M&A Vocabulary – Understanding Experts: “Due Diligence”

When merging with or acquiring a company or parts thereof, it is almost like purchasing a car: the factors decisive for the purchase must be evaluated, categorized, and ultimately weighed against each other.

Only once this process has been completed can a decision be made—and typically only based on the information available to the buyer.

Before concluding a purchase agreement—given the potentially far-reaching consequences—an adequate degree of care, due diligence, must be exercised. In M&A transactions, particular attention must be paid to the aspects of law, tax, and finance. Depending on the industry or sector of the target company, additional reviews may be necessary or at least advisable. For example, in the case of industrial companies, an environmental or technical due diligence should always be considered.

As part of the so-called legal due diligence, it is first necessary to establish all important legal facts about the company that provide an overview of its fundamental structure as well as its rights and obligations. These include in particular:

• corporate law matters such as formation, shareholding, registered office, representation rules, silent partnerships, relationships with other companies,
• the financing structure and any security rights such as loans or guarantees,
• contracts between the company and its shareholders such as shareholder loans or management service agreements,
• the legal situation regarding intellectual property with respect to industrial property rights, copyrights, usage rights, and know-how such as registered trademarks or domains,
• real estate and/or lease agreements,
• significant legal relationships such as customer contracts and cooperation agreements as well as assets,
• employment and service contract matters, in particular number of employees, collective bargaining agreements, works council, company regulations, pension obligations, temporary employment, secondment, freelancers, special payments, ongoing legal disputes, or compliance with minimum wage,
• overview of other legal disputes,
• insurance contracts.

Financial Due Diligence, in turn, is about analyzing the company’s key financial risks as well as its economic potential. Particularly decisive are:

• basic information such as date of establishment, registered share capital, names and shares of shareholders,
• the company’s sustainable economic earnings as well as existing receivables from deliveries or services,
• past sales and expense trends with regard to wage, insurance, freight, office supply costs, or investments,
• the breakdown of operating costs and existing inventory,
• loans and other liabilities that could jeopardize the company’s future economic performance,
• basic assumptions underlying management’s economic forecasts,
• personnel and accounting information systems.

No less essential is conducting a tax due diligence. This represents an important building block in the decision-making process and can provide insights into whether the target company can achieve the economic results targeted by the buyer after completion of the transaction. The target company’s tax concept is thoroughly examined during the tax due diligence, as it significantly influences its profitability.

A thorough tax due diligence includes in particular:

• the review of tax status and analysis of the tax audit status with regard to the potential impact on future fiscal years,
• tax compliance with respect to VAT, income tax, property tax, social security contributions, etc., and where they arise,
• the identification of past tax risks in fiscal years that can still be reviewed by the relevant tax authorities as well as risks in transactions,
• other topics: late payment penalties, subsidies, intra-group transfer pricing arrangements, tax benefits, taxation of dividend distributions, etc.

The goal of conducting a due diligence process is ultimately to uncover risks that inevitably exist in corporate transactions and to classify and evaluate them according to their risk potential. As in daily life, not every residual risk can be completely eliminated. Only through comprehensive and professional advice—within which legal protective measures can be taken—is it possible for the buyer to make a carefully considered decision with a clear conscience.

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