Legal due diligence (“DD”) is an essential part of M&A process. Legal DDs help the parties in various phases of an M&A process, including;

  • identifying the risks and provide an idea on the legal status of the target company,
  • determining the purchase price,
  • identifying the matters to be considered under the transaction documents (such as share purchase agreements),
  • setting up the deal structure, and
  • ultimately used in the decision-making process of the purchaser to conclude the transaction.

While it would be important to gather critical information to correctly assess the target company’s risks and compliance obligations and thus, usually quite an extensive full scope due diligence on the target is preferred by the purchasers, the parties also aim to strike a balance between the practicalities of the deal and potential costs and efforts of the DD process. A well-planned DD process often helps the parties finding such balance and we have summarized the points to be considered under this article.

Prior to DD Process – what to plan ahead?

  1. Setting the Scope of the Review. Understanding the deal mechanics, the target’s structure, and the goals of the parties, as well as the target industry and creating a tailor-made approach which fits the transaction is essential to evade problems throughout the process. In that sense, in certain cases it may be considered to limit the extent of the DD and just to focus on material issues that could significantly impact the transaction, such as critical contracts and compliance matters. However, ultimately, the comprehensiveness of the DD document request list should align with the specific objectives and risks associated with the deal to ensure efficiency. It is usual to even extend the scope of the DD after the initial set of documents are reviewed, due to risks identified in the first line of review.
  2. Legal and other teams’ alignment. In many cases, DD process not only involves legal due diligence but usually extends to financial, tax and technical due diligence as well. Especially, tax due diligence may become very critical for a cross-border deal for setting up the deal structure. As such, gathering the findings of all these due diligence exercises and conducting a risk evaluation, to correctly include the mitigating clauses for such risks in the transaction documents is often necessary.
  3. Plan ahead for communication process. Especially where the target company management is not familiar with an extensive DD process and they do not have necessary resources to allocate to the DD exercise, a good communication from the legal teams, correctly explaining why a DD exercise is also beneficial for the sell-side as well is usually beneficial for ensuring a smooth process. Usually, an initial meeting with legal counsels and target’s DD teams explaining whole process is advised, so that the sell-side engages the right persons to support the DD process and the whole process is completed faster.
  4. Setting up a VDR. As is possible to track which documents have been modified or added in an actual virtual data room (“VDR”) provider, setting up a good VDR would ease the work of the parties.

What topics should be covered within the DD process?
Some of the major topics covered under a due diligence request list to give an idea on the scope of a standard full scope DD are:

  1. Understanding the Business: One of the crucial steps in creating a DD checklist is to first understand how the business of the target works. In that regard, questions aimed at understanding what the product or service is, what are the sales channels and how the supply chain works, how is the supply relationship established and whether the company is dependent on a certain customer, supplier or employee to continue its business is usually questioned as an initial point.
  2. Corporate: Corporate structure and organization of the company is one of the main DD items, being critical for deal mechanics as well. To assess the corporate structure and its compatibility with the deal structure, information on shareholding structure and share certificates, authorized representatives and books are usually requested, in addition to various other corporate documents.
  3. Assets: Another topic to be covered is assets and real estates used or held by the company, to mainly ensure that the assets are sufficient for the continuation of the company’s activities. Issues such as whether there are encumbrances on the real estates, the suitability of IT assets if the target is an IT company (e.g. server, etc.), building usage and zoning status, lease agreements, etc. are examined in the process.
  4. Material Agreements: Material contracts, such as customer, supply, confidentiality and other long-term contracts are a part of the DD exercise as well. Any long-term risks under such agreements and change of control clauses which may require prior approval of third parties would be reviewed here. Related party relationships and agreements usually comes as a main review and discussion point, especially if the target is being fully acquired, as many companies in Turkey carry out related party transactions within their daily business. To detect and decide whether such relationships would continue or not is usually a critical part of the DD process.
  5. Financial Agreements: In addition to material agreements, a specific focus would be needed on financial agreements, such as loans and financial lease agreements. On that point, as the financial agreements in Turkey are usually secured with a full set of collaterals, such as share pledge, immovable property pledge, account pledge, sureties, commercial enterprise pledge, all financial and security documents are requested and evaluated thoroughly to determine the financial debts and securitization of the company. Items discovered in such step are also a part of the deal mechanics, as the continuation and / or removal of the collaterals should be structured well within the purchase agreements.
  6. Licenses and Regulatory: License and regulatory compliance review scope would be dependent on the business of the company. Usually, a basic review of standard operating licenses of the target, such as workplace opening license is sufficient for a company which does not operate in a specific regulatory sector. Whereas, if the target operates in a regulated sector (i.e an energy company or a company with a banking license), a more detailed review is made, which may also involve review of contracts and correspondence with public institutions.
  7. Environment: As to separate environmental DDs, while a through ESG based due diligence is not yet an established practice in Turkey, if a business is subject to environmental legislation, environmental permits and licenses are examined, which is usually done in addition to the technical DDs on environmental permits.
  8. Employment: In terms of employment, questions aimed at identifying the key personnel and whether they have sufficient contracts with adequate legal protection (e.g. non-compete and IP) is important. Also, issues such as overtime work, work accidents and the subcontractor risks are reviewed carefully.

    If there are foreign employees, in addition to questioning whether the work permits are complete, whether the target complies with the conditions (minimum capital or annual turnover obligations) to hire foreign employees are reviewed.

  9. Information Technologies and Intellectual Property: In terms of IT and IP, various intellectual property elements would need to be examined, such as copyright, trademark, patent, website and logos. Especially if the target is an IT company, additional IT assets and license investigation is also significant.
  10. Data Privacy and Data Protection: Especially for IT companies or any company handling personal data, a through data protection review would be needed, as Turkish rules may differ from GDPR.
  11. Litigation: Determining the litigation risk by initially requesting a legal counsel report on ongoing cases is essential to detect the litigation risks which may be significant for the deal. A more thorough review of the case files may also be necessary depending on the litigation risks discovered in the initial review.
  12. Insurance: A basic review on insurance policies of the company to detect whether the company has necessary insurances for continuation of its activities is usually completed as well.

Once the responses and documents are uploaded to the VDR, an additional follow up sessions are also usually needed in a standard DD process, as the initial documents may bring forward additional points to be assessed.

Limitations on the DD process and scope  
Frequently, the buyer wants as much time as necessary to conduct a thorough due diligence, whereas the seller will want to limit the length and scope as much as possible. Limitations may be requested for various matters, such as:

  1. Scope and materiality. In some cases, where the buyer is keener to complete the review in a shorter period of time and the seller wants to limit the DD process, certain limits on the scope may be agreed, depending on the size and risks of the target. Usually, materiality thresholds are requested by the sell-side, which would involve;

       – limiting the scope and documents with material items. For instance, for an IT company, the DD may focus more on corporate, employment and IP and IT issues. While for an energy company, a through IP due diligence may not be needed. Besides the limits on the scope, there may be monetary limits for major contracts.
       – time limits for some documents, such as not going beyond 5 years for corporate documents.

  2. Protecting confidential information. In order to protect sensitive information, certain limits on the documents are usually proposed by the sellers. Excluding certain categories of information would be accepted, such as commercial secrets, salaries and employee costs breakdown and financial content of the top-management contracts. Redactions on confidential parts of the documents are also usually proposed, so that the buyer gets a general idea on the document without having access to sensitive information. In that regard, sellers often request buyers to sign NDAs to protect sensitive information, which is common for a standard deal.
  3. Vendor DD. In some cases, the sell-side conducts a vendor DD, prior to initiation of the DD of the buyers. In case of existence a vendor DD, sell-side may request that an additional buy-side DD is not conducted and the buyer suffices itself with the documents provided in the vendor DD.

In any case, if there are issues that attract specific legal risk attention, those would also need to be reviewed even if there is a limit. The buyer must evaluate how to mitigate the risk stemming from such lack of review. Even if the target firm succeeds in reducing the amount of information disclosed to the target firm, depending on the deal, this may mean inclusion of more representations and warranties in the purchase and sale agreement. This will no doubt add to the negotiating time, if buyer would tend to include all items not covered in DD as a risk item in the transaction documents.

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