Put simply, due diligence in the M&A context is fact checking and elaboration.
If you (“Acquirer“) are buying a company, you will benefit from the sellers’ sworn summary of what you are buying, with the major pitfalls and liabilities exposed. That is the role of the Stock or Asset Purchase Agreement, or of the Merger Agreement, depending on how the deal is set up.
At the same time, you need to examine the innards of the company that you are buying (“Target“) yourself, normally using accountants and lawyers. Corporate officers and Boards of Directors, as well as their advisers like bankers, need to be duly diligent in conducting this examination. That’s the legal standard of review.
“Due diligence” in the M&A context is the level of prudence and diligence that is expected from, and ordinarily exercised by, a reasonable person in evaluating the risks involved in purchasing the Target. If an Acquirer’s Board of Directors does not exercise that level of prudence (for example through the Acquirer’s accountants and lawyers), the Acquirer’s shareholders may have a claim against them.
Due diligence is deal-specific and contract-specific, meaning that if you’re doing it right, you never do quite the same thing twice. Both the factual circumstances of the deal (e.g. the commercial domain or domains involved), and the legal structure and terms (e.g. asset or share purchase) need to be taken into account in pursuing due diligence.
The Acquirer’s legal due diligence serves to clarify and elaborate on the Target.
When a Target is sold, its financial statements give the Acquirer a picture of what the Target looks like from an accounting point of view.
Legal due diligence should give the Acquirer a corresponding picture of what the Target looks like from the point of view of “legal” assets and liabilities, many of which may not appear in the financial statements. Such legal assets may include, for example, trade secrets, and such legal liabilities may include, for example, guarantees.
The Target in an M&A context can also be an operating division of a company, for example when the Target company has two businesses and the Acquirer only wants one. The Target then has to be split in two, and the Acquirer only purchases the assets and liabilities comprising the business that it wants. That’s normally done through an asset sale
In an asset sale, the Acquirer has the same need for the clarification and elaboration offered by legal due diligence. Asset sales will include certain specified liabilities, which are those of the Target’s business sold. The Target’s other liabilities will remain with the business it retains.
The Acquirer still needs its legal due diligence to help identify all the legal liabilities which accompany the Target’s assets that it is purchasing. Not all are visible in the contracts.
For example, the legal assets may include sales contracts which have great value for the Acquirer because of the customer relations that they bring over. But these same contracts may also bring over serious liabilities, such as a risk of cancellation upon assignment of the contract to the Acquirer or even built-in unsustainable pricing.
Another example involves employees in certain foreign countries where employees have extensive rights. An Acquirer I knew (not then a client, I hasten to add!) was delighted to purchase “for a song” manufacturing facilities in Europe, including all the needed up-to-date equipment and well-trained employees, with only a few specified liabilities. But unknown to that Acquirer, those same employees brought with them massive liabilities whenever the inevitable rationalization or reorganization of the business occurred.
If that Acquirer’s due diligence had been done properly by the Acquirer’s lawyers, the Acquirer have not have been surprised by those liabilities down the road, as it was. The purpose of legal due diligence is to avoid those surprises.