Due diligence is the process of identifying, assessing and mitigating the risks associated with financing a business. It is an exercise an entity undertakes before entering into a transaction, and it is common for both investors and companies to carry it out while funding a business. The complexity and duration of the exercise depends on the scale of the transaction.
Types of Due Diligence
There are various kinds of due diligence, including:
- Legal due diligence
- Financial due diligence
- Tax due diligence
What Legal Due Diligence Covers
Legal due diligence refers to the extensive legal analysis of a company's corporate structure and legal compliance. Its ultimate goal is to give the party carrying it out a full understanding of the transaction.
Shares fall within the definition of "goods" under the Sale of Goods Act, and the principle of caveat emptor, "let the buyer beware," applies to them. The principle places the burden on the buyer to fully inspect the goods before purchasing, since recourse may or may not be available if an issue surfaces later. The process of inspecting those goods, in this case shares, is what legal due diligence involves, which is why it is prudent to contractually protect oneself before entering into a transaction.
How the Process Works
There are two key aspects to legal due diligence. First, legal advisors ascertain the current status of the business. Second, by assessing that current status, investors gain insight into the company's future potential.
Step 1: Legal advisors first scrutinise all business-related documents, including documents of incorporation, shareholding agreements, licenses and permits issued to the business, if any, and previous contractual obligations. Legal advisors typically compile a checklist of required documents, which may vary depending on the business under consideration.
Step 2: After thoroughly reviewing each document, legal advisors note any discrepancies, deficiencies or suspicious activity that could raise the risks involved. These issues are flagged as "red flags" and are then raised by the legal team and discussed in detail with the company.
Step 3: After evaluating the responses to the identified red flags and scrutinising the documents further, investors have the information needed to make a well-informed decision. The agreements that follow are drafted to incorporate provisions such as conditions subsequent, conditions precedent, representations and warranties, and indemnity, aimed at limiting liability and mitigating the risks involved in the investment.
Conclusion
Legal due diligence gives investors an opportunity to secure their position contractually. For instance, if one entity has a logo resembling another entity's and has not registered its trademark, that could lead to a potential legal conflict. Identifying this early allows the investor to draft their agreement accordingly.
A legal due diligence report can also influence a company's share price, since it may uncover legal concerns that affect valuation. Because of this, it is common for businesses to run mock due diligence exercises with their own legal team beforehand, to ensure everything is in order before they go looking for investors.
Disclaimer: The content of this article is intended to provide general guidance on the subject matter. Specialist advice should be sought about your specific circumstances.