establishing the legal, tax and accounting value of the target. During due diligence, an investor can learn the value of current assets of the target company, its past and anticipated returns, the contemplated development scenarios, and legal risks. The latter can be associated with the property the company has, with the contracts it has concluded with third parties, and with tax and bookkeeping risks. The information obtained helps a balanced decision to be taken as to whether the asset should be purchased.

Consequently, due diligence enables:

• a potential counterparty to be checked in terms of  its good faith and readiness to fulfil the obligation to sell the asset. For instance, by having information about the counterparty disclosed, one may discover the date when the company was founded and its issued capital. It is often the case that such information does not reflect the actual ability of the company to pay its debts. Moreover, with the help of due diligence, information can be revealed regarding the number of lawsuits initiated against the company or its bankruptcy.

• the legal status of an asset to be checked: its description and content; whether it actually belongs to the counterparty or there are third parties who enjoy a preemptive right of purchase or use with respect to the asset; whether the investor will be able to dispose of the asset at its own discretion (if there are any restrictions on the types of activities the target company is engaged in or objective obstacles to deploying the production process you desire in the premises or in the building of the enterprise you are acquiring).

• an objective determination to be made of the value of the target asset in order to calculate the purchase price.

For this purpose, the value of non-current and current assets should be first determined. Second, the company’s financial sustainability and potential profitability ratio should be established. Third, the potential costs should be specified which are associated with the enhancement of the enterprise’s or the company’s production process (the replacement or upgrading of equipment, repairs to the premises, or the recruitment of additional employees). Fourth, the company’s current obligations should be examined and it should be determined whether additional costs will be necessary to fulfil such obligations (for example, a purchase of additional raw materials). Fifth, one should examine the documents of title pertaining to the company’s property or to the enterprise. It should be checked whether the property was lawfully acquired and whether there are any rights of third parties (pledge holders). Sixth, intellectual property should be established that belongs to the company or constitutes part of the enterprise. All the above steps will facilitate an assessment of whether the purchase price of the assets is adequate.

• To check the transaction to be concluded as to its compliance with antitrust laws: will the investor hold a dominant position on the market of a certain product if it acquires the company or the enterprise that produces such product and, in terms of concluding the relevant transaction, should the consent of the antitrust authority should be obtained?

As a result of the due diligence conducted, the investor will be able to start negotiating certain additional terms of the transaction to acquire the asset:

– to establish a special payment procedure;

– to provide for security for the seller’s obligations to transfer the asset (pledge, suretyship, or an independent guarantee);

– to incorporate representations and warranties (that tax authorities do not have any claims with respect to the asset being sold, or that there are no third-party rights to it), which if breached will result in the seller being liable to the extent for which the contract provides;

– to stipulate conditions for the compensation of losses caused by certain circumstances (for example, legal expenses resulting from unsubstantiated claims of third parties or state authorities).

When the above conditions are agreed upon in the contract, this will enable you to exclude or mitigate the legal and economic risks of adverse effects.

In conclusion it is worth mentioning that an investor who has not conducted due diligence of a target asset may subsequently face the following complications:

• The seller may turn out to be a fraudster and fail to fulfil its obligations once it receives payment.

• The seller may subsequently be declared bankrupt and the transaction to dispose of the asset will be recognized as a major transaction under bankruptcy proceedings.

• The target company has numerous debts under its obligations to third parties.

• The acquired enterprise may have been pledged, and since the new owner did not conduct the due diligence, the pledge holder may foreclose on the property.

Acsour’s legal department recommends that due diligence should be conducted in the form of a complete and comprehensive examination of the target asset to shed light on all aspects of the business of the target company or the potential counterparty. The due diligence procedure helps an investor to avoid many risks which otherwise may result in the investment target being lost, and often also helps it to conclude the transaction on more favourable terms. Therefore, we urge you to treat your intended transactions with due care and once again make an additional check on your counterparties.