M&A Vocabulary – Explained by the experts: Due diligence

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner each present an important term from the English specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

Merging or taking over all or part of a company is in some ways similar to buying a car: the essential factors for the buying decision need to be evaluated, classified, and the pluses and minuses weighed up.

Only once this process has been completed can a decision be made – and generally this can only be done on the basis of the information available to the buyer.

Before concluding any purchase contract, – involving, after all, significant consequences – an adequate level of care or due diligence needs to be applied. For M&A transactions, special attention has to be paid to the legal, tax and financial aspects of the transaction. Depending on the industry or sector of the target company, further checks may be necessary, or at least sensible. For example, an environmental or technical due diligence should always be considered for industrial companies.

In the course of a legal due diligence the first thing is to establish all the important legal facts about the company, to provide an overview of its fundamental structure and its rights and obligations.

These include in particular:

• the company law situation, including date of incorporation, shareholdings, registered office, rules of representation, silent participations, relationships with other companies,
• the financing structure and any securities such as loans or guarantees,
• contracts between the company and shareholders, such as shareholder loans or managing director employment contracts,
• the legal situation relating to intellectual property of industrial property rights, copyrights, rights of use and knowledge, such as registered trademarks or domains,
• real estate and/or rental agreements,
• significant legal relationships such as customer contracts and cooperation contracts as well as assets,
• employment and service contracts, especially number of employees, collective wage and other agreements, works council, company handbook, pension obligations, temporary employees,
• econdments, self-employed contractors, special payments, ongoing legal disputes or compliance with minimum wages,
• overview of other legal disputes,
• insurance policies.

The financial due diligence for its part, is focusing on the company’s significant financial risks, and also analysing its economic potential. Particularly important are:

• basic information such as the date of incorporation, registered share capital, names and holdings of each of the shareholders,
• the company's sustainable commercial income as well as existing trade receivables,
• the underlying historic trends of both sales and costs such as salaries, insurance, freight, office costs or investments,
• a list of operating costs and existing inventory,
• loans and other liabilities that could jeopardize the company’s future business performance,
• basic assumptions underlying management’s commercial forecasts,
• personnel and accounting information systems.

Carrying out a Tax Due Diligence is equally vital. This is an important component in the decision-making process, and can provide insight into whether the target company can deliver the commercial performance the buyer is looking for after conclusion of the transaction. The target company's tax structure is given a thorough health check during the tax due diligence process, because it substantially affects its profitability.

A careful Tax Due Diligence includes especially:

• checking the tax status, and an analysis of the status of tax inspections with regard to the potential impact in future financial years,
• tax compliance in relation to VAT, corporation tax, land tax, social security contributions, etc. and where these are incurred,
• the identification of tax risks in past fiscal years that might still be audited by the competent tax authorities, and transaction-related risks,
• other areas: late-payment penalties, subsidies, intercompany transfer pricing arrangements, preferential tax arrangements, taxation of dividends, etc.

The goal of carrying out a due diligence process is ultimately to uncover and assess the inevitable risks that exist within business transactions, and to classify and assess them according to their potential risk. As in everyday life, not every residual risk can be completely eliminated. Only with comprehensive and professional advice – as part of which protective legal measures can be adopted – is it possible for the buyer to arrive at a carefully thought through decision with no hidden worries.