Due Diligence as an important preliminary step in company acquisitions

The term "due diligence" originates from Anglo-American legal systems and means the examination of a company with "appropriate diligence". Often, a potential buyer scrutinises the target's balance sheets, checks for legal obstacles, and, above all, assesses the economic development potential of a business. Typical benefits and functions of buyer due diligence include the information function, which provides the potential buyer with an overview of the object to be acquired, thereby at least reducing the existing information asymmetry between seller and buyer. This also allows for the identification of hidden opportunities and risks. Furthermore, the results of a due diligence investigation can contribute to the design of the warranty catalogue or lead to an adjustment of the seller's initial purchase price expectations. The significant costs often associated with conducting due diligence are frequently accepted because the acquirer's management seeks to achieve liability protection, thereby avoiding accusations of negligent conduct in the company acquisition.

Forms of Due Diligence Classification

Depending on the client involved, a distinction is made between vendor due diligence and buyer due diligence, the latter being significantly more common in practice. Vendor due diligence is typically useful when the seller first wants or needs to obtain information about their own company in order to prepare or legally structure a future sale. For instance, in a tender process, based on the results of a due diligence investigation, initial offering documents can be provided to prospective buyers.

A due diligence review can often be divided into the following sub-areas with different focuses.

Legal Due Diligence

Examination of the company's legal and contractual relationships and optimisation of the legal transaction structure (e.g. share deal or asset deal) by lawyers. The results of the legal due diligence often also form an important basis for the design of the warranty catalogue.

Tax Due Diligence

Examination of tax circumstances and identification of potential tax risks (e.g. in the context of future tax audits) by tax advisors or auditors. The focus is often on tax topics such as income and sales-related taxes, corporate financing from a tax perspective, consequences of group taxation, examination of wage and social security contributions, examination of loss carryforwards, or transfer pricing issues (not least due to the similarity between disguised capital repayment and disguised profit distribution).

Financial Due Diligence (Accounting Due Diligence)

Examination of the financial statements (usually the last three to five years) with regard to risks arising from the overvaluation of assets or the undervaluation of liabilities. Furthermore, hidden reserves that play a role in the purchase price determination are also identified. Financial due diligence is generally carried out by auditors. The plausibility and consistency of the company's planning or its internal control system are also examined, and the economic development potential of the target is critically assessed.

Commercial Due Diligence

This involves examining the company's strategic positioning, comparing sales, price, and market share information with the industry average, and assessing the attractiveness of the products or services generated. Commercial due diligence can be carried out, for example, by management consultants or, in the case of larger transactions, by investment banks.

Environmental Due Diligence and Cultural Due Diligence

Environmental due diligence examines the target company for possible environmental risks, with an important point also being whether the company possesses the necessary environmental permits or if there are any legacy environmental liabilities from the past. The area of cultural due diligence, and thus the review of "soft factors," has gained increasing importance recently. After all, company acquisitions sometimes fail not for legal reasons, but in the context of so-called "post-merger integration" due to the incompatibility of existing corporate cultures.

Practical Aspects of Conducting a Buyer Due Diligence

The core of conducting due diligence is the so-called data room, which is usually virtual these days and regularly restricts the ability to save or print documents. In the data room, the management of the target company makes the documents and information to be scrutinised available, although further documents can typically be requested during the due diligence process (due diligence request list). A critical aspect of due diligence should be a situation where the company being examined (in the data room) only provides outdated figures or makes important information available to the potential acquirer not at all or only very incompletely. The submission of overly optimistic financial projections that are disproportionate to past performance should also always be viewed critically.

The results of a due diligence review are usually recorded in a written due diligence report, with a "Red Flag Report" often of particular interest to the client. The Red Flag Report is intended to contain only those circumstances that are relevant to the purchase decision (especially "dealbreakers" as circumstances that could cause the transaction to fail). The due diligence report and the closing meeting regularly mark the end of the due diligence process. Ideally, this is followed by the commencement of concrete negotiations, provided both parties remain committed to the transaction.

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