A thorough due diligence is the foundation of every successful corporate transaction. We explain the key areas of review and typical risks.
What Is a Due Diligence?
The term due diligence originates from Anglo-American law and literally means "appropriate care". In the context of a company acquisition, it refers to the comprehensive examination of the target company by the potential buyer. The objective is to identify risks and opportunities as a basis for determining the purchase price and structuring the contract.
The Phases of Due Diligence
Phase 1: Preparation
Prior to the actual review process, a non-disclosure agreement (NDA) and a letter of intent (LOI) are typically signed. The seller sets up a data room (physical or virtual) in which the relevant documents are made available.
Phase 2: Execution
The review is generally carried out by an interdisciplinary team of lawyers, tax advisors, auditors and, where appropriate, additional specialists. The key areas of review are:
Areas of Review in Detail
Legal Due Diligence
The legal review covers:
- Corporate matters: Articles of association, shareholder register, commercial register entries, shareholder resolutions
- Contracts: Material customer contracts, supply agreements, lease and leasing agreements, cooperation agreements
- Employment matters: Employment contracts, works council agreements, pension commitments, pending litigation
- Intellectual property: Patents, trademarks, licences, know-how protection
- Permits: Regulatory approvals, concessions, certifications
- Litigation: Pending and threatened proceedings
Financial Due Diligence
The financial review analyses:
- Annual financial statements: Balance sheet, profit and loss account and notes for the last three to five years
- Projections: Business plan and integrated financial planning
- Working capital: Analysis of net current assets and their development
- EBITDA adjustments: Identification of non-recurring or non-operating expenses and income
- Financial liabilities: Net debt analysis
Tax Due Diligence
The tax review covers:
- Tax compliance: Review of tax returns and tax assessments
- Tax audits: Results of past and ongoing tax audits
- Tax risks: Transfer pricing, fiscal unity arrangements, loss carry-forwards under § 8c KStG
- VAT: Review of correct VAT treatment
Commercial Due Diligence
The commercial review evaluates:
- Market environment: Market size, growth trends, competitive landscape
- Customer structure: Customer concentration, customer retention, dependencies
- Business model: Sustainability and scalability of the business model
Typical Risks and Red Flags
The following findings should receive particular attention:
- Change-of-control clauses: Contracts that provide for a right of termination in the event of a change of ownership
- Key person dependency: Excessive reliance on individual employees
- Environmental liabilities: Contaminated sites or non-compliance with environmental regulations
- Back taxes: Outstanding tax audits or unsecured tax positions
- Pension provisions: Underfunded pension obligations
From Due Diligence Results to the Purchase Agreement
Purchase Price Adjustment
Identified risks feed into the purchase price negotiation. Typically, the purchase price is determined on the basis of an adjusted EBITDA and a market-standard multiple, less identified risks.
Representations and Warranties
The key due diligence findings are secured in the purchase agreement through seller representations and warranties. For known risks, specific indemnity clauses can be agreed.
Closing Conditions
Certain review findings may be included in the purchase agreement as conditions precedent, such as the granting of regulatory approvals.
Conclusion
A carefully conducted due diligence protects the buyer from unwelcome surprises and provides the foundation for a fair purchase price negotiation. The investment in a professional review regularly pays for itself many times over.
