The Role of Due Diligence in Private Acquisition

The Importance of Due Diligence in Private Acquisitions

What is Private Acquisition?

Private Acquisition refer to transaction whereby a buyer (“Buyer”) acquires privately owned companies, businesses or assets in Malaysia by way of either (i) acquisition of shares in a target company (“Share Sale”); or (ii) acquisition business or assets from a target company (“Business Sale”).

Usually, the process for a Private Acquisition involves the followings:-

1. Preparation and execution of preliminary agreements, ie, a memorandum of understanding, outlining the parties’ understanding and principal terms of the transaction.
2. Conduct of due diligence exercise by the buyer over the target company.
3. Drafting, negotiating and execution of definitive transaction documents.
4. Satisfaction of conditions precedent and completion of the acquisition.

What is Due Diligence and Why is it Important?

Generally, Due Diligence is the process of investigating the truth of statements contained in preliminary agreements before entering into a legally-binding sale and purchase agreement for the Private Acquisition and checking compliance by the target company of statutory requirements which impact on its operations. It involves the process of collecting, verifying and disclosing material information and examining the value or quality of the business or assets, potential contingencies and liabilities of the target company, thereby enabling the parties to make informed decisions while negotiating the deal.

Due Diligence allows the Buyer to analyze the transaction completely and will be able to understand the advantages and disadvantages of the Private Acquisition. When a Buyer acquires the shares or business of a target company, a general principle applies which is “let the buyer beware”. This is the rationale and justification for Due Diligence. It means that the Buyer must take responsibility for the quality of goods purchased. The Seller is under no legal obligation to inform the Buyer of any defects or liabilities of the target company unless the buyer requests for such disclosure. Hence, a Buyer will want to gather as much information about the target company or business as possible to understand what it is taking on and to ensure that the shares or assets of the target company intended to be acquired do not cause unforeseen harm to them. It also opens an opportunity for the Buyer to check whether the price offered for the Private Acquisition is sound commercial investment or will there be a room for negotiations.

What are the main types of Due Diligence in Private Acquisition?

There are two main types of Due Diligence in a Private Acquisition transaction, which is:-

1. Legal Due Diligence– Legal Due Diligence process plays a key role in the valuation of the private Acquisition, and in the structuring of the transaction and the contractual protections needed by the Buyer, as well as enabling the Buyer to gain as much background information as possible about the target company and to verify the accuracy of the information provided by the Seller.
2. Financial Due Diligence– Financial Due Diligence contains the investigative financial analysis of a business. It involves the engagement of a financial adviser to evaluate the company’s financial health via a review of financial statements, balance sheets, bad debts and income tax returns.

Scope of Legal Due Diligence

The scope of Legal Due Diligence should be adapted to the context of the transaction, thereby ensuring that the investigation matches the Buyer’s interests in the deal and avoiding unnecessary expenses. Typically, the scope of Legal Due Diligence covers the following items but may vary depending on factors such as the industry in which the target company operates, type of business of the target company operates, the size of the acquisition as well as time constraints:-

1. Corporate Information– to review all corporate information such as Constitution of the target company, minutes of meetings, shareholders agreement or similar documents as this provides a guideline as to the shareholder composition, board composition, corporate structure of the target company and any restriction as to the Share Sale or Business Sale. Besides, one of the objectives of reviewing the corporate information are to confirm that the target company is in good standing and the shares or business to be acquired are free of any liens or encumbrances.
2. Licenses– The purpose of reviewing is to ensure that the target company is licensed to conduct the business and to review the validity of all relevant licences and approvals required, i.e. compliance with guidelines issued by regulatory bodies and to be informed if there is anything done by the target company which may lead to revocation of any essential licenses.
3. Contracts– The purpose of reviewing contracts is to identify the contracts that are material to the target company’s business and to determine whether a change of ownership in the target company would nullify the contracts. While reviewing contracts, attention shall be paid to the main rights and obligations, and also clauses that may be triggered as a result of the Private Acquisition, such as change of control, early termination and penalty clauses, as well as identifying other issues that the Buyer may need to consider before committing to the Private Acquisition, such as, contractual obligations, restrictions and entitlements that will be in effect once the Private Acquisition is completed.
4. Real Property– In the case in which real property is involved in Private Acquisition, it is important to access the real property owned and/or used by the target company. Therefore, a list of the real property owned and/or used by the target company needs to be provided by the Seller. Then it should be established if the target company is indeed the legal owner of the property, or in the case of a lease, the lessor is the legal owner. Further, due diligence should also focus on the existence of any lien or encumbrance on the real property and any restriction on the transfer of the real property pursuant to the Private Acquisition.
5. Litigation– Discovery of any existing litigation action the target company is subjected to could in turn affect the pricing of the deal, allow the Buyer to define a fair price to be paid for the Private Acquisition or resulting in an indemnity being given by the Seller to the Buyer for potential costs.
6. Labour and Employment– It is important to review all employment contracts so that the Buyer know employment terms of key personnel especially matters relating to remuneration, benefits, bonuses, length of employment and termination provisions.
7. Intellectual Property- Intellectual Property rights form a substantial part of the company’s assets and value. A review would cover the documentation evidencing trademarks, trade names, copyright or patents that have been registered, rejected or are pending. The review should also determine the duration/ remaining duration of protection and any measures taken to effect or prolong the registration of the intellectual property rights.
8. Banking and Finance– To obtain copies of all loan agreements, offer letters, a schedule of all indebtedness owed by the target company or other documentation relating to bank loan and also to obtain details of all charges, debentures, guarantees or other security given by the target company.

The Procedure

The target company in a Private Acquisition transaction is obliged to provide every relevant document of the target company which is necessary for the Private Acquisition to review before finalising the deal. The Seller will create a data room physical through which they can offer all the relevant documents to the Buyer or their legal representatives. It is essential for the target company to provide all documents otherwise the process and timeline will unduly increase delaying the transaction unnecessarily.

Conclusion

Due Diligence in a Private Acquisition transaction is a pivotal step which evaluates the risks involved in the transaction and should not be overlooked. The objective of the exercise is to obtain all relevant and up-to-date information of the target company and to understand the significant shortcomings of the target company which were earlier not apparent. The exercise will inform the Buyer about the true features of the target company which subsequently guarantees that necessary precautions are taken while arranging and finalizing the Private Acquisition transaction. It is important to appreciate how contractual protections (such as warranties, indemnities and disclosures) are not sufficient to negate the need for Due Diligence. Carrying out as much Due Diligence as possible to the extent suitable for the Buyer’s needs is clearly the pre-requisite to a successful transaction. Having a reputable and experienced team of lawyers is crucial in all private acquisition transactions to achieve the intended outcome in the best way possible. Hence, please do not hesitate to contact us should you require any further information or have any queries.