The figure negotiated in the purchase of a company usually emerges not from the financial statements but from the legal due diligence report. The balance sheet tells the past; the legal review reveals the liabilities that will be carried into the future.
What does the review look for?
Legal due diligence systematically identifies the risks that will pass to the buyer following the transfer. The principal areas of review are as follows:
- Corporate structure: the share register, articles of association, general assembly and board resolutions, the regularity of share transfers, and signature authorities.
- Contracts: supply, distributorship, credit and lease agreements. Change of control clauses are particularly critical; the transfer may give the counterparty a right of termination.
- Employment law: payroll arrangements, severance pay provisions, subcontractor relationships, and pending and potential employment claims. In acquisitions this is generally the item most often overlooked and of the highest value.
- Assets: land registry records and encumbrances on immovable property, intellectual property rights, trade mark registrations, licences and permits.
- Disputes: pending actions, enforcement proceedings, administrative sanction decisions, and whether provision has been made for them.
- Compliance: the position as to compliance with data protection, competition, environmental and sector-specific legislation.
Price is the negotiation over who bears the risks identified. A risk not identified automatically remains with the buyer.
How do the findings feed into the price?
For each risk identified there are three options, and the essence of the negotiation is the choice among them:
- Price reduction: the monetary equivalent of the risk is calculated and deducted from the sale price. The most definite route, and the hardest for the seller to accept.
- Condition precedent to closing: it is stipulated that the risk be eliminated before the transaction completes — for example, that an action be settled or a missing permit obtained.
- Representations, warranties and indemnities: the seller gives representations and undertakings on specified matters; should these prove untrue, an obligation to indemnify arises. For this mechanism to be effective, part of the sale price generally needs to be held in escrow.
Share transfer or asset transfer?
In a share transfer the company's legal personality remains the same; all rights and obligations continue, including known and unknown debts. In an asset transfer, only the selected assets and specified liabilities are taken over. At first sight this makes an asset transfer appear safer.
Asset transfers, however, carry their own risks: the assignment of contracts may require the counterparty's consent, permits and licences may not be transferable, the transfer of employees is subject to its own legal regime, and on the transfer of an enterprise the transferee may be jointly liable for a specified period for debts arising before the transfer. The choice of the right structure must be assessed together with the tax consequences.
How should the process be conducted?
A well-run transaction is framed by three documents: a confidentiality agreement, a letter of intent or preliminary protocol, and the final share or asset transfer agreement. Determining the exclusivity period, the review timetable and the price mechanism in the letter of intent prevents the greater part of the friction that arises at later stages.
Our office conducts legal due diligence in coordination with certified accountants and sector advisors, and presents the findings together with a risk matrix classified by order of importance and with concrete proposed solutions.
