How this guidance note can help
This guidance has been developed by CollaborationNI to help VCSE organisations understand what is meant by the term ‘due diligence’, and to assist organisations considering merger or joint tendering understand what is involved in the process of appropriate risk assessment when considering collaborative working.
This guidance note can help you:
- better understand what due diligence is
- understand what the major areas of investigation in a due diligence exercise should be
- have an overview of how a due diligence exercise is carried out
- understand how to act on the findings of a due diligence exercise
What is due diligence?
Most often used when planning a merger, due diligence is an investigation exercise that each organisation undertakes to obtain a better picture of the other organisation(s) involved, including:
- potential risks involved in working together
The due diligence exercise investigates the records of the other organisation(s) to find out whether there are matters of concern or matters which require further information.
Due diligence provides comfort that collaborating or merging is in the best interests of each organisation and its beneficiaries and that the process can be supported by warranties and indemnities in the Merger Agreement.
When merging or joint tendering, an organisation is exposed to various risks and liabilities, so care must be taken to identify all potential risks before entering into an agreement to merge or work collaboratively. Due diligence should expose all potential risks, including liabilities, which could arise as a consequence of a merger. This will help eliminate post-merger surprises.
Trustees of a VCSE organisation must comply with their legal duty to act prudently and in the best interests of the organisation. They should ensure that any potential risk to their organisation has been identified and managed appropriately.
The cost of due diligence is a proper use of VCSE funds and can create and build trust and confidence which in turn will increase the likelihood of a successful merger. It is advisable to arrange regular reviews of the cost of due diligence to ensure its continuing proportionality to the risks involved.
There is more in depth analysis of due diligence and the areas to be covered by a due diligence exercise on the Charity Commission for England and Wales (CCEW) website entitled Collaborative working and mergers: an introduction (CC34). Charities may also find the CCEW Due Diligence Checklist useful.
Areas of investigation for a due diligence exercise
The three main areas of investigation which are typically included in the due diligence exercise are:
- commercial or operational
Legal due diligence will focus on legal issues such as:
- the constitution or governing documents of the organisation
- its powers and objects
- freehold or leasehold property
- contracts of employment
Although the areas of investigation for due diligence can be approached in any order, or simultaneously, it is advisable to begin by looking at the constitutions or governing documents of the organisations involved.
The charitable objects of the merging organisations must be compatible. The investigation should establish whether there is a power in each constitution to allow for the merger or collaboration of the organisations and to ensure that merger or collaboration can occur. There may also be issues in relation to the rules for appointing trustees to the newly merged body which may need to be checked and considered.
When considering the constitution or governing documents, the investigation should also examine whether the organisation is being run according to its constitution, and if not whether the constitution needs to be amended to reflect the organisation’s current practices.
Legal due diligence should look into whether the organisation holds any freehold or leasehold property and consider any issues relating to deeds or leases, eg the full details of any properties and whether there are any onerous clauses like:
- repair obligations
- charges (eg rates or service charges)
- requirement for the landlord’s consent for lease transfers
Contracts of employment should be reviewed and information relating to employees should be shared. This includes details such as:
- how many are, or will be, employed by the new organisation
- whether the terms and conditions are compatible for transferring employees
- whether The Transfer of Undertakings (Protection of Employment) Regulations 2006 and the Service Provision Change (Protection of Employment) Regulations (NI) 2006 (collectively known as ‘TUPE’) need to be taken into consideration
More information is available in the CollaborationNI Guidance Note entitled TUPE.
Financial due diligence will focus on an organisation’s financial affairs and will identify any financial risks and financial opportunities arising from the merger or collaboration. Financial due diligence will typically set out the organisation’s financial history, and include copies of accounts going back over the last three financial years. It may also include:
- financial results and forecasting
- accounting policies
- assets and liabilities
- management information
- accounting systems information
It should be noted that all accounts must be looked at within the current financial landscape.
Financial due diligence is extremely important as it can also help determine what legal structure is best suited for a merger. This financial investigation should also highlight whether any arrangements with banks or funders are subject to any ‘claw back conditions’ or ‘change of control provisions’. These restrictions can increase the transactional cost of a merger significantly. The trustees should be mindful of these issues particularly the transfer of any pension deficit.
Commercial due diligence involves agreeing the extent of the work of each organisation by, for example, conducting a SWOT analysis (strength, weaknesses, opportunities and threats).
It would also be beneficial to review the risk register and any appropriate minutes.
If the organisations merge there may be issues that need to be considered with regard to funders and donors. An assessment will need to be made as to whether or not funders will continue to support and fund the merged charity. As outlined previously, some banking and funding arrangements contain restrictions on change of control and claw back conditions.
Other charities with similar objectives should be identified in order to assess whether there is potential for too much competition in the relevant area of service provision or geographical area and whether the merged charities would be able to achieve their charitable objectives as a result.
What to consider when carrying out the due diligence exercise?
When carrying out a due diligence exercise there are a number of factors that a board should consider.
Who carries out due diligence?
It is important to be aware that there are no conventions for the best process to follow in a VCSE merger, unlike in commercial mergers; due diligence exercises vary in scope and depth from one merger to another. The process can be quite intensive and demanding so organisations will need to ensure that they apply appropriate resources, finances, and time commitment to the exercise.
Due diligence can be carried out by the organisations’ trustees and it is the trustees who should decide whether external professional assistance is required. The advantage of engaging a professional to undertake due diligence is that:
- they will have the necessary specialist skills and experience for the task
- they will be able to ask challenging questions
- they will be able to act independently and objectively
Thought should be given to the cost implications if more than one external advisor is appointed (eg if there is one for each party).
In deciding whether or not to carry out the due diligence process in-house, trustees should consider the following questions:
- Do the trustees have the necessary experience?
- Are the trustees able to act with sufficient independence and objectivity, ie are they able to ask difficult questions without affecting the relationship between the partner organisations?
- Do trustees have the available time to be able to take on a due diligence exercise?
Any due diligence exercise should be proportionate to the size and nature of the organisations, the proposed project, the finances and funding involved, the nature of the activities involved and any risks.
Due diligence should be commenced quite promptly once the parties have agreed to merge or collaborate; this allows for the identification of any problems early on in the process so that they can be worked through in a timely manner without disrupting the proposed timetable.
It is beneficial to agree the scope of the due diligence work for each partnering organisation and external professional advisor before it commences. A Memorandum of Intent and Confidentiality Agreements should be exchanged before the due diligence is started. The Memorandum of Intent sets out:
- the preliminary intention of organisations to merge
- the reasoning behind the decision to pursue a merger
- intention to formalise a definitive Merger Agreement
- how transaction costs will be divided between the organisations
- an agreement that the Memorandum of Intent does not form any legal obligation unless and until a definitive Merger Agreement is executed
This Memorandum of Intent should also contain agreement by the organisations that they will not negotiate or consider any other organisation’s proposal to merge. It is vital that the confidentiality obligations are made binding.
Charity Commission for Northern Ireland
In a merger of VCSE organisations with charitable recognition the Charity Commission for Northern Ireland (CCNI) will need to be notified so that the Register of Mergers can be updated.
In most cases a merger will not require the consent of CCNI, however if an organisation does not have the appropriate power in its constitution or governing document then it can be requested from CCNI. The charities’ governing documents may include trustees’ power to merge with other charities, but this should be carefully checked in each case and professional advice obtained.
Check the CCNI website as updated advice and new information and resources are being added regularly.
You will find more information on how the Charity Commission for Northern Ireland will manage mergers and closures here.
Due diligence outcomes
Once the due diligence exercise is complete, it should provide the trustees with a detailed and comprehensive picture of its prospective merger or collaboration partner(s). It should also increase the level of trust between all the organisations.
There are various possible outcomes to a due diligence exercise:
- It may not uncover anything of serious concern and therefore the merger or collaboration can go ahead as planned.
- There may be some discrepancies highlighted which will require clarification; as a result the merger or collaboration and its timeline may be delayed in order to discuss these issues or to renegotiate terms.
Always remember you do not have to merge!
Once the due diligence process is complete, the board may resolve not to continue with the merger or collaborative project.
This can be a difficult decision for a board, particularly after spending time, effort and money on the process generally, and on due diligence in particular. If the board has serious concerns however, it is right that the decision to merge or collaborate should be reconsidered and, if necessary, abandoned.
Trustees should be aware that they have ultimate responsibility for the decision on whether to proceed with a merger or collaboration once they have seen the outcome of the due diligence exercise.
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