Due diligence refers to the process of identifying, assessing and mitigating the risks associated with financing a business. It is essentially an exercise that an entity undertakes before entering into any transaction. It is quite common for both, investors and companies to undertake such investigation while funding businesses. The complexity and duration of the investigations depend upon the scale of the transaction.
There are various kinds of due diligence, including:
- Legal due diligence
- Financial due diligence
- Tax due diligence
Legal due diligence:
Legal due diligence refers to the extensive legal analysis of the company’s corporate structure and legal compliance. The ultimate goal of a legal due diligence is to fully understand the legal standing of a company or investor post transaction.
Shares fall within the definition of ‘goods’ as defined under the Sales of Goods Act. The principle of Caveat emptor applies to shares. Caveat emptor means “let the buyer beware”. The principle emphasises that the buyer must fully inspect the goods before purchasing them. If any issue or default is found later then they may or may not have any recourse. The process of inspection of goods, in this case, shares, is known as legal due diligence. Hence it is prudent to contractually secure oneself before entering into any transaction.
What is the Procedure?
There are two key aspects of legal due diligence. Firstly, the legal advisors ascertain the current status of a business. Secondly by assessing the company’s current status, investors gain insight into the company’s future potential.
The legal advisors first scrutinize all the business-related documents including, documents of incorporation, shareholding agreements, licenses & permits issued to the business (if any), any previous contractual obligations. Typically, legal advisors compile a checklist of required documents for such due diligence. This checklist may vary depending upon the business under consideration by the investors.
Step 2 :
Upon thoroughly reviewing each document, the legal advisors meticulously note any discrepancies, deficiencies or any suspicious activity that could elevate the risks involved. These issues are marked as “red flags”. Subsequently, these issues are raised by the legal team and are discussed in detail with the company.
After evaluating the responses to the identified red flags and scrutinizing the documents, the investors have all the necessary information to make a well-informed decision. Consequently, the agreements are drafted incorporating provisions like conditions subsequent, conditions precedent and representation and warranties, indemnity, with an aim to limit liability and mitigate the risks associated with such investment.
Legal due diligence offers the investors an opportunity to ensure contractual security. For instance, if one entity has a logo resembling another entity’s logo, and the former has not registered its trademark, it may lead to potential legal conflicts. By identifying this issue, the investor can draft their agreement accordingly.
The legal due diligence reports can also influence the share price as it could uncover various legal concerns. As a result, it is quite common for businesses to conduct mock due diligence exercises with their legal team to ensure that all aspects are in order. Only once everything is in order, can businesses attract investors they seek.
The content of this article is intended to provide general guidance on the subject matter. Specialist advice should be sought about your specific circumstances.