Pre-Sale Due Diligence in M&A transactions
What is pre-sale due diligence and why it is important for sellers to conduct before going to market?
This is the first episode in our third video series, “M&A Deconstructed”. In this video M&A experts, Justin and Shaun Guppy, Partner | Corporate from Steele Raymond LLP Solicitors, discuss the importance of pre-sale due diligence and the difference between actual due diligence. Although not a requirement pre-sale they discuss why the investment in time and money is recommended to identify and address any potential issues before going to market. Common issues that can arise during due diligence include; problems with the share register, ownership of intellectual property, compliance with data protection regulations and more.
The M&A experts discuss how addressing such issues up front can actually save time, money, and prevent deal-breaking issues from arising during the sale process as it is more difficult and time consuming to rectify issues mid-deal plus the potential exposure to an aborted sale, should skeleton(s) be found in the process, causing a buyer to pull out.
Learn what checks to do before a sales process is in play to avoid a company sale being derailed and how to avoid costly mistakes, don’t get caught out. Watch the video below for the in-depth discussion.
Quick find timeline:
00:00 – Introducing Pre-Sale Due Diligence
00:16 – What is Due Diligence (DD)?
01:14 – How sellers underestimate the time required for DD
01:50 – Different disciplines required for DD, (legal, financial and tax)
02:29 – Advantages of Pre-Sale DD; including time, resource & easier rectification, when required
04:06 – How in-depth and expensive is DD?
05:19 – How skeletons in the closet can stop a deal
05:30 – Common DD issue #1 – Share Register
05:57 – Why share register issues can make or break a transaction
06:59 – Common DD issue #2 – Company buybacks
07:06 – How company buyback issues can be rectified & why this is difficult mid-sale
10:14 – How issues affect the DD timeline
11:00 – Common DD issue #3 Intellectual Property (IP)
11:10 – Why you may not own your website, even if you had it designed and have paid!
11:35 – Why evidence of specific assignment provisions are important, particularly for creative services
12:29 – Common DD issue #4 Data Protection compliance
13:21 – GDPR policies and compliance
14:16 – The value of pre-sale Due Diligence
15:21 – How long is DD typically?
16:24 – Capability of advisors, especially financial, is different from day-to-day running
17:39 – Why experience and competency of advisors is vital for a company sale
18:40 – Summary – Pre-Sale DD
Series 3 – Topics
- Pre-Sale Due Diligence in M&A transactions
- Property in M&A transactions
- Trends for M&A Warranties and Indemnities
- Looking to Sell Your Business – Where to Start
In case you missed our first two series you can watch the videos on catch up below:
Series 2 – Topics
The conversations in the second more technical series of videos include:
- What is a Sales & Purchase Agreement (SPA)?
- M&A Warranties, Representations & Indemnities
- Getting Paid: Earn-Outs, Deferred Payments & Vendor Loans
- What could Derail a Company Sale?
- How much does it Cost to Sell a Company?
- 5 Insider Tips: A Successful Company Sale
Series 1 – Topics
- Introduction to the M&A Deconstructed series of videos
- What is EBITDA?
- What are Heads of Terms?
- Equity Share vs Asset Sale
- Completion Accounts vs Locked Box
- What is Due Diligence (DD)?
Meet your M&A experts
Shaun Guppy Partner | Corporate, Steele Raymond LLP Solicitors
Shaun has experience in business and company sales and purchases, company de-mergers, establishment of joint-venture companies, banking and finance together with advising and drafting terms and conditions and commercial contracts..
Justin Levine – Managing Director, The NonExec
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies.
CONTACTS:
Steele Raymond LLP
Richmond Point, 43 Richmond Hill, Bournemouth, BH2 6LR
steeleraymond.co.uk
TheNonExec Limited
Contact us here to chat about your business exit.
Transcript for video:
Pre-Sale Due Diligence in M&A transactions
Introducing Pre-Sale Due Diligence
Justin Levine:
Okay, so Sean,
Shaun Guppy:
Justin,
Justin Levine:
Welcome to our conversation. So we’re going to tackle the topic of due diligence today.
Shaun Guppy:
Yes
What is Due Diligence (DD)?
Justin Levine:
So just a brief explainer, Due Diligence, you know what it is. Let me put it in some plain language to start off with. So typically when somebody is selling a company for the first time or second time or third time, a buyer is examining the company to look for faults. And the way that I try and explain that to my clients, because often they’ve never done this before, is they’ve usually sold a house. They know the process of selling a house. And of course when you sell a house, the buyer will put a surveyor to come in and have a good look around and look for faults, right?
Shaun Guppy:
Yep, exactly.
Justin Levine:
So that’s the process. Of course, it’s fairly un-intrusive takes half a day, and at the end of it, the surveyor says, yes, there’s faults, and if there is, so happy be if there isn’t, no problem. So it’s exactly the same process that a buyer sends a team of experts into a company to examine the business and look in a lot of detail to saying, are there any faults?
Shaun Guppy:
Yeah
Justin Levine:
of course it’s slightly more intrusive.
How sellers underestimate the time required for DD
Shaun Guppy:
In depth definitely. I think it’s the one part of the M&A process that people probably underestimate in terms of the amount of time it takes. I think that’s certainly what we find in terms of feedback at the end was that the due diligence process is, yeah, it’s intrusive. A buyer is looking to make sure that they are acquiring what they think they’re acquiring and identifying any potential issues. They either need sorted pre-completion or things that they probably need to then feed into their sort of a hundred day plan or whatever their plan is post completion. So no, it is certainly a lengthy process that a lot of sellers underestimate the amount of time involved.
Different disciplines required for DD, (legal, financial and tax)
Justin Levine:
So instead of in a house buyer analogy, the surveyor coming in. When it’s due diligence for a company, then we’ve got usually three teams coming in, haven’t we? So we’ve got the legal due diligence, so that’s the lawyers having a look at the company and all the legals inside the business. Then we’ve got the financial due diligence, and that’s the accountants all going in to check the numbers. And then we’ve got the tax due diligence looking at tax affairs. So of course is that most company owners probably have never had their business examined in the level of depth ever before.
Advantages of Pre-Sale DD; including time, resource & easier rectification, if required
Shaun Guppy:
I think that’s the thing, when you’re running a business, you’re not looking at it from all of those specific angles. You’re running the business, you’re doing what you need to do in order for the business to operate, and you are doing what you need to do and you are aware of in terms of legal compliance and various regulatory compliance aspects. But as soon as somebody starts asking you those probing questions, sometimes you start to go, okay, yes, I’ve got that in place, but actually does it do what it needs to do? And I think we’re certainly finding more and more that people going down the route of trying to front load that due diligence process, not just it’s time consuming, but I think also because it allows people to try and identify issues before a buyer does. And I think there’s a number of advantages and disadvantages for doing a pre-sale due diligence exercise. Time saving is the main one I think in terms of your management team. When you are starting with a transaction, usually it is not well known within the company, so you don’t have your entire team available to help you with a due diligence exercise. Normally it’s a seller, maybe some key members of the management team. And so actually you’ve got to continue to run the business whilst doing this exercise as well. And I think it’s quite difficult for people to manage that. And so actually, if you do a pre-sale due diligence exercise, it allows you to front load some of that time. But I think in terms of identifying potential issues, they’re sometimes easier to sort pre-sale and pre going to market than they are when you’re in the midst of a transaction.
How in-depth and expensive is DD?
Justin Levine:
And that’s my experience. My experience is that, so one is that due diligence is intensive. Typically my clients will receive a due diligence sort of questionnaire. There’ll be a bit of shock horror that goes on behind the scenes at the number of questions and the depth of the questions. And of course, so there’s a realisation that it’s extensive. It’s an extensive sort of piece of analysis that teams of people are going to do. The second part of it is due diligence is expensive. It’s expensive for the buyer and it’s expensive for the seller. So at the time you’ve struck heads of terms, you’ve agreed to deal with a buyer / seller, enter the due diligence, then the seller is having to pay lawyers, tax advisors, accountants, money to support the process, and the buyer is doing the same. So money is getting burnt quite rapidly, and it can feel quite painful if the buyer finds, I’m going to call it skeleton in the closet.
How skeletons in the closet can stop a deal
Now we deal with all different types of companies, manufacturing companies, distribution companies, e-commerce businesses, a wide range. But there are some typical things that float to the top that are what I would call the skeletons in the closet. And these are the things that, because of course if I go back a step due diligence is to try and find faults, but occasionally there is a major fault line. These are the skeletons which actually can stop a deal.
Shaun Guppy:
Yes, make or break a deal.
Common DD issue #1 – Share Register
Justin Levine:
Make or break a deal, definitely. So let’s have a conversation because the first one that comes to mind, and it’s a one that you and I have often sort of crossed the bridge on, and that’s the share register. Most business owners give zero focus on the share register. They start their business 30 years ago, they run the company, 30 year elapses, and they go, we’re going to go sell it. You ask the question, is the share register okay? Of course there’s a question mark to think where is it?
Why share register issues can make or break a transaction
Shaun Guppy:
Yeah, I think I was going to say 50% of the time people don’t even know either what it is or where it is. And then even when they do, sometimes it’s out of date, it’s not up to date. And I think it’s really important, I think what people need to realise is that is what a buyer is purchasing, they’re purchasing the shares. Everything else in the due diligence exercise is really important, but actually the asset that somebody is buying is the shares in the company. And so, if your share register is not in good order and you haven’t done your historic share transactions legally in a legal compliant way, you then potentially have a major issue. Like you say, I think that is probably the biggest aspect of a due diligence exercise that could make or break a transaction. So no, certainly share registers, working out where your register of applications, allotments, transfers members is in the first instance is important, but yes two, making sure that it’s up to date because it’s one of the things that a buyer will really, really focus on.
Justin Levine:
And there are some critical, I’m not the lawyer in the room, so I have to stress that you’re the lawyer, I’m not.
Shaun Guppy:
Yes
Common DD issue #2 – Company buybacks
Justin Levine:
But there are some critical share transactions that really are game changers aren’t there. So company buybacks…
How company buyback issues can be rectified & why this is difficult mid-sale
Shaun Guppy:
Share buybacks and capital reductions are the ones that lawyers in specific will hone in on. The main reason for that is if you’ve undertaken a share buyback incorrectly and not in compliance with the Companies Act, it’s potentially void, which means that the shares remain with the person who you purportedly bought them back from. That can be a real, real problem because unless that person is a friendly face or somebody that’s still involved in this process, it involves quite an awkward conversation going back and trying to rectify that. And sometimes in extreme circumstances, you need to go to the court and get a court order to almost rubber a stamp and say, yeah, the share buyback has been completed. Not withstanding the procedural deficiencies, the share buyback has been completed. And it’s certainly far easier I find if you can work out if you have any share capital problems before you go to market, or certainly before you’ve got a buyer who is looking at your share transactions and looking at your statutory books.
I don’t want to say it’s far easier to sort out, but you are in control of that. I think as soon as a buyer becomes aware of a share capital problem, it’s going to be resolved to their satisfaction as well as yours. I think you have less control over exactly how you’re going to do that. And I think also where a third party’s involved, I think sellers sometimes feel slightly awkward, certainly where you then have to go back to somebody against the backdrop of a transaction. I think people’s biggest fear is they’re going to be held to ransom because somebody’s now realising, oh, there’s a transaction in the offing, these guys need to sort this out. And I think that’s certainly a seller’s biggest fear when these sorts of things spring up halfway through a transaction.
Justin Levine:
And I think it’s a realistic fear because I’ve had that happen. We’ve had a number of transactions, and I’m thinking anonymously where somebody thinks they own a company. And it turns out that when the share register’s examined is that, let’s say they bought out, the company, bought some shares from a third person that’s now disappeared, and it was a sizable chunk called it 25%. They think that that person’s gone. They were paid a smaller amount because it happened a long time ago.
And suddenly the lawyer’s saying, you’ve got to go to that person, and basically the share transaction didn’t happen, then you’ve got to do the paperwork now, today. And the reality is a seller is right to be concerned because going back to that third party and saying, could you just sign 10 or 12 different pieces of paper here? The share transaction didn’t happen. We’re selling the company, by the way. Gosh, it’s worth a lot of money now. Of course, what do you think is going to happen? So there’s a risk, right? There’s a risk that individual goes, “gosh, well actually I’d like my slice of that now”. So that’s one issue. So what we’re pointing a little bit to due diligence is a long process. We’ll cover that off in a minute. But there are some aspects of due diligence that if you were to advise a seller, you’d say, there are certain aspects you want to get examined before you go to market. You do not want this to happen. Real time live, in a transaction, this can stop it or delay it severely.
How issues affect the DD timeline
Shaun Guppy:
I think that’s the point when at heads of term stage, most people will agree a timetable, and as soon as we’ve agreed the timetable, hopefully people are fairly focused on achieving that. You then come across a problem. People don’t really want that timetable to slip. And so actually the way in which you rectify the problems that have been identified might be the most efficient way or that the buyer is reasonably comfortable with. They might still want indemnity coverage, even if you do go about it, rectifying a problem mid transaction, but it might not always be the best way. Sometimes the best way will take weeks or months, and people feel that the transaction can’t afford that sort of time slip. So yeah, it’s certainly easier if these things are identified early on to be able to go and have those conversations. They’re never easy conversations.
Common DD issue #3 Intellectual Property (IP)
Justin Levine:
No, that would be my recommendation. So we’ll pull it up and summarise it at the end. What’s another type? I mean, I’m thinking about intellectual property and the one that seems to come up for me time and time again, more and more businesses are using e-commerce. So they have a website, they’re transacting using that website. It could be all of their business or some of their business. And when I ask my clients, do you own the intellectual property to these important assets? The answer is always, yes, of course we do. We had it designed by an outside company.
Shaun Guppy:
We paid for it.
Justin Levine:
We paid for it. And of course is that we know that sometimes that is not true, they don’t own the intellectual property.
Why you may not own your website, even if you had it designed and have paid!
Shaun Guppy:
No, and I think that’s the thing. Intellectual properties are a slightly odd concept in a way. I think you’re right. A lot of people go down the mistaken route of, well, I’ve paid somebody to perform a service, usually the building of a website or creation of content for a website, I’ve paid them in full, so that’s the matter done. I now own that intellectual property arises in a specific way that it’s owned by the creator unless it’s specifically assigned.
Why evidence of specific assignment provisions are important, particularly for creative services
So when people enter into agreements with creative agencies or anybody who’s pulling those sorts of things together for them, they’re probably not looking at specific assignment provisions. And so again, that’s something that needs to really be looked at. And if there isn’t a specific assignment of intellectual property created by a third party, so essentially a non-employee, then there will need to be some form of actual assignment, a deed of assignment or otherwise to make sure that the intellectual property is then held by the target company.
A buyer will always want to know that they don’t want an unknown person owning any part of the intellectual property at the company. We’ve sort of seen that a number of times. It’s probably, in comparison to the shared register, it’s usually an easier issue to get around, but you still have the point of, well, why now? Why have you suddenly identified this? Oh, well, it gets the backdrop of a transaction. Ultimately, if somebody owns that IP, again you find yourself in a very similar position where you could be backed into a corner to make an additional payment for actually that IP to be assigned over. So it’s certainly another, the problem area. I think another one we see more and more at the moment is data protection. Lots of quite broad brush indemnities and SPAs around data protection. And that’s normally because a buyer may well identify data protection policy issues.
Common DD issue #4 Data Protection compliance
They will say, actually, we’ve got policies we can put in place at completion, but that doesn’t actually get you to a point where they’re comfortable. You were compliant pre completion. And so the easiest answer for a buyer there is, well provide us with indemnity coverage. Whereas actually, I think, again, if you look at your data protection requirements, because not everybody will have to.
GDPR policies and compliance
I think the issue when GDPR came in was, it was quite a complex area, people didn’t necessarily get completely under the bonnet of actually, what do I do with personal data? What am I am a controller? Am I a processor? What documents do I need? And so I think there’s lots, certainly at SME level, there’s lots of companies out there that are operating not necessarily completely in breach of GDPR, but they certainly don’t have the policies to back it up. And when that’s identified during due diligence, it’s certainly an area that a buyer will hone in on to make sure that they’ve got sufficient coverage for any pre completion problems.
The value of pre-sale Due Diligence
Justin Levine:
So I think we can probably summarise, I think we’d probably be on the same page if I’m thinking that anybody selling a company would be advised to take their business through a degree of due diligence before going to market. I know that when I speak to my clients, when I say, you want to spend some money doing this, and the answer is invariably, gosh, well, there’s no value in that, but there is, there really is because it can save a deal from failing. I think the statistics on the number of companies that come to market that do not sell are horrifying. It’s allegedly somewhere around about 80% of companies don’t sell, well, there’s a reason they’re not selling. So a lot of it will be due to the fact that they failed due diligence. So the cost of that is just hugely expensive. And then when you factor management time… So, let’s talk about just the brief period of how long this due diligence takes. Brief was not the right word there, but it’s a period, right?
Shaun Guppy:
Yeah, it’s a significant period. I think if you ever see, we’ve seen many, a transaction timeline. Due diligence takes up a good chunk of that.
How long is DD typically?
Justin Levine:
How long typically?
Shaun Guppy:
It is really difficult to say because actually I think it depends on the size of the business. And you mentioned the sort of three core strands. We are seeing more and more now people going into specific insurance due diligence or commercial due diligence on top of your legal, financial, tax. And they’re really drilling into some of these aspects in a lot more detail than probably we’ve seen before. So I would say due diligence is a good month to three months, depending upon the size of the transaction, the size of the business, the complexities involved, but it’s certainly not a quick throw a few documents at the buyer and they’ll be happy. It is very much, there’s rounds to due diligence as well. You’ll get an initial questionnaire, which will be sizeable. It’ll be hundreds of questions. You hope that the next round of further due diligence, there’ll be less questions and it gets less and less. But we’ve all been there where actually that due diligence exercise sometimes just feels like it goes on forever. But until the buyer is satisfied, they’re not going to move forward to signing. And so unfortunately, it’s a necessary evil as part of a transaction.
Capability of advisors, especially financial, is different from day-to-day running
Justin Levine:
And I think to just add something slightly tangential to that, and this is something that I would always counsel anybody selling a company, so most businesses might have used their local accountants over the years to produce the statutory accounts. There’s a difference in capability in the type of advisor that a seller needs in the due diligence to take the business to an exit. And we see this all the time, and what I’m pointing towards is that the local accountant, the three person accountant that’s done the books for the past 10 years might not have the level of capability to answer, let’s say technical due diligence questions from one of the big four accounting firms in the UK. And we see this time and time again, so sellers are loath to change their accounting team and spend more money. But I always counsel to saying, you need, because there’s three strands of due diligence, legal, tax, financial, and you need three specialist teams in your corner to help you get this deal over the line. So don’t skimp on the monies, because if you’re talking about we deal with transactions from 5 million to what’s the highest number, it’s a big number, right? As a firm, you handle 300 million, 400, that kind of size. So the relative cost is actually marginal compared to; will the deal get over the line?
Why experience and competency of advisors is vital for a company sale
Shaun Guppy:
I think that’s the thing. And I think in terms of the advisors, you need somebody in your corner who’s fighting for you. You don’t have the time to deal with every single aspect of that due diligence exercise. You will need somebody else to assist you with it. And so you need somebody that’s competent. You need to have complete comfort that the answers being provided by your team are correct and you’re being led in the right direction. Like you say, lots of people have not gone through this before. The first time we meet a lot of people, it’s the first time they’re selling their business. They don’t necessarily know the process. So to have an advisor who equally is maybe not as familiar with that process or doesn’t necessarily have the ability to deal with the due diligence exercise, that can be fairly problematic. Again, from a cost, time and just in terms of actually the length of that DD process I think is extended.
If you’re not giving sufficient answers to the questions, it just rumbles on and on and on. So it is one of those things, it’s getting the right people in your corner. Definitely.
Justin Levine:
And we’ve seen that. We’ve seen that actually happen in practice.
Shaun Guppy:
Lots of times.
Summary – Pre-Sale DD
Justin Levine:
So let’s summarise it. So due diligence, so it’s legal, tax, financial, it’s three months, typically two to three months at least. It’s intensive, it costs money. Then anybody selling a company would be best advised to do some of that work upfront. Definitely. So the share register, intellectual property, data protection and so on and so on, so on, is doing that work up front can save a major embarrassment during the due diligence phase?
Shaun Guppy:
Yes, definitely, time, money, and yeah, ultimately the deal.
Justin Levine:
Okay, thanks Shaun. It was great.
Shaun Guppy:
Thanks Justin.
