Legal due diligence - understanding the drivers behind the transaction

1. Introduction

Even if an acquisition can be agreed by a simple handshake between a seller and a buyer, this is rarely the case as a buyer generally wants to assess what is being acquired to identify potential risks and opportunities before determining the value of what is being acquired.  

In the realm of M&A, legal due diligence is a critical process that involves a thorough investigation of a target company's legal standing and potential risks before determining purchase price and potential conditions for a transaction. While the primary objective of legal due diligence is to identify and mitigate legal risks, it is equally important to understand the buyer's drivers behind the transaction. This understanding can significantly influence the scope, focus, and outcomes of the due diligence process and ultimately the acquisition. 

2. Aligning due diligence with strategic objectives

It is crucial to consider how an acquisition strengthens the buyer's long-term strategy and its potential M&A agenda. Understanding the buyer's drivers behind the transaction allows its advisors to determine the type and scope of due diligence to align with the buyer's strategic objectives. For instance, if the buyer is primarily interested in acquiring intellectual property (“IP”) assets, the due diligence process should place a strong emphasis on evaluating the target company's IP portfolio, including patents, trademarks, copyrights and trade secrets. In addition, a technical due diligence may be required to analyze technical aspects such as IT systems. Conversely, if the buyer's focus is on expanding market share, the due diligence should prioritize assessing the target's market position, e.g. through a commercial due diligence and a legal due diligence of e.g. customer contracts, supplier contracts and regulatory compliance.

Tailoring the scope of the due diligence also involves understanding the buyer's industry and market dynamics. For example, in the technology sector, rapid innovation and competitive pressures may necessitate a deeper dive into the target's R&D capabilities, technology licensing agreements, and potential IP litigation risks. In case the buyer is a competitor of the seller, a higher requirement of protection around business sensitive data may be required from a commercial and competition law perspective. The seller may in such case decide to restrict access to the sensitive data. If the data is of importance for the buyer, it should be considered to involve a so-called clean team to review the restricted data which also needs to be carefully considered by the buyer and its advisors. In the healthcare sector, regulatory compliance, patient data protection, and healthcare fraud and abuse laws may take precedence. By aligning the due diligence process with the buyer's industry-specific concerns, legal advisors can provide more relevant and actionable insights.

By comprehending the buyer's motivations, legal advisors can identify potential deal breakers and key risks that are most relevant to the buyer's strategic goals. For example, if the buyer is driven by the desire to enter a new geographic market, legal due diligence should scrutinize the target company's compliance with local laws and regulations, potential litigation risks, and any existing legal disputes in that market. Identifying such risks early in the process enables the buyer to make informed decisions and negotiate appropriate protections in the transaction agreement.

Moreover, understanding the buyer's risk tolerance is crucial. Some buyers may have a higher appetite for risk and may be willing to proceed with a transaction despite certain red flags, provided that appropriate risk mitigation measures are put in place or reduction of the purchase price is made. Others may be more risk-averse and may require more stringent representations, warranties and indemnities. It is also important to identify already known or suspected risks and what would constitute showstoppers for a buyer. A buyer should also consider if the transaction shall be insured through a W&I insurance or not, meaning that warranty claims are directed towards an insurance company instead of the seller which often is an advantage if it is crucial for a buyer that the seller remains in the target company on good terms after closing. By aligning the due diligence process with the buyer's risk tolerance, legal advisors can help to ensure that the transaction structure and terms are acceptable to the buyer. 

3. Enhancing Negotiation Leverage

A deep understanding of the buyer's drivers behind the transaction empowers legal advisors to provide more informed and strategic advice during negotiations. For instance, if the buyer's primary goal is to acquire a specific technology, legal advisors can focus on ensuring that the transaction agreement includes robust representations and warranties related to the ownership and validity of the technology. This targeted approach enhances the buyer's negotiation leverage and helps secure favorable terms that align with the buyer’s strategic objectives.

Understanding the buyer's motivations also plays a crucial role in structuring the transaction. For example, if the buyer is interested in acquiring only a portion of the target company's assets, legal advisors can structure the transaction as an asset purchase rather than a share purchase or a carve out the assets into a new company prior to a share purchase. Additionally, understanding the buyer's drivers can inform decisions related to earn-outs, indemnification provisions, and other key terms of the transaction agreement. 

This approach allows the buyer to selectively acquire the desired assets while minimizing exposure to the target's liabilities. Depending on whether a transaction is carried out bilaterally or multilaterally, this usually affects a buyer’s risk appetite, timing, and pricing. In a multilateral process, a buyer has to compete against other buyers, sometimes through a structured auction process. During such a process, it is crucial for a buyer to strategically evaluate its desired risk mitigating actions in the transaction document, as a seller often values a smooth process highly.

4. Mitigating Post-Transaction Risks

A thorough understanding of the buyer's strategic objectives facilitates effective integration planning post-transaction. Legal due diligence should not only focus on identifying risks but also on assessing how the target company's operations, culture, and legal obligations align with the buyer's long-term goals. For instance, if the buyer aims to integrate the target's workforce into their existing operations, due diligence should evaluate employment contracts, labor relations, and potential issues related to employee retention and integration. This proactive approach helps mitigate post-transaction risks and ensures a smoother transition.

Integration planning also involves assessing the compatibility of the target's technology systems, supply chain, and customer base with the buyer's existing operations. For example, if the buyer is acquiring a company with a different technology platform, legal advisors should evaluate potential issues related to data migration, software licensing, and cybersecurity. Similarly, if the buyer is acquiring a company with a different customer base, legal advisors should assess potential issues related to customer contracts, data privacy, and marketing practices. 

Understanding the buyer's drivers behind the transaction is also essential for addressing compliance and regulatory considerations. For example, if the buyer is entering a highly regulated industry, legal due diligence should assess the target company's compliance with industry-specific regulations, licensing requirements, and potential regulatory risks. This understanding enables the buyer to develop a comprehensive compliance strategy and avoid potential legal pitfalls that could jeopardize the success of the transaction.

In addition to industry-specific regulations, legal advisors should also consider cross-border regulatory considerations. For example, if the transaction involves a foreign buyer or target, legal due diligence should assess potential issues related to foreign investment regulations, export controls, and anti-corruption laws. 

A buyer may need additional services during a limited period of time until the acquired assets or business have been fully integrated into the buyer’s organization. There may also be dependencies with the seller’s organization that will have to be considered and regulated contractually and costs for such services need to be considered. Before initiating a transaction, it is therefore important to have an integration plan already from the start. By addressing these integration challenges during the due diligence process, legal advisors can help to ensure a successful post-transaction integration.

5. Conclusion

In conclusion, understanding the buyer's drivers behind the transaction is a critical component of conducting a value-creative due diligence. By aligning the due diligence process with the buyer's strategic objectives, advisors can tailor the scope of due diligence, identify relevant risks, enhance negotiation leverage, and mitigate post-transaction risks. This holistic approach not only ensures a thorough evaluation of the most important aspects of the target company, but also supports the buyer's long-term goals and maximizes the value of the transaction. So before initiating your next transaction, sit down with your advisors to discuss the rationale behind the transaction.

Authors: Maria Lilliestierna, Martin Tenselius and Alice Clarin