Introduction

Getting the due diligence process right is essential to making an informed decision in any M&A. When done correctly, it can lead to securing a favourable valuation and completing the sale. However, neglecting this process can result in the potential buyer aborting the sale. In an inter-connected industry where news travels rapidly, overcoming the adverse perception of a failed deal can cause reputational damage which may linger well into the future.

Reflecting on the deals of the past year, we have identified a few key factors which may be crucial in determining a successful M&A process.

Market Trends and Opportunity

A key client of the firm, Corum Group a global leader in M&A advisory for the technology industry in its recent “Selling Up Selling Out” conference disseminated important guidance on how a seller can fully optimise its company’s valuation and ensure a successful M&A deal. The Founder-CEO of Corum Group, Mr Bruce Milne highlighted a recent interesting trend which estimates that 80% of acquisitions from the United States of America are focused in Asia, with potential buyers targeting smaller companies with regional presence. With global inflation in the post-pandemic world, the focus has shifted away from larger companies. Thus smaller South East Asian companies offer potential acquirers the opportunity to use the M&A to enhance the target’s product portfolio, technological position, market reach or customer service capabilities at a much lower level of investment.  Based on this recent trend, companies based in South East Asia, including Malaysia, should ensure that they are properly prepared with the right mindset and tools once they are in the market to look for a buyer.

Corum also noted that potential acquirers are working on much more compressed timelines.  Post-pandemic, virtual due diligence is now the norm and advisers’ reporting times have been drastically reduced.  Clients have increasing preference for a Red Flags Report highlighting only high level issues which are either potential deal breakers or result in price adjustments, as opposed to full form reports. For targets, this signals a critical need to instil a housekeeping discipline of being in a state of readiness so that internal data is managed daily where information is current and can be accessed in real time.

One of the key components to achieve a seamless M&A is the seller’s preparedness of the imminent legal due diligence process.  In order to close the gap between the seller’s expectations and the buyer’s valuation of target, sellers are highly encouraged to conduct a dry run of due diligence to identify any potential issues and allow sufficient time for risk mitigation.

Seller’s Due Diligence-10 Key Issues

The following are some key issues which assist in enabling a target to achieve a seamless and value-optimised due diligence: 

(1) Getting Document Management Right

In an M&A transaction, the valuation of a company encompasses company’s finances as well as critical legal considerations.

Not all documents are required to be reviewed but as due diligence is intended to be a verification exercise, it is essential that key documents are made available subject to an NDA being first executed. Lack of or unavailability of documents may be a deal-breaker if it leads to the belief that material documents are being withheld or reflective of an incomplete or inefficient data repository. To the potential buyer or investor, this can lead to a credibility issue and trust can be rapidly lost. That being said, frequently the potential buyer may be a competitor and it is expected that delicate caution should still be exercised as due diligence remains an exploratory process and if the sale is aborted, highly sensitive information may already be exchanged.  In certain tender exercises, the due diligence is sometimes split into a levelled 2-stage process where trade secrets are withheld and reserved for the selected final bidder and only until it is absolutely necessary and negotiations cannot proceed further in its absence.

Generally, advisers may further request for information if documents disclosed during the due diligence review are insufficient.  Where a target company is not forthcoming with their disclosures, multiple requests for information would be required. This may reflect poorly on the overall governance of the target.

Some best practices for organising key documents include creating a comprehensive documents checklist, utilising a secure virtual data room and using consistent naming practices to standardise document names. Having a ready management presentation deck which is accurate, comprehensive and most importantly, honest, able to capture history, strengths and address upfront justifications for weaknesses, may enable the seller to set the right tone to the process.

(2) Responding to advisers’ queries

In a due diligence exercise, the legal advisers would usually deal with representatives of the target company to obtain further information and confirmation. The representatives dealing with the legal advisors would need to be knowledgeable in the particular area of the due diligence review and be able to respond to queries raised by the legal advisers.

When representatives are unable to respond to the queries accurately or sufficiently, this may cause advisers to unnecessarily raise early red flags as compared to if disclosures were properly made from the outset.  Having key personnel in the company who understand the process and are equipped to deal with any challenges as they arise will help to expedite an often otherwise slow and drawn-out state of proceedings that may delay or even threaten the transaction’s closing. A due diligence review would be less strenuous on the target company if multiple representatives from different departments (e.g., corporate information, contracts, finance, employment, intellectual property, real estate and legal) are actively involved in the due diligence exercise. However, it is always best to centralise all queries to a key person to ensure consistency of responses.

This in itself would provide the buyer a snapshot into the target’s personnel, their core competencies and problem-solving abilities.  Ideally the management team should engage in mock presentations in which tough questions can be fielded to gradually develop their ability to respond under pressure. Amongst other things, the key personnel should be trained to:

• To have complete documentation organised and ready for upload to a data room or physical inspection.
• To manage buyer’s due diligence checklists.
• To ensure sufficient copies of documents are prepared in the case of request for physical inspection.
• To anticipate and respond to questions and otherwise liaise with the buyer or appointed due diligence consultants/ accountants/ lawyers.

(3) Virtual Data Room Dooms

(i) First Impressions count

Utilisation of a virtual data room should optimise time, improve due diligence efficiency and reduce costs and geographical limitations. However, opting for a virtual data room alone would not be enough to secure a deal if the seller does not take sufficient measures in ensuring a secured repository and a seamless fact-finding process between the target company and the buyers and/or their advisers.

The organisation of documents made available on the virtual data room will also provide a first glance indicator as to the overall data management system and the standard of record keeping of the target company. Given the volume of information and document disclosure required during a due diligence exercise, a structured document organisation system will prove critical to a deal. Simple steps such as making use of folders and subfolders based on relevant division of matters or jurisdictions and avoiding generic naming of documents would greatly streamline the fact-finding process and ensure that the parties are able to conclude the due diligence exercise expeditiously.

(ii) Security First

There are instances where sellers choose not to disclose critical documents to entry level bidders for fear of leakage of confidential information during the due diligence process. Although such fears are not entirely unfounded, most virtual data rooms are equipped with security features including an invite only access and tracking capabilities, making sure that access is limited to those on a need-to-know basis.

However, in order to design a controlled environment where commercially sensitive documents and information are shared, it is imperative to secure a binding non-disclosure agreement between the seller and the buyer alongside their advisers prior to the grant of access to the virtual data room. This would create and impose a strict obligation of confidentiality.  There may be a need to also secure and anonymise confidential data of the target company, particularly if it concerns customer or supplier contracts that the company may not wish to disclose to competing bidders. For the highest of sensitive data, enhanced electronic tools which restrict and monitor the digital trail of all activities and prohibit copying and downloading and subject to time limitation is recommended. The management of sensitive information would also create an overall impression of the target’s systems, internal governance and management of in-house data.

(4) Intellectual property chain of ownership

When evaluating the aspects that contribute to a company's worth, real property or other tangible assets are the major value drivers.  For tech companies, intellectual property (“IP”) can be far more valuable than any physical asset. The importance of sufficiently protecting IP rights cannot be overstated.

Sellers should note that when conducting an IP due diligence exercise, legal advisers will seek to identify all IP that the target company uses or claims to own and verify whether such IP is in fact registered / applied for in the name of, or beneficially owned by, the target company. Other key IP-related issues to be aware of include, amongst others, the following:

• whether the target company is using any third-party IP and if so, whether there are licence agreements evidencing the target company’s authorisation to use such third party IP;
• whether any competitors or other businesses are infringing the target company’s IP rights, and if so, what measures are target company taking to resolve these issues; and
• whether there are any material encumbrances on the target company’s IP rights or post-acquisition restrictions on use of the same.

A seller’s failure to address any gaps in ownership or provide sufficient evidence of protection of IP rights may result in having to accept increased warranties and indemnities in the definitive agreement, and correspondingly, unnecessarily increasing the time spent on the negotiation table.

(5) Regulatory approvals or third party consent

Depending on the nature of business and industry sector of the target company, the target company must be in possession of all relevant licences and fulfil the relevant regulatory requirements in order to carry out its business. In this regard, it is important for the seller to disclose to the buyer any information which may relate to the status of licenses and whether the target company has engaged in any activities or transactions that may lead to the potential revocation of those licenses.

Additionally, M&A transactions are commonly subject to legal, regulatory or governmental restrictions on the transfer of shares in the target company.  Transactions in specific industries require consent from industry regulators, and certain governmental licences may limit foreign shareholding. Third-party consent may also be required from landlords, financiers and counterparties in licensing and supplier contracts in the event of change of control in the target company. Buyers will necessitate third-party consent in the negotiation stages to ensure that the business can continue to operate smoothly after the transaction is concluded.

Securing third-party consent may involve significant time, effort, costs and bureaucracies. As such, it is important for the seller and buyer to identify the required consents and approvals for the transaction early on in the due diligence process, so as to allow for sufficient time to obtain those consents and approvals, as well as planning for contingencies in the event that consent cannot be obtained.

Sellers are reminded to be circumspect in obtaining third-party consent. A risk in the process of obtaining consent is the disclosure of details of the transaction to the third-party, which may breach any duty of confidentiality the seller has to the buyer.

(6) Litigation or disputes

Any ongoing litigation or disputes involving the target company is an adverse information on the target company. The inclination for some sellers is to conceal facts on any ongoing disputes in the bid. This is counterproductive as buyers can carry out their own due diligence exercise where a subsequent discovery of ongoing disputes may strain negotiations between both parties. The buyer may also only discover information on litigation after the acquisition, in which case the seller may be in breach of its warranty on litigation matters.

To illustrate an example, a seller failed to disclose an ongoing litigation involving the target company on basis of their misunderstanding that only ‘significant’ litigation disclosure was required. After the error was discovered, the seller had to persuade the counterparty of the litigation suit to enter an out of court settlement with their own funds so as not to breach the warranty provided to the buyer. The seller  should be open with the buyer, including disclosure of any adverse information involving the company at the outset of any negotiations. This allows both parties to manage their expectations and will assist the seller’s due diligence to be completed expeditiously.

(7) Lack of anti-corruption safeguards

With the enforcement of the Section 17A of the Malaysian Anti-Corruption Commission Act 2009 (“MACC Act”)—which introduced corporate liability to corporate entities and their directors—it is vital to ensure that the target company, amongst others, has anti-corruption practices and policies in place. Due to the strict liability imposed pursuant to Section 17A of the MACC Act, the seller may be exposed to both financial and reputational risks associated with any corrupted acts committed in connection with the target company even prior to the acquisition of the target company. If there are no anti-corruption practices and policies implemented in the target company, a buyer may require the seller’s warranty that there is no ongoing or anticipated anti-corruption investigation which may criminally implicate the target company.

(8) Antitrust issues

Conducting due diligence allows the identification of potential antitrust risks, allowing the target company breathing room to mitigate such risks by implementing any necessary procedures and antitrust measures.

Antitrust risks are generally present in 2 scenarios:

• Merger control: Presently in Malaysia, merger control notification is only applicable for mergers for certain industries. With proposals by the Malaysia Competition Commission (“MyCC”) to introduce a merger control regime through amendments to the Competition Act 2010¹ , scrutiny of the antitrust implications of a potential deal is expected to become more frequent. Mergers or anticipated mergers which exceed the prescribed threshold must be notified to MyCC, who after reviewing, will decide whether to clear or prohibit the consummation of the merger. The proposed new regime would prohibit mergers from all sectors (within and outside of Malaysia) that may result in a substantial decrease of competition in any market for goods or services in Malaysia.
• Ongoing antitrust compliance: With the constant development of the competition law landscape worldwide and the ongoing scrutiny of MyCC in respect of business agreements entered into by entities containing anti-competitive provisions, it is vital for the target company to have an existing antitrust compliance programme which is up to date with the current regulatory requirements.

It is also important for both buyers and sellers to identify any antitrust violations arising from the potential deal in addition to any antitrust sanctions, penalties or damages that have been imposed on the target company, as it may otherwise lead to unforeseen roadblocks in respect of the deal.

(9) Identification of Representations and Warranties

The share purchase agreement is one of the final forms of negotiation, and the representation and warranty clauses forming a key part of said agreement are valuable tools which will assist the seller with accurate risk allocation.

The findings from the due diligence exercise are instrumental in informing the seller about the possible representations and warranties to be included, as well as verifying their accuracy and flagging issues which may require the qualification of the representations and warranties made. A well-drafted and accurate list of representations and warranties, and appropriate disclosure letter by the seller, can help limit and ring-fence the seller’s potential liability in an M&A transaction.

Some examples of common representations and warranties include:

• the company’s compliance with legal and regulatory requirements;
• no pending disputes or litigation involving the company;
• the accounts and financial records being accurate and updated; and
• all existing contractual agreements with the company that meet the threshold having been disclosed to the buyer.

(10) Talent Retention

An M&A exercise may be perceived negatively by employees of the target company due to the potential organisational changes in management and in some circumstances, a shift in culture. It is critical to ensure business continuity as far as possible during and upon completion of the M&A exercise. As such, the buyer must take proactive steps to prioritise retention of key talent and instil a sense of trust amongst the employees of the target company.

As an illustration of a case where the buyer had neglected to effectively secure the retention of key talents: Although the transaction documents had initially included clauses on retention of a list of C-suite employees, it was subsequently discovered that none of the terms of the retention employment contracts were even raised as a discussion point with the said employees, resulting in the employees disagreeing to stay on with the target company post-acquisition.

The due diligence process is often described as a minefield that may kill an M&A deal.  Failure to conduct a due diligence effectively can lead to an aborted transaction or being exposed to a breach of warranty, among other unfavourable outcomes for the seller. A dry run of due diligence conducted beforehand can help the seller to avoid obvious pitfalls and prepare for the due diligence proper, including securing the professional expertise required to guide them through the process.

Zain & Co. acknowledges associates Lynette Ajeng, Gan Jing Ru, Muneerah Mohd Azlan and Lim Yan Er for their contributions to this article. For further information or any related inquiries, please contact our Partner: Abdul Shukor Salwah

1. https://www.theedgemarkets.com/article/firms-seeking-mas-may-need-obtain-myccs-nod-2024