What is due diligence and why is it key before buying a company?

What is due diligence and why is it key before buying a company?

Buying a company is not like buying any other asset. Along with the shares, the buyer acquires the company’s history: the contracts it has signed, the taxes it has paid (or not), its workforce, its disputes and its permits. Much of that history does not appear in the annual accounts or in the presentation prepared by the seller.

Due diligence exists to uncover it. In practice, a serious transaction rarely closes without one. And when it does, the buyer usually finds out later, and at its own expense, what it did not review.

What exactly is due diligence?

Due diligence is a review of the company to be acquired (the target). It is carried out by the buyer, with the help of its advisers, before signing or closing the sale. Its purpose fits in one sentence: to confirm that the company is what the seller says it is and to identify the risks the buyer will be taking on.

The work is based on the documents the seller makes available, usually in a virtual data room. It is supplemented by written questions, interviews with management and searches in public registries such as the Commercial Registry, the Land Registry or the Spanish Patent and Trademark Office. The result is a report that sets out the findings, ranks them by severity and proposes how to deal with them in the contract.

What is reviewed

There is no single type of due diligence. The scope depends on the size of the deal, the sector and the buyer’s concerns. The most common areas are:

• Corporate and contractual. Ownership of the shares and chain of title, corporate resolutions, the board or management body, shareholders’ agreements, key contracts with customers and suppliers and, in particular, change of control clauses.
• Employment. Workforce, employment contracts, the applicable collective agreement, Social Security debts, possible bogus self-employment and any committed incentive or variable pay plans.
• Tax. Compliance with tax obligations for the years still open to review (generally four years, under article 66 of the Spanish General Tax Law), ongoing tax audits and related-party transactions.
• Intellectual property, data and regulatory. Trademarks, software and domain names registered to the company rather than its founders, GDPR compliance, and the licences and authorisations needed to operate.
• Financial. Quality of earnings, actual debt and working capital. This part is usually handled by auditors or financial advisers, in coordination with the legal team.

 

Why it is key before buying

Because the law offers the buyer of a company little protection. The rules on hidden defects in the Spanish Civil Code (articles 1484 et seq.) were designed for the sale of goods, not companies, and the deadline to bring a claim is only six months from delivery (article 1490). Moreover, in a share purchase what the buyer formally acquires is the shares, not the underlying business. Courts extend protection to defects in that business only in limited cases. The buyer’s real protection lies in the contract, and the contract only protects well if whoever negotiates it knows what needs protecting.

Because it sets the price. What the review uncovers translates into money. A quantified tax contingency, an unrecorded debt or a key customer that can terminate its contract after the sale are very concrete negotiating points. They can be reflected in a lower price, a holdback of part of the payment (escrow), deferred payments or an earn-out linked to future performance.

Because it shapes the contract. The seller’s representations and warranties should reflect what has been reviewed. Risks already identified, which the seller will normally exclude from the general warranties once disclosed, are covered by specific indemnities. And anything that must be fixed before closing becomes a condition precedent: obtaining the consent of a customer with a change of control clause, updating the shareholders’ register or releasing a guarantee.

Because some liabilities are inherited even when only assets are bought. Buying the business instead of the company does not remove every risk. If a business unit is transferred, article 44 of the Spanish Workers’ Statute requires the buyer to take over the employment contracts and makes it jointly liable for three years for prior employment obligations. Article 42.1.c) of the General Tax Law extends the previous owner’s tax debts to the successor in the business. And, in a merger or absorption, article 130.2 of the Spanish Criminal Code transfers the criminal liability of the legal entity to the resulting company.

Because it reveals obstacles to closing. Some transactions require prior clearance: from the CNMC (the Spanish competition authority) when the merger control thresholds of Law 15/2007 on the Defence of Competition are met, or from the Council of Ministers when a foreign investor enters a strategic sector, under article 7 bis of Law 19/2003 and Royal Decree 571/2023. There are also private obstacles: restrictions on transfer in the bylaws (articles 107 et seq. of the Spanish Companies Act), and pre-emption or drag-along rights in a shareholders’ agreement. It is better to know about them before signing than to discover them at the notary’s office.

How it works in practice

The process tends to follow a similar sequence. The parties sign a confidentiality agreement and, often, a letter of intent setting out an indicative price, the deal structure and an exclusivity period. The buyer sends a document request list, the seller opens the data room and the review begins, alongside rounds of questions and answers. In a mid-sized deal, this phase usually takes between three and six weeks.

The report can be comprehensive or limited to the material risks (the so-called red flag report). The second format is increasingly common because it gets to the point: what problems exist, how much they could cost and how they are dealt with in the contract. In a previous article we went through the red flags we come across most often in this type of transaction.

Two practical points. First, the review has to be proportionate. Not everything deserves the same attention, and setting materiality thresholds from the outset saves time and cost. Second, due diligence does not end with the report. Its value lies in how it feeds into the negotiation and the sale and purchase agreement, and in following up on the conditions until closing.

The seller can also take the initiative with a vendor due diligence: reviewing its own company before going to market, fixing what can be fixed and arriving at the negotiation without surprises. It usually shortens timelines and strengthens the seller’s position with the buyer.

How Letslaw can help

At Letslaw’s Corporate and M&A practice we advise buyers, investors and sellers on company acquisitions. We agree the scope of the review with the client, coordinate the different areas, prepare the report and, above all, carry its conclusions into the contract and the negotiation with the other side, through to closing. If you are considering buying or selling a company, we can help you do so with the information you need to make the right decision.