Due Diligence

What is a due diligence?

Due Diligence (literally “due care”) denotes the systematic review of a company that an investor or acquirer carries out before taking a stake or making a purchase. In German it is also called Due-Diligence-Prüfung or Sorgfaltsprüfung. The economic, legal, tax and technical circumstances of the target company are examined, that is, the company in which an investment is to be made or which is to be bought. The aim is to identify risks and to decide which of them reduce the price, which are secured by contract and which speak against the transaction.

A due diligence takes place in funding rounds, in a company sale, in a purchase by the company's own management (management buy-out) and in larger loan financings. The term is also common in the purchase of real estate: there, surveyors mainly review the land register, tenancy agreements and the condition of the building so that defects are reflected in the price or contract. The reviewing side usually works with a law firm, auditors and, depending on the business model, technical experts. The scope and timetable are set by the term sheet (the outline document of a funding round) or the letter of intent (LOI); access to information is governed by a confidentiality agreement (NDA).

Areas of due diligence

A full due diligence is divided into areas, each handled by its own specialists:

• Financial due diligence (Financial): analysis of the quality of earnings, that is, the question of which part of the result is sustainable. The focus is on EBITDA (earnings before interest, taxes, depreciation and amortisation) adjusted for one-off effects and on net debt (financial debt less freely available liquid funds, supplemented by debt-like items). In addition comes working capital, that is, the capital tied up in the ongoing business.
• Tax due diligence (Tax): years for which tax assessments can still be amended, ongoing tax audits, constructive dividends (benefits to shareholders that are treated for tax purposes like a distribution), payroll tax and VAT. On a sale, unused tax loss carry-forwards lapse in principle under Section 8c of the German Corporation Tax Act (KStG) if more than 50% of the shares pass to an acquirer within five years and no exception applies.
• Legal due diligence (Legal): company law, material contracts, intellectual property rights, data protection and litigation. An acquirer can rely on the shareholder list only under narrow conditions (acquisition in good faith, Section 16(3) of the German Limited Liability Companies Act (GmbHG)). Every notarised transfer of shares since the founding up to the current shareholder list is therefore traced.
• Commercial due diligence (Commercial): market, competition, customer concentration, contract terms, churn and pricing power, often supplemented by customer interviews and a reconciliation of the key figures in the pitch deck with the accounts.
• Technical due diligence and IT (Technical): architecture, scalability, technical debt (deferred improvements to the code), IT security and open-source licences. For software from freelancers or agencies, it is checked whether the rights of use were granted by contract. By operation of law, the employer obtains the rights only to programs that employees create in performance of their duties or on the employer's instructions (Section 69b of the German Copyright Act (UrhG)).
• Personnel (HR): contracts of key persons, participation programmes and oral promises, false self-employment (freelancers who are legally treated as employees) with the risk of social security contributions to be paid retroactively, works agreements and pension commitments.

Course of a due diligence: data room, question list, report

1. Request list: The reviewing side sends a list of the documents needed, structured by areas of review, the due diligence checklist. It typically includes the shareholder list, articles of association and shareholders' agreement, annual financial statements and monthly figures, the plan, material contracts, employment contracts, intellectual property rights and tax assessments.
2. Data room: The company makes the documents available in a virtual data room with an access log and staged release. If shareholders are selling their shares, a consenting shareholder resolution is in practice obtained before opening because of the management's duty of confidentiality.
3. Question list: Follow-up questions run through a numbered list with responsibility and deadline.
4. Discussions: Management discussions and expert sessions supplement the written documents.
5. Report: The advisers summarise the results in the due diligence report, either in detail or as a red flag report with only the significant findings.

Due diligence in a funding round and a company sale

Review before a funding round

Through a capital increase, the investor acquires a minority stake. The main points reviewed are the business model, growth and unit economics (profitability per customer), team, plan and use of funds, and the rights of earlier investors. Further investors in the round often rely on the review by the lead investor, who leads the round and negotiates the terms. Warranties are usually given by the company, in part supplemented by founder warranties with low liability caps.

If the company pays money to the investor, who has meanwhile become a shareholder, because of a breach of warranty, this may violate the rules on maintenance of capital. The assets required to maintain the share capital may not be paid out to shareholders (Section 30 GmbHG). A breach of warranty is therefore often compensated primarily by additional shares for the investor.

Review before a company sale

The buyer takes over the majority or all of the shares and with them the risks from the past. The review covers all areas and prepares the integration. It also clarifies whether closing requires clearance by the Federal Cartel Office (merger control under the German Act against Restraints of Competition, GWB) or, for acquirers from abroad, an investment screening under the Foreign Trade and Payments Act (AWG) and Foreign Trade and Payments Ordinance (AWV). The sellers are themselves liable under the warranties of the purchase agreement, and the findings act directly on the purchase price and contract terms.

Legal framework in Germany

There is no general statutory duty to carry out a due diligence. For the management of an acquirer, however, it regularly follows from their duty of care (Section 43(1) GmbHG). A business decision is protected against the reproach of a breach of duty only if it is based on adequate information. For the stock corporation, this principle is set out in the statute (Section 93(1) sentence 2 of the German Stock Corporation Act (AktG)); for the GmbH it applies accordingly.

According to case law, the seller is subject to duties of disclosure about circumstances that are recognisably material to the buyer's decision. The buyer's review does not simply remove these duties. Whether knowledge that the buyer gains in the review excludes its later claims is regulated by the purchase agreement in its own knowledge clauses.

From finding to contract provision

Findings are assigned to a contractual solution according to their nature and whether they can be quantified:

• Purchase price: Findings that change the sustainable result or the debt reduce the enterprise value or are deducted as debt-like items in the bridge to the purchase price for the shares (Equity Bridge).
• Warranties: For circumstances that cannot be conclusively reviewed, the seller gives independent warranties. What has been properly disclosed in the disclosure schedule is, as a rule, excluded from them.
• Indemnities: Known, quantifiable risks, for example from a tax audit, are assumed by the seller through an indemnity. It applies regardless of the buyer's knowledge and is often secured by a retention in an escrow account.
• Closing conditions: Remediable defects become prerequisites that must be met before closing, for example the subsequent granting of rights or a customer's waiver of its termination right on a change of control.

Practical example: due diligence in the sale of a software GmbH

A software company in the legal form of a GmbH (German limited liability company) with EUR 12 million in revenue is sold to a strategic buyer. The letter of intent states an enterprise value (value of the business before deduction of debt) of EUR 36 million, derived from an adjusted EBITDA of EUR 3 million and a multiple of 12. The review produces four material findings:

• Finance: The EBITDA includes a one-off licence income of EUR 0.25 million. Adjusted, 3.0 minus 0.25 = EUR 2.75 million remain, and the enterprise value falls to 2.75 × 12 = EUR 33 million.
• Tax: An open tax audit carries an estimated risk of EUR 0.4 million. A tax indemnity and a retention of that amount in an escrow account are agreed.
• Legal: A core module comes from an agency that never granted the company exclusive rights of use. The subsequent granting becomes a closing condition.
• Market: The largest customer, with 30% of revenue, may terminate on a change of control. Its written waiver also becomes a closing condition.

With net debt of EUR 2 million, the purchase price for the shares is 33 minus 2 = EUR 31 million. At closing, 31 minus 0.4 = EUR 30.6 million is paid. The retention is not a price reduction: it is paid out to the extent that the tax risk does not materialise. The finding on the quality of earnings, by contrast, costs the sellers 36 minus 33 = EUR 3 million of enterprise value; the other findings change the timetable and contract structure, not the price.

Distinctions: due diligence, vendor due diligence and statutory audit

• Vendor Due Diligence: The client is the seller, who hands the report to the prospective buyers. The report does not replace the buyer's review because it is produced on behalf of the other side. The buyer, however, often limits itself afterwards to a confirmatory review (confirmatory due diligence).
• Financial Health Check: an assessment of the financial position commissioned by the company's own management, usually before a process begins. It anticipates questions of the financial due diligence from an internal perspective and remains internal.
• Statutory audit of annual financial statements: the statutory audit of medium-sized and large corporations (Section 316 of the German Commercial Code (HGB)) as to whether the annual financial statements comply with the accounting rules. Financial due diligence, by contrast, asks about sustainable earnings and risks from the standpoint of a particular acquirer.

Common mistakes

• Preparation only after the letter of intent. Anyone who only collects documents when the request list arrives uses up the exclusivity phase, in which negotiations are conducted with only one interested party, on searching instead of answering.
• Contradictory figures. If the pitch deck, financial model, monthly figures and annual financial statements differ from one another, the other side checks every further statement with heightened scepticism.
• Withholding known problems. What the review brings to light anyway costs credibility. Anyone who deliberately conceals recognisably material circumstances also risks liability for fraud, against which contractual liability limits do not protect.
• Answers outside the question list. Undocumented information by telephone or email leaves open later what the buyer knew and what counts as disclosed.

Frequently asked questions

How long does a due diligence take?

In funding rounds often four to eight weeks, in a company sale rather six to twelve weeks. The duration depends less on size and sector than on the quality of the documents and the speed at which follow-up questions are answered.

Who bears the costs of the review?

In principle each side bears its own advisers. In funding rounds, however, the company commonly bears the lead investor's review and contract costs up to an agreed maximum amount.

Must a company hand over all the documents requested?

No. Limits are set by confidentiality obligations towards customers and partners, data protection and, if a competitor is reviewing, competition law. Such documents are redacted, anonymised or made accessible only to a small circle of external advisers.

Does a serious finding lead to the transaction being abandoned?

Rarely. It is usually translated into a price adjustment, an indemnity, a retention or a closing condition. Transactions are abandoned mainly when a finding fundamentally calls into question the basis of the valuation, the rights to the core technology or the credibility of the management.

The Roemer Capital view

At Roemer Capital, preparation for the due diligence begins with the start of the mandate, not with the letter of intent. The aim is a data room that is ready within 24 hours and a set of figures in which pitch deck, financial model and accounts show the same values. Roemer Capital classifies known weaknesses in advance and clarifies with the management whether they are remedied or disclosed with a proposed solution.

During the review, Roemer Capital keeps the question list and also answers the financial questions. The other answers are coordinated with the client's law firm and tax adviser, with whom the legal and tax assessment lies. Roemer Capital's contribution is to translate each finding early into its effect on the purchase price and the draft contract.