Prior to an investor’s commitment to invest in a project or business, conducting a target project or business appraisal is an important and indispensable activity. Preliminary due diligence (also known as Pre-Due Diligence) aims to gather, assess, and analyze all legal documents and information related to the target business. This activity provides all involved parties with the opportunity to identify and evaluate potential legal risks before formally entering into the transaction.
1. The need for pre-due diligence
Pre-due diligence can be defined as the systematic collection and evaluation of all legal documentation and information pertinent to a prospective transaction. This activity will help the parties in the transaction have the opportunity to assess the initial legal risks that may arise before, during and after the transaction process.
From the Buyer’s perspective in the transaction, Pre-due diligence is a process that helps investors and their professional team gather, learn, research, review and evaluate information about the target company or a specific entity in a merger and acquisition (“M&A”) transaction. The goal of this activity is to identify legal issues that may impact the transaction, as well as potential risks that may arise before, during, or after the M&A process. Armed with this information, investors can gain a clear understanding of the nature and status of the venture, facilitating an informed decision on whether to proceed with the transaction or not.
From the perspective of the other party in the transaction, in other words the Seller, pre-due diligence will help the business owner assess the level of legal compliance from the establishment of the business throughout its operational history. In case deficiencies are discovered, prompt and appropriate corrective measures can be devised. This, in turn, enables the completion of the business’s legal documentation, thereby creating advantages in the context of soliciting investment and negotiating M&A transactions.
2. Basic issues in pre-due diligence
The initial and also crucial step in pre-due diligence is to determine the goals of the parties in the transaction. Subsequently, strategies and approaches must be devised to assess various facets of the target company. These facets encompass a broad spectrum of considerations, including:
- Legal compliance during establishment and ongoing operations;
- Adherence to regulations pertaining to labour, taxation, investment, business practices, compensation;
- And potential litigation risks.
On the other hand, the Buyer must ascertain whether the target company possesses:
- An established customer base, strategic partnerships, or a significant market share;
- Long-term or medium-term investment potential;
- And whether there exist any inherent advantages that the target company currently enjoys, such as land holdings, infrastructure, available facilities, a skilled workforce, and more).
After performing the tasks mentioned in the commencing step of the process, the Buyer can utilize the preliminary assessment results to engage legal consulting firms, professional financial advisors, or experts in various other professional domains to conduct a comprehensive evaluation of the target company. This evaluation serves as the foundation for determining whether to proceed with an M&A transaction.
Pre-due diligence will include tasks such as: comprehensive review of legal issues including a thorough review of legal matters dating back to the target company’s establishment, capital contributions, organizational structure, legal compliance throughout its business operations, property rights, contracts, key agreements, and labor-related considerations.
Within the scope of this article, we analyze some typical aspects and contents that investors can pay attention to:
- Business legal records: This section provides insights into the target company’s history, including its registration date, nature of business activities, operational duration, and details concerning its headquarters and subsidiary units. During this evaluation, the assessing unit scrutinizes the target company’s adherence to legal regulations, evaluating whether the necessary licenses have been obtained and whether it meets the prerequisites for conducting its business activities.
- Important contracts and agreements: In this section, the appraisal team will report the main contents of important and high-value contracts that the target company has signed. Accordingly, the appraisal team will raise unclear issues and risks stemming from the terms of these key contracts and agreements. This activity will help the Buyer ascertain the legal rights and obligations that the target company currently possesses, as well as the terms of agreements currently binding the target company’s obligations
- Capital and capital structure: The appraisal team will consider capital factors including the registered operating capital and actual contributed capital. They will assess how assets were contributed as capital during registration and the manner in which this contribution was executed. The capital structure will be examined by the appraisal team providing the Buyer with a clearer understanding.
- Level of legal compliance of the target company: The appraisal team will gauge the target company’s adherence to legal requirements by considering factors such as whether the company has obtained the necessary licenses as per legal provisions related to conditional business lines that require a license to actually carry out business or not. Additionally, the team will assess whether the target company has complied with legal requirements during its operations, including tax compliance, labour regulations, fire safety, and more. If the appraisal team identify and simultaneously provide the legal consequences that the parties will have to bear due to such lacking or inadequate compliance.
- Litigation: The appraisal will compile a list of disputes in which the target company is involved or may become embroiled, whether as a plaintiff, defendant, or party with relevant rights and obligations. These disputes span various domains, including civil matters, as well as areas like labor, commercial business, and criminal cases. Evaluating this aspect is crucial for determining potential legal risks, financial obligations, or compensation liabilities that the target company might encounter in the future.
In addition to the appraisal activities mentioned above, depending on the content and objectives of the transaction, the Buyer may request the appraisal team to conduct appraisal activities to review other necessary factors and fields as required.
The result of the pre-due diligence activity mentioned above is a legal due diligence report, which will provide the Buyer with a comprehensive picture of the legal status of the target’s legal standing in various relevant fields. Thereby, this report assists the Buyer in mitigating potential risks and provides insights into matters that require attention when carrying out merger and acquisition transactions.
The crucial role of the proactive legal due diligence phase is evident. To successfully execute this stage, it requires coordination from various different factors. Therefore, to gain a thorough understanding and receive advisory support on legal due diligence before proceeding with M&A activities, investors should reach out to a professional legal organization for specific guidance. After obtaining the legal due diligence report, investors need to review and assess the risks to make a decision on whether to proceed with the transaction. Simultaneously, they should establish binding conditions, determine the transfer price, and address other relevant matters when conducting the transaction.