1. Introduction

Prior to permitting access to a potential Buyer to perform an investigative due diligence review, a Seller who desires to optimise the outcome of the sale would be wise to perform a pre-emptory self-due diligence first. There are a few key reasons how this could be pivotal leading to either an outcome of a sale of enhanced premium to the Seller – or in the alternative, the Buyer abandoning the sale. In this article, we analyse the importance of carrying out a Seller’s due diligence.

2. What is Seller’s Due Diligence?

Generally, a due diligence exercise is an investigative process and analysis often carried out by a prospective Buyer on a Seller’s company. A Buyer’s due diligence will assist in assessing the company’s viability as well as to scope out any potential red-flags and key risks in the company.

A Seller’s due diligence on the other hand, is a self-internal review housekeeping process carried out by the Seller which aims to analyse key aspects of the Seller’s company and to ensure that all such aspects are in order prior to permitting access to the Buyer and its advisers.

3. 5 Main Benefits of a Seller’s Due Diligence

1. Enables the Seller to identify any possible gaps in the Seller’s company’s documents;
2. Enables the Seller to have all the necessary documents ready for presentation when the Buyer carries out their own due diligence on the Seller’s company. Being able to present a house-in-order and familiarity of business would create an overall good impression, builds trust and enable a smoother negotiation process;
3. Reduces time taken for the Buyer’s due diligence process and consequently, expediting consummation of sale;
4. Reduces the amount of issues identified during the Buyer’s due diligence process which may lead to a more favourable negotiation process with the Buyer, may avoid potential deal breakers and lead towards favourable pricing; and
5. Enables the Seller to identify and anticipate possible fundamental issues and risk areas within the Seller’s company early on before the Buyer’s due diligence, allowing the Seller to address matters that requires rectification before the Buyer’s due diligence.

4. Items a Seller should look out for during the Seller’s Due Diligence exercise

The best way to approach the Seller’s Due Diligence is for the Seller to perform a critical self-review of its own business and to place itself in the shoes of the Buyer – what are the key risk areas that could deter a sale decision or reduce the sale price? These issues should be resolved or mitigated to extent possible prior to commencement of Buyer’s due diligence. In a situation where residual risks remain, upfront disclosure to the Buyer with explanatory mitigating circumstances may be preferable to leaving the issues to be uncovered by the Buyer’s professional advisers. Adverse findings may lead to a trust deficit between the parties as well as the Buyer instructing a more detailed investigative scope for fear of more contingent undisclosed issues. A Seller would find that being subjected to a Buyer’s due diligence review would place all your internal processes under magnifying light.

(a) Corporate Secretarial Documents

• Potential deal-breaker: One of the key red-flag matters in a Buyer’s due diligence exercise is the failure to trace the full chain of share ownership to when the particular shares were issued and allotted by the Seller’s company. Should the Buyer be unable to trace share ownership, this would mean that the Seller is unable to establish the requisite proof that the Seller does indeed have legal and beneficial ownership of the shares that they intend to sell to the Buyer. Hence a Buyer may elect to walk away from the deal should such an occasion arise as the very basis of the sale is questionable.
• Other negative impacts: Even if the Buyer chooses not the pull-out from the deal, there could potentially be more stringent representations and warranties included in the transactional documents to safeguard the Buyer’s position and hence, further exposing the Seller to more responsibilities and may risk affecting the valuation of the Seller’s company.
• Safeguard: To best safeguard the Seller’s position, the Seller should ensure that all gaps and inconsistencies in records and documents in respect of share ownership are pre-empted and covered to the extent possible prior to the Buyer’s due diligence. Where such gaps and inconsistencies cannot be rectified, Sellers must ensure that all disclosures in respect of the same are clearly and sufficiently communicated to the Buyer prior to execution of the transaction documents.

(b) Financial Statements

• Potential deal-breaker 1: The purchase consideration of the deal is often tied to the financial performance of the company. A potential deal-breaker is if the Buyer finds that the Seller’s accounts and financial statements are inconsistent or raises non-compliance issues with the accounting standards and contain significant misstatements / abnormalities.
• Potential deal-breaker 2: Sellers who are unable to produce audited financial statements or present to the Buyer qualified audited financial statements with unresolved issues may lead to the Buyer terminating the deal.
• Other negative impacts: Even if the Buyer chooses not the pull-out from the deal, this will significantly negatively impact the valuation of the Seller’s company and the Buyer may impose more significant condition precedents and warranties in the transaction documents, ultimately exposing the Seller to more responsibilities and liabilities.
• Safeguard: The Seller should ensure that the accounts of the company is managed by a competent accounting and finance team and routine internal audits are carried out. This will reduce the risk of the any significant misstatements in the financials of the company and ensures that the company’s books are in order with minimal gaps and inconsistencies. Sellers should endeavour to resolve all such issues prior into entering any negotiations with a Buyer.
• Other considerations: As the filing of the company’s audited financial statement is a regulatory requirement, a Seller’s due diligence will ensure that all such filings are carried out in accordance with the applicable legislations.

(c) Key material contracts

• Potential deal-breaker 1: Buyers are buying into the target’s business and its potential – and a key consideration is that key operational contracts remain intact post-sale and will not be affected by any change in shareholding resulting from the acquisition. A potential termination of a material contract due to the change in shareholding in the Seller’s company as a result of the Buyer’s acquisition can potentially disrupt the Seller’s company’s business activities. This may result in the Buyer not proceeding with the deal or may impact the purchase consideration unfavourably for the Seller.
• Potential deal-breaker 2: During a Buyer’s due diligence on the Seller’s company, the level of organisation with respect to the Seller’s company’s documents is a key indicator of whether the Seller’s company is well managed. Especially for start-ups and technology companies, significant commitments between key third parties / customers are often not documented and even if it is documented, such agreements are often not signed and/or stamped. This may eventually lead to the termination of the deal by the Buyer.
• Safeguard: To reduce the risk of the same occurring, Sellers should implement good contract management measures which includes:
1. Always ensure all agreements entered into between third parties / customers are documented by way of a formal contract which is duly signed and stamped;
2. Maintaining a ledger of all contracts entered into and their contractual value; and
3. Providing ample notification to all counterparties of material contracts relating to the deal that is being entered into and securing all written consents required prior to completion of the deal.

(d) Regulatory Licences

• Potential deal-breaker 1: Certain industries, such as the fintech industry, are in a highly regulated space. Hence, Sellers should be aware of what licences they have and what licences they should have in respect of their business activities. Should the Seller be representing to the Buyer that they are currently carrying a certain regulated activity, the Seller should have the necessary proof ready to justify such a representation. A failure to produce such licence or presenting an expired licence may lead to the termination of the deal by the Buyer.
• Potential deal-breaker 2: Should the Seller’s company be in a regulated space, the Seller will have to ensure that the company has been compliant with the conditions imposed on such licenses. Should the Buyer discover that the Seller has not been compliant with certain regulatory requirements, this may be sufficient reason for a Buyer to terminate the deal or impose harsher warranties on the Seller thus exposing the Seller to more responsibilities and liabilities.
• Safeguard: A Seller’s due diligence will enable the Seller to ensure that all necessary licences have been obtained and are subsisting. If such licences are near expiration, the Seller will be able to identify these licences before entering formal negotiations with the Buyer and will be able to secure the licence renewal even before the Buyer’s due diligence commences. Further, a Seller’s due diligence will enable the Seller to identify if the Seller’s company has been compliant with the regulatory requirements. Should there be any non-compliance, the Seller would be pre-empted to resolve it immediately prior to the Buyer’s due diligence hence avoiding a potential deal-breaker.

(e) Intellectual Property (“IP”)

• Potential deal-breaker: The IP of the Seller’s company may be the most crucial asset forming the purpose of the proposed acquisition. Buyers will want to ensure that all IP rights belong absolutely and unequivocally to the Seller’s company and there are no material encumbrances on these intellectual property rights. Specifically for technology companies, Buyers often carry out an IP due diligence on the Seller’s company to ensure that all the IP that the Seller claims they own, are actually protected and actually owned by the Seller and/or the Seller’s company. A gap in such IP ownership / protection may demonstrate the Seller is unable to claim exclusivity to the core IP and there may be exposure to a third party claiming ownership over the IP. This may lead to a potential termination of the deal.
• Safeguard: Best IP practices dictates that a Seller should implement good IP management from day one. Ensure that the ownership of any IP generated from the Seller’s company belongs exclusively to the Seller’s company and not any other party who developed the IP while working in or with the Seller’s company. This will avoid any potential ownership issues. All IP generated by the Seller’s company should be properly protected through timely registration which must be kept up to date and not left to lapse. A ledger of all the IP generated by the company should be kept and maintained by the Seller to enable good IP management.
• Other considerations: Software licences being used would need to be inspected to ensure all are legitimately authorised. Some technology companies jointly develop IP together with external consultants. Hence, the Seller will have to consider whether all the assignment documents been regularised so that the business can claim the proprietary of the IP in its entirety. It is important to note that in certain arrangements, the consultants may place claim on the base IP and only the project IP is jointly owned.

(f) Litigation

• Potential deal-breaker: Litigation exposure will not automatically lead to a deal-breaker for a Buyer. For clarity, litigation exposure can include adverse litigation matters against the Seller (i.e. the founder of the company), the Seller’s company and directors of the Seller’s company. However, the active concealment and non-disclosure of such litigation matters by the Seller may result in a Buyer deciding to walk away from the deal. A Seller should never attempt to conceal any litigation matters as the Buyer would generally be able to discover such litigation cases during a Buyer’s due diligence.
• Safeguard: The Seller is expected to provide full disclosure of any past or ongoing litigation matters. Thus, it is vital that Sellers maintain good records, and frequent status updates in respect of each claim which the Seller’s company is pursuing or defending. It is also good practice to seek legal opinions assessing the probability of success of any substantial claims made against the Seller’s company and ensuring that contingencies (i.e. insurance) have been adequately provided for.

(g) Documents repository

• Potential deal-breaker: Due diligence exercises are often carried out virtually today.  A virtual data room will be created and will be expected to be populated with the Seller’s documents in response to the Buyer’s request list. Many deals are terminated at this stage due to one key factor – the Seller’s inability to upload the requested documents onto the virtual data room within the requested timeline caused by the Sellers’s state of unpreparedness and being overwhelmed by a Buyer’s due diligence questionnaire.
• Safeguard: Carrying out a Seller’s due diligence prior to any Buyer’s due diligence provides a Seller with the opportunity to organise the Seller’s company’s documentations and ensure that everything is in order. It is very important to recognise that a properly maintained house will provide a strategic positive impression of the Seller’s company and ultimately increases the likelihood of closing the deal favourably.

In summary, the Seller’s due diligence is a worthy exercise to get the seller ready for the Buyer’s and their advisers’ questions to ensure a smooth and expedited sale process.

5. Additional Seller Due Diligence-Consider a Due Diligence on the Buyer

Whilst the Seller’s due diligence ensures internal processes are ready, there is a key external point the Seller should consider – a due diligence on the Buyer. This is especially useful in situations where there are multiple offers on the table.

Key Questions

• What is each Buyer’s motivation and industry reputation?
• What is the financial capacity of the Buyer? Apart from its upfront capital position, what resources are available to the Buyer to operate the Seller’s company after acquisition and for the foreseeable future after acquisition?
• How will the Buyer finance the acquisition?
• Evaluation of the prospective Buyer’s plan for the Seller’s company. Some important things to consider are:
1. Whether the Buyer will be replacing or terminating current employees in the Seller’s company upon acquisition?
2. What is the Buyer’s vision for the company’s future?
3. Are the Buyer’s responses to (i) and (ii) or the Buyer’s intention in general, aligned to the Seller’s own values and vision?

• Has the Buyer got an established track record of consummation of deals? Are they in the same industry?
• Would the Buyer allow access for the Seller to interview and gain insights to previous sellers?

A due diligence exercise on the Buyer will allow the Seller to confirm such key points to demonstrate the legitimacy and seriousness of the Buyer’s offer and the likelihood of closing the deal.

Zain & Co. acknowledges Associate Chin Wei Shen for his contribution to this article. For further information or any related inquiries, please contact our Partner Salwah Abdul Shukor.