The Importance of Due Diligence

Commercial transactions such as agreements between companies and/or mergers occur when companies of similar size join forces to form a larger organisation. Before the two businesses can finalise and execute the transaction, they must ensure that the other party is in good standing, both legally and financially, and that their operations will benefit each other once they become one. 

These are often high-value transactions, so a careful review beforehand is crucial. Our commercial litigation team get involved where these commercial transactions have gone wrong, and for whatever reason or circumstances, due diligence has failed. That can lead to professional negligence claims and/or other claims such as for breach of contract, trust, negligence and/or misrepresentation amongst others. 

This article explains due diligence in the context of something going wrong, why it’s important, how to conduct it, and potential challenges. Contact Helix Law today for expert advice where you have encountered a failure or problem of due diligence and you need assistance in recovery of losses suffered as a result. 

What Is Due Diligence?

Due diligence (DD) refers to the process of conducting an in-depth review of another company’s financial, legal, operational, and strategic aspects before finalising a deal. It allows the investigating company to identify potential risks or issues that could impact the success of the venture. Adequate due diligence means each party entering the transaction is fully informed about the circumstances of the other, or should be. 

The most common types undertaken in say commercial transactions can include: 

• Legal, including assessing the company’s compliance with laws and regulations. 
• Financial, including an analysis of financial records, liabilities, and revenue. 
• Operational, including a review of how different departments run and identifying areas for improvement. 
• Commercial, including examining the company’s position in the market and competition. 
• Tax, including ensuring the company has correctly calculated and paid its taxes.

The Importance of Conducting Due Diligence

Due diligence is one of the most vital aspects of a commercial transaction. It ensures:

• Transparency: Parties receive and review all relevant information about the deal, enabling them to make informed decisions. Companies can confidently negotiate terms based on this, forming a relationship of trust from the outset. 
• Lower risk: Understanding potential issues that could arise allows parties to address them and avoid nasty surprises. 
• Valuation accuracy: Financial DD helps the investigating organisation determine if the agreed price is accurate, as it uncovers hidden debts and liabilities. 
• Smoother implementation: Having a complete picture of how the business runs beforehand leads to easier post-deal integrations, minimising operational disruptions. 
• Compliance: Conducting adequate due diligence ensures companies comply with relevant transactional laws and regulations. This reduces the risk of disputed agreements or hefty fines for non-compliance. 

How Is Due Diligence Carried Out?

Scope

Often in commercial transactions either in-house counsel or external company and commercial solicitors or counsel will be instructed to assist the company in relation to the terms of the deal. As we are specialist litigation solicitors, we only deal with these transactions when something has gone wrong. The investigating party must first identify the scope of the DD based on the particular company and the complexity of the deal. Companies should involve legal counsel, financial advisors, and other industry experts to examine the elements they need to review. The relevant factors that help determine scope include:

• Company size and structure: For example, an in-depth review will likely be appropriate for a larger organisation with a more complicated set-up. 
• Industry: For example, intellectual property will be a more prevalent issue in a tech company, so it should be subject to DD.
• Objectives: The investigating business will want to align the DD’s scope with its goals. 

Once the organisation determines the scope, it collates a list of the documents it requires from the other party to address different areas. 

Requests for Documents

The target company should provide all requested documents within reason. It normally includes:

• Financial records: For example, balance sheets, profit and loss statements, and tax returns. 
• Contracts: For example, with suppliers, consumers, and employees. 
• Regulatory documents: For example, certificates and licences. 
• Intellectual property: For example, patents, trademarks and licensing agreements.
• Litigation records: For example, details of past and ongoing disputes. 

These documents provide a comprehensive overview of the business’s current standing, potential risks, and compliance issues.

Parties must transfer documents safely to ensure security and confidentiality. It’s common to use secure virtual data rooms (VDRs) so companies can share their information securely. 

Document Review

The above documents will then be thoroughly reviewed, usually dealing with the following:

• A legal review to understand existing contracts, litigation and disputes, compliance, and intellectual property protection. 
• A financial review to gain a complete picture of the company’s financial position and value. 
• An operational and IT assessment to understand day-to-day practices and infrastructure. 
• An Environmental and Social Governance (ESG) review to assess the company’s sustainability policies. 

Further Questions

Following their review, the business conducting the DD may need to ask further questions or request more information. This stage is an opportunity to fill in any gaps and address ambiguities. For example, unexplained transactions or anomalies in the financial records will need clarification before the parties can proceed. 

Reporting 

Once the investigating party has the necessary information, it prepares a report on its findings. The report summarises the key issues, sets out a risk assessment, and includes recommendations for addressing such risks. It will provide a detailed analysis of each DD area, highlighting those which pose complications. 

The report will conclude whether the deal is advisable based on the DD results. Following the agreement concluding, parties may consider renegotiating or requesting indemnities to protect themselves. It’s vital that parties seek independent legal advice to help them decide how to proceed. 

How Long Does the Due Diligence Process Take?

The length of the process varies depending on the company’s size and industry, which affects the volume of documentation that needs reviewing. Smaller businesses can usually complete DD within a few weeks, whereas larger companies can take several months. 

Additionally, more regulated industries, such as finance and healthcare, tend to take longer due to the added compliance checks. Parties should communicate promptly to ensure they exchange information in good time. 

While the delays associated with DD can seem offputting, parties should spend time ensuring they do it correctly to avoid future problems. 

What Happens After Due Diligence?

Following DD, the parties has the following options: 

• Proceed with the deal on the terms initially agreed. This will happen if no significant issues arise during due diligence. 
• Renegotiate the terms, which tends to happen if the company discovers more minor problems or those they can easily address. 
• Withdraw from the deal because they discover critical issues they cannot or don’t want to spend the time resolving. 

What Are the Difficulties Associated With Due Diligence?

The main difficulties that arise during DD are:

• Time and resource-intensive: It can be lengthy, requiring different personnel to review the relevant information. Parties often impose deadlines, leading to time pressures and overlooking potential issues. 
• Access to information: Target businesses can withhold documents or fail to provide information in a timely manner, leading to gaps in the assessment. Without such information, preparing a comprehensive report can be challenging. 
• Data volume: Due diligence usually involves the transfer, storage, and review of vast amounts of data, particularly for larger businesses. This process can be complex and requires expert involvement to ensure security and regulatory compliance. 
• Regulatory barriers: In regulated industries, parties must overcome additional hurdles to ensure they adhere to the relevant laws. It usually adds delay and cost to the process. 
• International issues: Companies merging in different countries may face challenges due to differences in time zones and cultures. International contracts must comply with laws from multiple jurisdictions, which can lead to increased delays and resource needs. 

Frequently Asked Questions

What Is the Difference Between Due Diligence and Disclosure?

Due diligence refers to the process of gathering and reviewing documentation and information from the target company. Disclosure relates to the target business’s obligation to provide complete, accurate information as requested. The investigating party will use due diligence to review the disclosures and decide whether to proceed with the deal. 

What Can go Wrong?

The most important part of Due Diligence is being very careful to state exactly what is required and the agreements/assumptions that the deal is based upon.

The entire process starts from there and if you get this part right then if other side does not provide those documents, you are well-placed to provide properly reasoned arguments why they should/you need them before proceeding with the deal.

Secondly, regrettably, sometimes people provide documents that are not entirely accurate and where this happens and you have relied upon them, with a well-formulated request you are then well-placed to obtain legal remedies for such actions. 

Final Thoughts

Conducting thorough due diligence is an essential step for any successful commercial deal. It allows companies to fully understand their potential partner’s legal, financial, operational, and commercial standing. By meticulously assessing risks, liabilities, and opportunities, organisations lower the chances of post-deal complications, creating a smoother integration process.

Whether reviewing contracts, financial records, or regulatory compliance, robust due diligence protects your investment and establishes a foundation for trust and collaboration. While there are numerous challenges associated with due diligence – such as time constraints and regulatory hurdles – neglecting this critical step can lead to costly surprises and pitfalls post-deal.

If your company has been involved in a commercial transaction where due diligence has taken place but you have later encountered difficulties- we are well placed to assist you. Our expert litigation solicitors are experienced in considering and advising on the basis of potential claims. Our specialist litigation team will be able to answer any questions where things have gone wrong and help you take action. Contact us today for more information.