Due Diligence in Demergers: Key Aspects and Considerations

Due Diligence in Demergers: A Comprehensive Guide

Demergers, the separation of one company into two or more businesses, are complex transactions with unique due diligence requirements. Due diligence in demergers aims to identify potential risks and assess the impact on the new entities, their tax status, financial implications, and customer obligations. This guide will explore the key aspects of due diligence in demergers, providing insights into the process, its importance, and how it differs from due diligence in mergers and acquisitions (M&A).

The Role of Due Diligence in Demergers

The purpose of due diligence in demergers is similar to that in M&A: to provide accurate information, increase chances of success, and prevent costly mistakes in the long run. It plays a crucial role in identifying any existing or potential risks and liabilities associated with the target company's operations, helping both parties make informed decisions during the transaction.

Key Issues in Demerger Due Diligence

Financial Analysis

Financial due diligence in demergers involves analyzing the financial health of the business being separated, including revenue streams, profitability, assets, liabilities, and cash flow. Additionally, it may require a review of historical tax returns, government audits, and correspondence with taxing authorities to understand any potential liabilities associated with the new entities.

Tax Implications

Tax due diligence in demergers focuses on identifying any income, sales, or other tax returns filed by the company over the last five years, government audits, and correspondence with taxing authorities regarding any filed returns or failures to file. It is essential to understand the potential impact of a change in control on net operating losses, credit carryforwards, and tax sharing agreements.

Customer and Warranty Obligations

Due diligence should also address customer-related issues such as warranty obligations, repair indemnification arrangements, liquidated damages claims, and the status of sales backlog. Understanding these aspects will help assess the financial risks associated with the new entities' customer relationships.

Technical Due Diligence

Technical due diligence in demergers may involve an investigation into technological strategies, information technology infrastructure, technology processes, tech staffing contracts, intellectual property documents (including licenses and patents), internal audit reports, policies and procedure documents, products and services architecture, software architecture, and security mechanisms and development frameworks. This approach helps determine significant risks affecting operations, particularly those related to integrating legacy systems and identifying environmental concerns.

Environmental Considerations

Environmental due diligence involves examining the site's history, current operations, and surrounding areas for existing or potential environmental risks and liabilities that could impact the property. This evaluation assists parties in determining the distribution of risks and liabilities post-completion, allowing them to develop negotiation strategies and identify opportunities to mitigate associated costs.

Compliance and Cybersecurity Assessment

Comprehensive due diligence in demergers must include a review of regulatory compliance records, including environmental regulations at local, state, and federal levels. Additionally, cybersecurity due diligence is crucial to ensure the target company's data protection tactics and general cybersecurity measures are up to par. This prepares both parties for potential post-transaction challenges.

In conclusion, due diligence plays a pivotal role in demerger transactions by providing valuable insights into potential risks and enabling informed decision-making. A thorough assessment of financial health, tax implications, customer relations, technical capabilities, and environmental factors will significantly reduce uncertainty and prevent costly mistakes during and after the transaction.