Agreeing on a price does not necessarily mean that the buyer considers it final. Before concluding the deal, they usually conduct a thorough company due diligence to ensure that the business condition, risks, and asset value correspond to what was relied upon during negotiations.
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The scope of due diligence is usually determined by the buyer in each case, but most often financial, tax, legal, and technical-infrastructure checks are performed. During company due diligence, the buyer evaluates not only how much the business earns today but also the profitability prospects for the future and what will have to be taken over along with it. Unresolved rights to the main product, a contract significant to the company that a client or supplier can terminate if the shareholder changes, tax risks, or business dependence on a single client – all these can become a concrete question: is the company still worth as much as was intended to be paid for it?
The product is valuable, but who owns the rights to it?
“One of the most unpleasant discoveries for a buyer during due diligence is when it turns out that the company’s most important asset is not legally as well protected as thought. This is especially relevant for businesses where a large part of the value consists of intellectual property,” says G. Linartaitė.
For example, the software code might have been created by an external programmer or a company employee, but the contract ambiguously addressed the transfer of rights to the company. The trademark might have been registered in the founder’s name rather than the company’s. As long as the business operates successfully, such details may cause no concern for years. However, it is natural that the buyer wants clear and precise answers to these questions.
“If the main product or technology of the company does not belong to it or if there are possible disputes over the rights to them, the problem is not only legal. It forces a reassessment not only of what the buyer thought they were acquiring but also of how much it is worth paying for it,” notes G. Linartaitė.
The biggest client can become the biggest problem
It is important for the buyer not only what contracts the company has today but also whether they will remain valid after the ownership changes. If a large part of the business depends on one contract whose continuity is not guaranteed, this inevitably affects the negotiations for the deal.
“The company may have a reliable long-term client generating a significant portion of revenue, but during due diligence, it may become clear that the client can terminate the contract if the company’s control changes. The same applies to dependence on a single supplier – if the company uses rare components supplied by one supplier for a long time, replacing them can be a complicated and lengthy process. The risk for the buyer becomes even greater if such a supplier has the right to terminate the contract upon a change in company control,” says Ž. Voronavičius, advisor at the law firm “Cobalt,” working in corporate law, commercial law, mergers, and acquisitions.
He also mentions dependence on the human factor as a risk: if relationships with key clients are maintained only by the founder or if critical knowledge is held by one employee, the buyer will be concerned whether that person will remain with the company after the deal.
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Risks are taken over along with the company
“By purchasing company shares, the buyer takes over not only its future potential but also its past. An unfinished legal dispute, an employee claim, possible unpaid taxes, or a previous deal whose tax assessment is unclear do not disappear after the share sale if the relevant limitation periods have not yet expired,” says G. Linartaitė.
If due diligence reveals a potential risk of 200 thousand euros, the question arises as to who will pay if it becomes a real 200 thousand euro liability after a year?
“This does not necessarily mean a 200 thousand euro lower price. The parties can agree that the buyer’s risk will be managed in other ways – by withholding part of the price, additional seller guarantees, the seller’s obligation to compensate specific losses, or additional security for the seller’s obligations. But the essence is the same – a problem that seemed theoretical before the sale acquires a very concrete monetary value,” comments Ž. Voronavičius.
An unexpected problem can cost trust as well
Most deficiencies found during due diligence are not such that the buyer would immediately withdraw from the deal or demand a price reduction. Missing bank, client, or supplier consent can be obtained, intellectual property rights can be properly formalized before concluding or completing the deal, and tax or legal risks can be addressed in the contract. “More distrust between the parties arises when significant problems come as a surprise to the buyer. And it leaves a feeling of distrust – what else does the buyer not know?” draws attention G. Linartaitė.
Preparation for the deal allows the seller not only to correct some deficiencies. “Equally important for the seller is to assess in advance what the buyer will find during due diligence and how it will affect the further course of the deal. The seller’s reluctance to disclose essential company-related risks to the buyer in advance, which the buyer is likely to discover during due diligence, can significantly reduce mutual trust between the parties and complicate the negotiation process. In negotiations, the difference between risks disclosed to the buyer in advance and those unexpectedly found during due diligence can be very significant,” adds Ž. Voronavičius.
“Therefore, it is worth preparing for the company sale even before the start of due diligence. A few processes arranged in advance or missing documents prepared may not increase the company’s value, but according to the “Cobalt” advisor, they can help preserve the agreed price or at least facilitate the negotiation process and speed up the conclusion and completion of the deal,” summarizes G. Linartaitė.
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