The life cycle of a deal | Part 2: Purchaser's due diligence

In Part 1 of the Life Cycle of a Deal series, we examined the types of acquisitions and the various stages of a deal’s life cycle. As Part 2 of the Life Cycle of a Deal series, this article provides an overview of the legal due diligence process a prospective purchaser would typically complete when determining whether to acquire the shares or assets of a target business. For further information on a seller’s due diligence, please refer to our seller due diligence article.

This article assumes the target business is a privately held company.

What is due diligence?

First and foremost, due diligence is the process where a prospective purchaser investigates the target business or the target assets before making a formal commitment to purchase. Due diligence allows the purchaser to learn more about the target business, but is also an opportunity for the parties to learn more about each other.

There are a variety of reasons why a prospective purchaser completes due diligence. For example, a purchaser seeking to acquire a target business or its assets will conduct due diligence to confirm whether the acquisition is a sound commercial investment and to help mitigate potential risks associated with the acquisition.

The due diligence review may confirm information a purchaser already knew about the target, but it may also reveal significant issues. Such revelations can lead to changes in the provisions of the purchase agreement or changes to the transaction structure. It could also result in the purchaser using ‎the information to negotiate contractual protections or reducing the purchase price. In extreme ‎cases, a purchaser may decide to abandon the transaction as a result of its due diligence findings.

At a minimum, the legal due diligence process should:

• Confirm the seller has title to the purchased shares or assets;
• Identify obstacles or impediments that will need to be addressed - such as third-party consents;
• Identify legal risks and liabilities associated with the acquisition;
• Confirm the legal documentation necessary to properly complete the transaction; and
• Educate the purchaser about the operations of the target business.

Scope of due diligence

The nature and scope of a purchaser’s due diligence is dependant on numerous factors, including:

• Structure of the transaction - In a share acquisition, the purchaser acquires all assets, liabilities and obligations of the target (other than those explicitly excluded). As a result, a purchaser’s diligence efforts will typically be quite extensive when acquiring the shares of a target business, will relate to all aspects of the business being acquired (e.g. real estate, intellectual property, tax, employment and regulatory matters) and will thereby require the involvement of legal professionals that specialize in such practice areas. When acquiring assets, the purchaser cherry-picks certain assets and ‎liabilities of its choosing. ‎Therefore, the purchaser’s due diligence will focus on matters relating to the purchased assets and assumed liabilities (for example, whether the seller holds unencumbered title to such assets). Since the due diligence is more narrowly focused, the due diligence process for an asset acquisition typically takes less time than that required ‎for a share acquisition.‎
• Costs and time constraints - Due diligence can be a time-consuming undertaking involving multiple professionals and individuals. A purchaser should consider any cost and timing constraints when defining the scope of due diligence that it wishes to conduct.
• Risk tolerance of the purchaser - Before commencing the due diligence process, a purchaser should assess its risk tolerance level. Certain considerations, such as purchase price, may impact the risk tolerance of a purchaser. Typically, the higher the purchase price, the lower the risk tolerance, and therefore, the more extensive the due diligence process may be.
• Regulatory environment of the business - If the ‎target business is part of a regulated industry, the purchaser should ensure that the target business is acting in compliance with applicable regulations. Consideration should also be given to whether certain regulatory approvals are necessary to properly authorize the transaction.
• Industry of the target business - The industry of the target business may affect the level of due diligence a purchaser undertakes. If a purchaser is knowledgeable about, or operates in, the target’s industry, a purchaser may not engage in the same level of operational due diligence as a purchaser that is unfamiliar with the industry that the target operates in. Further, the likelihood of certain risks may be more prevalent in specific industries. For example, if the target business provides waste management services, more extensive environmental due diligence may be required.
• Multi-jurisdictional presence of the target business - If the target business operates in multiple jurisdictions (on a subnational and international level), legal due diligence will often involve engaging counsel in each applicable jurisdiction.

The due diligence process

Though the extent of due diligence that is conducted by a purchaser may vary based on the nature of the transaction at hand, the due diligence process will usually require the following:

Minute book review ‎

The minute books of the target business should be reviewed to confirm certain corporate matters such as: incorporation and existence under its laws of incorporation, authorized capital, and capitalization. The minute book should also be reviewed to confirm the target business has the requisite authority to conduct its business and affairs. Any shareholders’ agreements of the target business should be reviewed to ensure proper authorization is obtained with respect to the proposed acquisition. Notably, the extent of the minute book review will depend on whether the transaction is structured as a share or asset acquisition. In a share acquisition transaction, any minute book review that is conducted will be more extensive, given that the shares of the target will be acquired by the purchaser and thereby, the purchaser will want to have an opportunity to require the target to rectify any issues that are revealed in a minute book review prior to closing.

Public record searches ‎

A purchaser should also conduct public record searches on the seller and the target business - including searches relating to: bankruptcy (under the Bankruptcy and Insolvency Act and the Companies’ Creditors Arrangement Act), section 427 of the Bank Act, real estate, personal property security registrations, ‎intellectual property rights, litigation, and status and standing. These searches assist a purchaser with confirming whether there are any encumbrances affecting the target business or assets, and impediments that may need to be addressed prior to closing. Searches are typically completed in the province or municipality where the target business or assets are located. If the target business operates in multiple jurisdictions, searches should be conducted in each applicable location.

Contracts

Contracts of the target business should be reviewed for provisions that may impact the transaction. Contracts may contain change of control provisions that will need to be addressed prior to acquiring the shares of a target business - if any such contract is material, and consent is not obtained from (or in some cases, prior notice is not provided to) the counterparty, the counterparty may have a right to terminate the contract in question, which could reduce the value of the company being acquired. In an asset sale, the purchaser will need to similarly examine assumed contracts for assignment provisions under which a counterparty’s consent would be required before such contract can be assigned to the purchaser. In sum, if a purchaser wants to retain the benefit of a lease or contract, a third party consent is often required.‎ Some other contractual provisions that may be of interest to a purchaser include: term (consideration should be given to whether a contract is expired or soon to be expired), renewal rights, termination provisions, restrictive covenants, most-favoured nation provisions, and those relating to security interests.

Engaging specialists

Depending on the nature of the transaction, certain legal specialists, such as real estate, tax, intellectual property and environmental lawyers may need to be engaged to assist with due diligence matters relating to their respective areas of expertise. Additionally, the due diligence process is not limited to legal diligence - a purchaser will often retain other professionals to assist with the process. For example, it is common for a purchaser to involve accountants to complete the financial and tax review of the target business. IT specialists may also be engaged to assist with technology diligence. 

Conclusion

It is common practice for legal counsel involved in the diligence process to prepare a due diligence report that summarizes its findings. Such reports typically discuss the due diligence that was conducted, describe the target business and/or assets and summarize the issues and risks that were identified. Often, these reports will include appendices attaching summaries of the material contracts, the public record searches completed and the minute book review.

While the due diligence process will vary with every transaction, the foregoing provides a summary of ‎some of the essential components of a purchaser’s due diligence. ‎

Top five takeaways

1. There are numerous reasons why a prospective purchaser completes due diligence on ‎a target business. ‎
2. The legal due diligence process should: confirm title to purchased shares or assets, ‎identify obstacles to ‎be addressed, identify legal risks and liabilities, confirm the ‎documentation necessary to properly effect ‎the transaction, and provide ‎information about the target business.‎
3. The extent of a purchaser’s diligence will vary depending on considerations such as: ‎the structure of ‎the transaction, costs and time constraints, the purchaser’s risk ‎tolerance, regulatory environment and ‎industry of the target business, and whether ‎the target business has a multi-jurisdictional presence.
4. The ‎due diligence process will typically involve: a review of the target business minute ‎book, public record ‎searches on the seller and the target business, and a review of ‎the contracts of the target business. ‎
5. Certain legal specialists and tax/financial specialists may also be engaged to assist with certain aspects ‎‎of diligence.‎

The next installment of our Life Cycle of a Deal series will discuss the key terms in a purchase ‎agreement.‎