When preparing to purchase a business, a buyer should conduct a thorough investigation of the target to confirm it is a sound investment and to understand the risks involved in the investment. To this end, as part of due diligence, a buyer will seek to confirm the assets and liabilities of the target, to gain information about the operations of the target business, and to identify any risks, barriers or hurdles to the proposed purchase. In some cases, the information revealed during buyer due diligence merely confirms the information that the buyer previously knew about the target. However, in other cases, significant issues are identified during due diligence which result in changes to the transaction structure, revisions to the purchase agreement, reduction of the purchase price, or even the abandonment of the transaction altogether. The nature and scope of the due diligence investigation will depend on a variety of factors, including the size of the deal, the structure of the transaction (e.g., a share purchase versus an asset purchase), the business of the target, and the amount of time and money available to the buyer for the investigation.
In this article, we review the potential scope and nature of buyer due diligence and factors that influence such scope. We also consider the main sources of information typically included in the legal due diligence process, and discuss certain confidentiality and privacy issues.
Nature and scope of buyer due diligence
The focus of this article is legal due diligence, which is generally conducted with the assistance of legal counsel. In addition to legal due diligence, buyers also ordinarily conduct investigation of the target’s financial position, tax issues, marketing, operations, environmental issues, and other areas, and use other professionals, such as accountants and tax advisors, to carry out such investigations.
Purchase and sale agreements usually provide the buyer with the opportunity to conduct due diligence on the target, and they also require that the seller cooperate with the buyer’s reasonable investigations. Some information, such as public database searches, can be obtained by the buyer without any input from the seller. However, most information necessary for thorough due diligence is provided by the seller at the buyer’s request. In transactions where a large amount of information and documents are reviewed, the information may be provided to the buyer by way of a virtual data room maintained by the seller. Information can also be conveyed or supplemented by Q&A sessions conducted with management of the target.
The nature and scope of the due diligence will depend on a variety of factors:
- Share purchase versus asset purchase. In an asset purchase transaction, the focus of due diligence investigations is on the assets themselves. In a share purchase transaction, the buyer will focus significant attention on corporate matters, in addition to the assets.
- Public company or private? Public companies are required by securities laws to publicly disclose a significant amount of information, including audited financial statements, material agreements, and annual reports. This information can help a buyer of a public company familiarize itself with the target and identify issues for investigation.
- Regulatory environment. Depending on the nature of the target business, a significant amount of legal due diligence may focus on regulatory matters in respect of the target. Is the target business in compliance with all of its regulatory approvals? Does the transaction itself need to be approved by the regulators?
- Competition issues. Are the buyer and seller competitors? If so, certain pricing or other confidential information may need to be excluded from the due diligence prices to comply with competition laws.
- Cost and time restrictions. Extensive due diligence is time-consuming and expensive. Due to these constraints, a buyer may curtail the due diligence to prioritize key areas of investigation, such as significant assets in an asset purchase transaction.
Sources of information reviewed in due diligence
The following is a non-exhaustive list of sources of information that buyers often draw from during legal due diligence.
- Public database searches. Public searches are a relatively inexpensive way for buyers to obtain information about the target or the target’s assets. Some common database searches, as well as some questions that may be answered by conducting such searches, are as follows:
- Corporate registry searches - Is the target company in good standing and up to date in all required filings?
- Courthouse searches - Are there any court actions outstanding or that appear to be outstanding? Does the public record of litigation match what the seller has disclosed to the buyer?
- Personal property registry - Do the liens registered on the shares or the assets match the disclosure by the seller? Will “no-interest” letters or subordination agreements from lenders be required in order to complete the transaction?
- Bankruptcy and insolvency searches - Has the seller or the target company filed for bankruptcy or has an insolvency application been made by a third party creditor? Was the target company or the seller previously insolvent?
- Land titles searches - If the target assets include land, are there liens registered against title to the land? Are there any leases or caveats registered against title that may affect the purchaser’s use of land?
- Intellectual property searches - Does the seller own or have the right to sell and transfer to the buyer the copyrights, trade-marks, patents or other intellectual property that constitute part of the assets being sold in or as a part of either an asset or share purchase transaction? Do any third party consents have to be obtained to such transfer or sale (an example being any licensed works or software that are being transferred as part of the transaction but in respect of which the licensor of the works or software has the right to restrict the transfer of same)? Do third party intellectual property infringement claims come into play that may threaten or affect the right of the seller to transfer the intellectual property? Searches should be made in Canada at the Canadian Intellectual Property Office and, if the intellectual property is registered internationally, certain international searches also need to be conducted, to confirm the status of any intellectual property registrations.
- Minute book and other corporate documents. In share purchase transactions, the buyer should review in detail the minute books of the target company and any subsidiaries. Minute books include the following types of documents:
- Organizational documents - Are there restrictions on transfers of shares or assets in the articles, bylaws or under a unanimous shareholder agreement?
- Share registers - Are the sellers in a position to sell all of the shares of the company?
- Directors and shareholder minutes - Has the target company complied with corporate law and the organizational documents, e.g., by providing shareholders with annual financial statements and approving the issuance of shares? Have the directors been appointed in accordance with the applicable law? Have any unusual dividends been approved by the directors?
- Material agreements - Have key contracts been approved by the board of directors?
- Licenses and permits. If the target requires licenses, permits, or other regulatory approvals in order to operate the business, the seller should provide copies of the same and all related documents, including any correspondence with the applicable regulators.
- Commercial contracts. Depending on the scope of the due diligence, the buyer may wish to review all commercial contracts that are in effect, or may focus only on certain material contracts. For each contract, the buyer will seek answers to the following questions:
- What are the assignment and transfer provisions of the contract? Is assignment by the seller to the buyer permitted without the consent of the counterparty to the contract?
- When does the contract expire? Is renewal of the contract permitted?
- Can the contract be terminated by the other party for any reason? If so, what is the notice period?
- Are there restrictive covenants in the contract, such as non-competition or non-solicitation provisions?
- If material contracts include any joint venture, partnership or other collaborative arrangements with counterparties, then the contracts and other information relating to those arrangements should be reviewed by the buyer in detail.
- Litigation documents. For all outstanding court or tribunal proceedings against or involving the target or the seller, the seller should provide sufficient details, including the risks. Ideally, the legal counsel of the seller should provide a summary of the proceedings including the likelihood of the seller’s success. The buyer should also review any settlement agreements which have outstanding obligations.
- Employment records. If the proposed transaction will involve the purchaser hiring employees of the seller or assuming their employment contracts, the buyer should review the employment agreements and other documents. Such review is subject to restrictions under privacy law, as discussed in the next section.
Confidentiality and privacy concerns
In most situations, much of the information that the seller provides to a buyer during due diligence is confidential, and disclosure of such information could detrimentally affect the target company’s competitive business position. As such, prior to due diligence, sellers and buyers often enter into confidentiality agreements to protect such information. There may be commercially sensitive information that a seller does not want to disclose, even though the buyer has entered into a confidentiality agreement.
Personal information relating to the target’s employees and consultants may be protected under privacy laws. Both sellers and buyers need to be aware of privacy issues when providing or receiving such information, to ensure that applicable privacy laws are not breached.
Prior to purchasing any business, a buyer should conduct a thorough investigation of the target to ensure that the proposed investment is sound. Appropriate due diligence, conducted with professional advisors, can ensure that the target is a good investment by the buyer and will assist in identifying important risks that may affect the purchase transaction.
This article provides only general information about legal issues and developments, and is not intended to provide specific legal advice. Please see our disclaimer for more details.