Legal due diligence before equity investment

By Cai Zongxiu, AnJie Law Firm 
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The main operation procedure of private equity investment funds is “fundraising-investment-management-exit”. In the investment process, there are problems of information asymmetry, and passive response, or even intentional concealment of the true situation, by the invested party, which adds hidden dangers and risks to the investment. Therefore, it is crucial to do legal due diligence before investment. This article analyses the legal due diligence in the investment process and provides guidelines for the legal issues that both parties to the transaction need to pay attention to in the investment and financing process.

蔡宗秀, Cai Zongxiu, Partner, AnJie Law Firm
Cai Zongxiu
AnJie Law Firm

Q: What is legal due diligence?

A: Due diligence, also known as “prudential investigation”, originally means to conduct proper or due diligence duty. Legal due diligence of private equity investment projects refers to the investigation of a series of legal issues of the target company by a professional lawyer hired by the investor after the initial co-operation intention is reached with the target company.

Q: Why is legal due diligence needed?

A: First of all, through due diligence, the investor can understand all aspects of the target company in detail, and solve the information asymmetry problem between the two sides of the transaction to a certain extent, thus reducing the investment risk. Second, the investor can improve its negotiation position, know the problems of the target company through due diligence, make a more reasonable offer, adjust the deal structure, or even reject the deal. Finally, due diligence is the reference base to prepare transaction documents.

Q: What aspects should be checked to complete legal due diligence?

A: We check the target company from the following 13 aspects.

(1) Current status of the target company, including its basic information as stated in its business licence, shareholding structure, business credit situation, etc.

(2) The history of the target company, including whether its establishment procedures and conditions are satisfied, and its historical development, etc.

(3) The registered capital of the target company, including whether its shareholders’ capital contribution is paid in, the transfer situation of non-monetary capital contribution, etc.

(4) The compliant operation of the target company, including its articles of association, internal organisational structure and operation status, qualification of directors, supervisors and officers, violations of laws and regulations, capital management system, etc.

(5) The independence of the target company, including whether its assets, personnel, finance and institutions are independent.

(6) The finance and taxation of the target company, including its audited financial reports for the past three years and one certain period, its own and its subsidiaries’ tax registration, and basic information on tax payment, tax incentives and financial subsidies.

(7) Business development and technology of the target company, including its business scope, business qualification, business model, core personnel, technology research and development, business development strategy, etc.

(8) The major assets of the target company, including the assets owned by itself and its subsidiaries, such as major buildings, major intangible assets, major production and operation equipment, long-term investments in others, important assets outside of China, and encumbrances.

(9) Intellectual property rights, including a summary of all IPR held or owned by the target company (including patents, trademarks, service marks, trade names, know-how, logos, domain names, software copyrights) and their registration certificates and extensions, transfer or licence agreements with third parties for the above IPR and relevant registration certificates, existing or potential disputes concerning IPR, technology contracts, etc.

(10) Material debts and liabilities, material contracts to be, or being, performed by the target company, potential risks of fully performed contracts, other significant receivables and payables, material debts arising from infringement, etc.

(11) Related-party transactions and horizontal business competition, including its related parties and affiliations, the existence and fairness of related-party transactions, the existence of horizontal business competition between the target company and its related parties, and disclosure of related-party transactions and business competition.

(12) Human resources and labour relations, including the employees of the target company (including the number of employees, professional structure, education level, age distribution, etc.), part-time employment of board members and officers, proof of social security, and proof of payment of relevant fees.

(13) Litigation, arbitration and administrative penalty matters, including any and all litigation, arbitration, administrative penalty or administrative reviews that have occurred, are ongoing, or have obvious indications that may occur involving the target company.

Q: What is the significance and role of legal due diligence in equity investment?

A: First of all, after the legal due diligence is completed, the lawyer should prepare a legal due diligence report and provide it to the client. Its content usually includes: An overview of the basic facts of each major issue; a summary and analysis of the major issues, with legal defects or risks that may be involved; a comprehensive overview of the legal analysis; and a concluding opinion.

Second, based on the results and suggestions of the legal due diligence report, the parties to the transaction may negotiate on which party should bear the objective risks in order to clarify the rights and obligations of both parties, determine the terms of the contract, agree on the valuation of the investment, and improve the transaction plan.

Finally, the parties make representations and warranties regarding the potential risks that cannot be determined through due diligence, and transfer or reduce the risks through this clause. Therefore, the representation and warranty clause is a supplement to due diligence and can fill the loopholes of due diligence to a certain extent.

Cai Zongxiu is a partner at AnJie Law Firm

Dong Xiao Zhao Huili AnJie Law Firm International arbitration

28/F, K. Wah Center

1010 Huai Hai M. Road
Shanghai 200031, China

Tel: +86 138 1798 1380


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