When an individual or entity considers acquiring a business (referred to as the Target Business), it's natural to want to gather as much information as possible about the business in question. This is not only good practice but essential for making informed decisions. However, it's important to tailor the level of due diligence to the nature of the deal. Factors such as the risks involved, the purchase price, and the buyer’s familiarity with the Target Business should be carefully considered to determine the appropriate depth of review.
What is a due diligence report?
A due diligence report is a comprehensive document prepared by the buyer's advisors. It summarises their findings from reviewing documents and information provided by the seller regarding the Target Business. In some cases, the seller may also produce their own due diligence report, particularly in competitive bidding situations where multiple potential buyers are interested in the same Target Business. In such cases, the Target Business may choose to produce the report themselves to streamline the process.
Common types of due diligence approaches
Double red flag only
The term "double red flag only" is often used colloquially but has become a more common approach in recent years. In this type of due diligence, only the most significant risks are highlighted. Specifically, those risks that could either prevent the deal from going forward or pose substantial risks to the buyer.
Issues reported in a double red flag due diligence report typically fall into one or more of the following categories:
- Dealbreaker: The issue could significantly affect the buyer’s willingness to proceed with the transaction.
- High value: The issue is of a considerable monetary value, typically set against a threshold aligned with the overall deal value.
- Irremediable risk: The issue presents a substantial risk to the buyer and resolving it would be difficult or impossible.
Red flag only
As implied by its name, a "red flag only" report focuses on highlighting issues that pose potential risks to the deal, but these are generally not dealbreakers. Often, these issues can be addressed or mitigated, though they should be carefully considered during negotiations.
Examples of issues commonly raised in red flag only reports include:
- Filing errors: Mistakes or discrepancies in official filings, such as those with Companies House.
- Change of control provisions: Clauses in material contracts that could be triggered by the change in ownership.
- Termination fees: Early termination penalties in significant contracts that may affect future business operations.
- Ongoing legal disputes: Litigation involving employees or other parties that could impact the business's stability or reputation.
General due diligence
In a general due diligence approach, the focus is broader with the goal of providing a comprehensive picture of the Target Business. This type of report covers a wide range of issues including both potential risks and routine aspects of the business’s operations. It offers more in-depth insight compared to the red flag only reports and may include a variety of information to help the buyer fully assess the Target Business.
Key areas typically covered in a general due diligence report include:
- Material contracts: Details about significant agreements and contracts the Target Business has in place, which may impact future operations or the buyer’s obligations.
- Employee information: Anonymised details about the workforce, including key employees and any outstanding issues like ongoing disputes or labour concerns.
- Government correspondence: Copies of communications with regulatory authorities such as HMRC or local government agencies, providing insight into the business’s compliance and regulatory standing.
Ultimately, the general due diligence approach provides a holistic view of the Target Business, including both its strengths and potential risks.
Conclusion: choosing the right level of due diligence
The appropriate level of due diligence will depend on a variety of factors such as the nature of the deal, the buyer's familiarity with the Target Business and the specific risks involved. By understanding the different types of due diligence approaches, buyers can make more informed decisions and better manage risks in their transactions.
This article was created by Gemma Trencher, Associate in our Corporate team, please get in touch with the team should you have any further questions.
The information provided in this article is provided for general information purposes only, and does not provide definitive advice. It does not amount to legal or other professional advice and so you should not rely on any information contained here as if it were such advice.
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The information published across our Knowledge Base is correct at the time of going to press.
