Due Diligence

The English term due diligence comes from Anglo-American legal practice and means “due or necessary care.” The term stands for a risk assessment originally carried out or commissioned by the acquirer (buy-side or purchaser due diligence) when acquiring complex or economically significant assets and by the seller (vendor due diligence) as required.

In Europe, you carry out such due diligence regularly or as a matter of principle in M&A procedures/company acquisitions/share purchases. However, due diligence is also one of the standard instruments for risk protection in commercial real estate transactions (real estate due diligence) and other investment measures.

The essential task of due diligence is to inform the client about the object of the audit (usually the object of the purchase), to make it easier for the client to evaluate it, and to enable an assessment of the risks associated with the transaction. The result of this audit, therefore, has a direct influence on a possible purchase price and the contractual arrangements (e.g., regarding purchase price adjustment clauses or guarantees) for the acquisition or investment measure.

In addition, due diligence fulfills the function of safeguarding the decision-makers (usually managing directors and board members as executive bodies of corporations) internally, as this risk assessment enables them to fulfill their duties of care as prudent and conscientious businessmen and managers (Sections 347 HGB -German Commercial Law Code-, 43 GmbHG -German Limited Liability Companies Act-, 93 AktG -German Stock Corporation Act-) if they base their actions concerning their own company on the audit results (compliance or good governance).

Due diligence examines the company or investment object for all relevant economic and legal risks. Such risks can arise for various reasons based on internal or external circumstances. During the audit, commissioned experts in their respective fields (consultants) evaluate the object of the audit by inspecting the company’s documents and data based on informative discussions with the persons responsible for the object of the audit (management interviews) and based on knowledge to be gained externally. Due diligence is a direct and personal audit, the results of which are summarized in an audit report (due diligence report).

You can differentiate the content of due diligence according to the material focus of the audit. Traditionally, you distinguish between the commercial, financial, and legal areas. Tax due diligence is an independent subtype of legal due diligence. Separate specialist areas are technical due diligence, environmental due diligence, and, more recently, ESG due diligence for sustainability. Fraud due diligence focuses more on the inner workings of an organization. In the case of a planned IPO, IPO due diligence is regularly carried out in advance to check whether the company is ready to go public.

You distinguish between red flag due diligence and full scope due diligence according to the intensity of the audit. Red flag due diligence focuses on identifying significant risks and obstacles to implementation (deal breakers).

In addition, the market distinguishes between different types of due diligence depending on the transaction phase or decision-making process. In principle, you divide an investment or acquisition process into three stages: preparation, negotiation, and execution. Furthermore, you can carry out a risk assessment in these phases.

The seller can have vendor due diligence carried out at the very beginning of the preparation phase to identify the weak points of the negotiation object and, if necessary, mitigate or remedy them. The buyer carries out the purchaser’s due diligence at a relatively early stage of the negotiation to conduct his decision-making process and the talks in his best interests. Depending on the deal structure, this due diligence conducted by the acquirer can also be carried out as so-called confirmatory due diligence if certain information is only disclosed shortly before or after the contract is concluded to confirm previously made assumptions. However, you can also carry out such an audit after the contractual relationship has been concluded. This situation is known as post-acquisition due diligence. As a rule, this determines the acquirer’s liability or claims for damages against the seller and thus also avoids liability from the acquirer’s management.

Conducting due diligence is a professionally challenging activity that has to be effected quickly. Appropriate representatives of the respective specialist disciplines carry this out on behalf of their clients. As a rule, lawyers, tax consultants, auditors, corporate finance specialists, engineers, or specialized experts are commissioned depending on the desired focus of the audit.

There has yet to be a legal obligation to carry out due diligence. It is not a mandatory audit within the meaning of the HGB. Nor does the obligation to investigate under Section 377 HGB apply, as you only apply this standard to the physical transfer of goods. However, effecting due diligence without having a legal cause is now standard and standardized practice for specific areas and certain industries. This statement applies in particular to the purchase of companies or shareholdings. Failure to carry out such due diligence may, therefore, constitute a breach of duty concerning one’s own company, which may give rise to liability on the part of managing directors or board members (Section 43 GmbHG, Section 93 AktG) if an investment is made without an appropriate risk assessment and subsequently fails. Due diligence also serves to avoid liability.

Suppose you embed due diligence in a procedure for the takeover of companies or assets of third parties. In that case, a non-disclosure agreement (NDA) must be concluded with the target company/asset owner in addition to an assignment to the consultants involved, as the auditors gain access to very confidential commercial and legal data and information about a company or organization. This procedure includes, for example, personal data, customer or supplier data, financial data, and other business information. You shall protect data; its confidentiality and integrity must be ensured legally and in practice.

It is also advisable to conclude a separate procedural agreement on the due diligence process to define the game’s rules. In particular, you should determine which person or organization will carry out the DD and in what time frame. Finally, such an agreement should also specify which persons are the exclusive contact persons on which side and how the question-and-answer (Q&A process) takes place after reviewing and evaluating the submitted documents. The Q&A process is a necessary part of due diligence to validate or sharpen the findings obtained from the papers inspected. Individually, you will accompany the Q&A process by personal management meetings.

By default, the data to be queried and checked shall be exchanged in an electronic or virtual data room. When selecting a data room provider, it is essential to ensure that the documents remain unalterable, that you can archive the data and document structure in an audit-proof manner, and that user access is documented in time and personally. This standard is necessary to be able to demonstrate in subsequent legal disputes about any breaches of warranty or property defects who gained knowledge of which information and when.

The audit usually begins with submitting the due diligence checklists for the respective specialist areas. These checklists contain a thematically organized overview of the information requested, which may involve both the submission of documents and the answering of questions.

The actual due diligence process is almost identical once the client is clear about the objective of the due diligence, regardless of whether it is an internal audit or an audit by a potential acquirer.

The complexity of the audit requires the appointment of expert consultants. You shall conclude a written audit assignment with them. Together with the consultants, you specify the objective of the audit, which then leads to a corresponding list of questions made by the consultants. On the part of the audit object, the documents must then be compiled and disclosed for the audit in a coordinated manner. The consultants evaluate and report to their clients. Depending on the agreement, these audit findings may also have to be disclosed to the representatives of the audit object. However, this is rare. The documents are provided and reviewed via an electronic data room as standard. Once the data has been evaluated, a Q&A process is carried out to clarify questions relating to the findings or to discuss further issues in more detail. You shall record this Q&A process in the electronic data room. The audit findings of the consultants then result in a written report to your clients. The scope and detail of this report (due diligence report) varies depending on the scope of the audit and the required audit standard.

Finally, you will use the audit findings and results in further negotiations, particularly in preparing the necessary legal documents and contracts.

Due diligence is a risk assessment carried out intensively in a relatively short period. On the part of the seller or the representatives of the subject of the due diligence, due diligence should be prepared in a structured manner by consulting specialist advisors at an early stage by preparing and compiling the documents, as you can influence the success of this audit in an orderly manner during this phase. Since most of the audit questions expected for the audit object will also generally be known in advance, at least if consultants are involved, you can do this part of the preparation outside the actual audit period.

During the performance of the audit, the seller or the representative of the audit object also requires orderly monitoring of the audit, which you can achieve by appointing one or more responsible persons as contact persons for the audit teams. These responsible persons should be entrusted exclusively with this task to carry out the audit and should fulfill the respective requirements daily. On the part of the auditors or the acquirer, due diligence requires the composition of a team of professionally trained auditors who provide sufficient resources to carry out the audit and report within the agreed time.

Due diligence has a considerable influence on the drafting of contracts. In the area of tax DD, for example, it can answer whether the transaction is better completed as a share deal or an asset deal. The identified risks and findings influence the company valuation and, derived from this, the possible purchase price, e.g., by reconciling the enterprise value with the equity value. The risks determine the guarantee catalog or can even lead to negotiations being broken off if deal breakers cannot be eliminated.

However, the inspection can also limit the seller’s liability because, according to § 442 BGB -German Civil Law Code- (unless waived in the contract), the buyer is deprived of the corresponding claims in the event of knowledge of defects. In any case, the buyer must allow himself to be held responsible for the knowledge or awareness of the reported risks by the inspectors (imputation of expertise). In turn, the seller’s duty to provide information, who may have to provide information about circumstances that could frustrate the buyer’s contractual objective without being specifically requested to do so, conflicts with the attribution of knowledge.

Finally, managing directors and board members fulfill their duty of care as managers towards their company if they have due diligence carried out before deciding on an investment or the acquisition of a company and can thus exclude their liability.

The costs of a DD cannot be determined schematically. They depend on the size and complexity of the audit object, the definition of the focal points, the number of consultants involved, and the audit duration. For smaller, medium-sized audit objects, you can expect low- to mid-five-digit range costs. These costs are part of the transaction costs. Depending on when you decide to acquire, these costs are either immediately tax-deductible in full or must be capitalized as part of the incidental acquisition costs. In the case of failed transactions, the costs are fully deductible.

Irrespective of the respective costs of the audit, the saved costs and damages that can arise for the acquiring company or the responsible person (keyword: manager liability) should always be considered if risks of the acquisition object materialize without a careful audit. In this case, due diligence can save much misfortune.

Thorough preparation and implementation of the DD is the most crucial success factor. Since risks and unforeseen problems after the planned transaction should be avoided as far as possible, you shall pursue a comprehensive and careful audit approach. In addition, the consultants’ expertise, team resources, adherence to the audit timeline, and effective use of the data room are relevant success factors. Finally, all parties involved should seek and maintain sufficient communication and coordination between the acquirer, DD team, advisors, and representatives of the audit object.