Key Facts About Due Diligence

Contents

• What is a Due Diligence?
• What is examined in the course of Due Diligence?
• Red Flag or Full Scope Due Diligence?
• Who commissions the Due Diligence?
• How does the Due Diligence process work?
• Why is Due Diligence necessary?
• Legal support in Due Diligence reviews

What is a Due Diligence?

Due diligence literally means “required diligence”. In the context of M&A transactions (mergers and acquisitions), Due Diligence refers specifically to the necessary diligence taken in the course of an upcoming corporate transaction. A Due Diligence review (also referred to as “DD”) represents a risk analysis in which the target company is examined comprehensively, particularly with regard to its legal, tax, and financial structures and circumstances. with the aim of identifying relevant risks, recognizing optimization potential, and developing a suitable transaction structure.

The results of the due diligence are documented in a Due Diligence Report (“DD report”). The parties involved in the upcoming transaction can use the DD report and the recommendations contained therein to make a well-founded decision for or against the acquisition or sale of the company, as well as determine how the deal should be implemented in practice. Besides company acquisitions, due diligence reviews may also be required in the context of real estate transactions or prior to an initial public offering (IPO).

What is examined in the course of Due Diligence?

A Due Diligence review is usually carried out by external advisors and covers various areas. The exact scope always depends on several factors such as the size of the target company, its industry, and the complexity of its structure. Of particular importance are the legal due diligence, tax due diligence, and financial due diligence. Depending on the nature of the target company’s business, further specific reviews are also common.

1. Legal Due Diligence

The legal due diligence examines, among other things, corporate law matters (corporate structure, chain of title, corporate bodies, etc.), employment law aspects, contractual relationships with customers and suppliers, compliance with data protection regulations, potential compliance violations (see also Compliance Due Diligence), risks arising from existing or anticipated litigation, and intellectual property rights.

2. Tax Due Diligence

The tax due diligence analyses the target company regarding its current tax situation as well as potential future tax implications related to the transaction. It is essentially a type of “pre-audit” carried out in advance of the deal.

3. Financial Due Diligence

The financial due diligence provides an in-depth analysis of the assets, earnings, and financial position of the target company. This is particularly critical for purchase price calculations and determining the purchase price mechanism (e.g., variable purchase price / earn-out or fixed purchase price / locked box).

4. Commercial Due Diligence

The commercial due diligence focuses on the target company’s business model and market, especially with regard to the future viability of the business. It is often conducted alongside financial due diligence.

5. Environmental Due Diligence

The environmental due diligence serves to assess environmental risks associated with the target company, both those arising from the company itself and those to which it is exposed.

6. Technical Due Diligence

The technical due diligence assesses the technical condition of the company’s facilities and assets. Additionally, it provides a forecast of remaining useful life and evaluates the quality of the products being manufactured.

7. Compliance Due Diligence

The compliance due diligence is often part of legal due diligence. However, its importance has grown significantly in recent years, so in larger transactions, compliance due diligence can form an independent area of review. It deals with potential compliance risks and violations of the target company, including the company’s existing compliance management practices. Typical review points include violations of competition law, antitrust law, and data protection regulations. In addition, issues such as corruption, fraud, and money laundering are highly relevant.

Legal and compliance due diligence is performed by lawyers, while tax, financial, and commercial areas are reviewed by tax advisors and auditors. Environmental and technical due diligence is carried out by experts with the relevant technical knowledge. Close interdisciplinary cooperation among advisors is always required to achieve the best possible outcome. In particular, all risks identified in the various due diligence areas must be considered in the contract design.

Without the knowledge of risks obtained through due diligence, optimal contract structuring is not possible. The scope of due diligence should be tailored to the specific case. For a small domestic target company without subsidiaries, operating in a less risky sector, the review scope is smaller than for an internationally active corporate group with numerous subsidiaries and sub-subsidiaries.

Red Flag or Full Scope Due Diligence?

With regard to the scope of due diligence, a distinction can be made between a “full scope due diligence” and a “red flag due diligence.”

A red flag due diligence focuses on identifying potential deal breakers. It does not provide a detailed, explanatory presentation of the company structure. A Red Flag due diligence is particularly suitable when, for example, due to time constraints, a comprehensive full-scope due diligence is not feasible.

Of course, combinations of both models are also possible. Certain areas of review can be examined in more detail if they appear to be particularly significant in the specific case or if there are already indications of certain risks.

In addition, for reasons of efficiency and cost, it may be advisable to start with a red flag due diligence. If no deal breakers are identified and the decision to acquire the company solidifies, a transition to a Full Scope Due Diligence can then be made.

Who commissions the Due Diligence?

Due diligence reviews can be distinguished not only by the areas examined but also by who commissions the process – the buyer or the seller.

If the buyer commissions the due diligence, this is referred to as a Buyer Due Diligence (BDD) or Buy Side Due Diligence. If the client is the seller, it is referred to as a Vendor Due Diligence (VDD) or Seller Due Diligence.

When the buyer commissions the due diligence, the primary objective is to uncover any potential risks, including those that may reduce the target company’s value. These risks should either be eliminated prior to the transaction or adequately addressed within the purchase agreement – for example, through representations, warranties, and indemnities. Particularly serious risks may even act as deal breakers and lead to the termination of negotiations.

The vendor due diligence (VDD), on the other hand, usually takes place earlier in the process than buyer due diligence (BDD). The seller’s aim is to obtain an objective review of their company before engaging with potential buyers. This helps identify and address potential risks that could jeopardize the sale or reduce the purchase price. The VDD also aims to identify value-enhancing potential and optimize it, possibly incorporating it into optimization processes. In this way, a proper company valuation and purchase price range can also be determined.

The VDD report, often referred to as a “Fact Book,” is presented to potential buyers at the start of negotiations, after signing a non-disclosure agreement (NDA). It provides buyers with a transparent and reliable overview of the target company. Over time, VDD has become a standard in auction and bidding processes.

By conducting a VDD, the seller eliminates the risk that the buyer might discover previously unknown, value-reducing risks or deal breakers during their own due diligence, which the seller could have addressed beforehand. After completing VDD, the seller is also in a stronger position to define their negotiation strategy together with their advisors.

From the buyer’s perspective, it should be noted that, although the VDD report is prepared by external advisors, it is advisable to conduct at least a reduced, independent due diligence to verify the findings.

How does the Due Diligence process work?

The structure and process of a due diligence review depend both on whether it is a Buyer or Vendor Due Diligence and on the scope of the review. The process can generally be outlined as follows:

BDD (Buyer Due Diligence):

1. Engagement of advisors (lawyers, tax advisors, auditors)

2. Execution of a Non-Disclosure Agreement (NDA)

3. Preparation of an information request list by the advisors

4. Compilation of documents by the seller

5. Provision of documents in a data room for review by the buyer and their advisors, review of the documents, initiation of the Q&A process for open questions, and assessment of the respective answers

6. Preparation of the due diligence report (DD report)

VDD (Vendor Due Diligence):

1. Engagement of advisors

2. Provision of documents to the advisors

3. Review and analysis of the documents

4. Risk mitigation, e.g., through minor restructuring or addressing optimization potential

5. Determination of the purchase price range

6. Delivery of the Vendor DD report to potential buyers (after the signing a non-disclosure agreement)

Why is Due Diligence necessary?

As already outlined above, conducting a due diligence review offers numerous advantages for both buyers and sellers. It provides a transparent overview of the target company, including its strengths, weaknesses, and potential risks. It enables optimal contract structuring tailored to the individual case, significantly reducing legal, financial, and operational risks. Due diligence also forms the basis for purchase price calculation and structuring, preventing the acquisition of a “black box.”

Such risk reduction cannot be achieved solely through a standard warranty catalogue, as a company is far more than just its assets and liabilities. The constant changes within a company must always be considered on a case-by-case basis.

Furthermore, due diligence reduces the personal liability risk of the management of the acquiring company. According to established case law, management is obliged to conduct a due diligence investigation before completing a business acquisition as part of its duty of care for proper corporate governance.

Legal support in Due Diligence reviews

As GEMS Schindhelm, we are happy to support you in connection with the execution of a due diligence review, whether from the buyer’s or seller’s perspective, as well as in the subsequent contract drafting. From drafting the confidentiality agreement, preparing the due diligence information, reviewing and evaluating documents, clarifying potential risks within the framework of personal consultation, all the way to the corresponding contractual arrangements – we are at your side with our many years of expertise.

For individual legal advice on the subject of due diligence, please feel free to contact our law firm directly.

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