Due Diligence in a Corporate Acquisition

Due Diligence as a Strategic Tool for Investment Protection

From a legal perspective, it is a fundamental tool for risk management and the proper valuation of a transaction. Without it, a seemingly advantageous purchase can quickly turn into a financial disaster. The case law of Czech courts confirms that conducting due diligence before acquiring a business is one of the prerequisites for fulfilling the duty of members of a statutory body to act with due managerial care.

The due diligence process is properly structured and begins with the seller making documentation available through a secure virtual repository (Data Room). Based on these documents, the buyer conducts a thorough assessment, the output of which is a written report containing a risk analysis.

Cooperation between the various teams of specialists, which the lawyers at ARROWS law firm regularly coordinate, is crucial.

In practice, legal, financial, and tax due diligence are most often combined, with the scope of the review depending on the area of business and the size of the company.

In addition to the three basic pillars, specialized reviews are added depending on the nature of the target company. Their scope is always a matter of the cost-to-risk ratio, not an automatic checklist—for a small company with a single lease agreement, it makes no sense to order four separate analyses.

• Real estate due diligence — for companies whose substantial value lies in buildings or land. It verifies ownership, encumbrances, compliance of buildings with the land registry records, and their defect-free status under construction law. A special chapter is unrecorded buildings, which do not appear in the land registry at all. More details in the article real estate portfolio review.

• HR due diligence — for companies where value is created by people. It reviews contracts with key employees, non-compete clauses, unused vacation, and wage liabilities. See HR due diligence.

• Environmental due diligence — for manufacturing and industrial sites where there is a risk of liability for old environmental burdens. The costs of remediating contaminated soil can rewrite the entire economics of a transaction, and liability for them passes to the new owner of the company. See environmental due diligence.

• Technology due diligence — for software and technology companies. It focuses on whether the company actually owns the rights to the developed software, whether licenses for used components, including open-source, are properly handled, and whether key knowledge is not tied to individuals without contractual security. Unclear ownership of intellectual property is one of the most common findings in technology acquisitions that drive down the price—if you are buying software, you are buying a license chain, not just code.

• Building plot due diligence — for acquisitions aimed at future construction. It addresses the zoning plan, access to the land, utilities, protected zones, and whether the project is even permittable.

• Due diligence in regulated industries — for companies operating under a license or permit (financial services, healthcare, energy, food). The key question is whether the authorization will survive the change of ownership and whether the regulator's consent is required.

• Due diligence of subsidies and state aid — if the target company has received a subsidy, it is often associated with a project sustainability period and an obligation to report changes in the ownership structure. A breach can mean repaying the subsidy, including penalties, even after the transaction is complete.

Financial Due Diligence: Uncovering Hidden Financial Risks

Financial due diligence focuses on a detailed analysis of the accounting, financial statements, assets, and liabilities of the target company. It is a review designed to answer key questions about the company's real financial health and the existence of hidden debts.

Common findings from a financial review include the failure to account for potential liabilities that may arise from litigation. Other frequent issues are uncollectible receivables or the company's failure to comply with its legal obligations, which auditors must unravel.

The difference between a statutory audit and financial due diligence is that an audit verifies the true and fair view of the accounts as of a date in the past. Due diligence, in contrast, focuses on the sustainability of results, EBITDA normalization, and the future development of the company.

The Most Common Financial Problems in Acquisitions

When buying a company, the buyer faces a number of risks, such as overdue receivables, poorly structured loans, or overvalued assets. Careful record-keeping and thorough financial analysis should prevent financial disarray.

A potential buyer of a company should be interested in whether the company has loans and under what conditions it is repaying them. It is also necessary to check for the existence of so-called covenants and overdue liabilities.

Another risk is uncollectible receivables, where enforcement is ineffective due to the debtor's insolvency. In accounting, such risks should be reflected in the form of provisions; otherwise, the company presents a distorted picture of its assets.

Without a cash flow analysis, you could buy a company that is profitable on paper but lacks the funds to pay wages or settle liabilities. In practice, we often encounter situations where a company shows a profit on paper but has serious cash flow problems in reality.

Assets and Their Valuation

A company's assets must be correctly recorded in the accounts, so when reviewing real estate or inventory, it is crucial to verify the reality of their book value. A common problem is the incorrect distinction between asset repair and technical improvement, which affects the tax base.

A specific risk arises with real estate if the price is not correctly allocated between the value of the building and the land, leading to incorrect depreciation. If you are buying a company with significant assets, it is advisable to arrange for an independent valuation or technical inspection.

Accounting and Documentation – Hidden Errors

Proper accounting is a legal obligation, and neglecting it can lead to high penalties. If a company does not publish its financial statements, it faces a fine of up to 6% of its total assets under the Act on Accounting.

For a new owner, it is difficult to trace historical data if documentation is missing. Therefore, financial and tax due diligence involves reviewing historical periods, usually 3 to 5 years back, and in justified cases, even longer.

Tax Due Diligence: Hidden Risks in the Tax System

Tax due diligence reviews compliance with tax obligations and identifies the risks of additional tax assessments, penalties, and late payment interest. It focuses primarily on corporate income tax and VAT, but also on other taxes for specific entities.

Main Areas of Tax Review

Tax due diligence uncovers risks and quantifies their financial impact. It primarily monitors the correctness of tax returns, the existence of arrears, the setting of transfer prices, the application of VAT deductions, and the use of investment incentives.

The result is a risk overview (Red Flag Report), which serves as a basis for negotiating a discount on the purchase price. This report also helps in defining specific warranties in the purchase agreement.

Transfer Pricing – An Often Overlooked Risk

One of the riskiest aspects for group-affiliated companies is transfer pricing. Prices agreed between related parties must correspond to prices that would be agreed between independent entities in normal business relations.

If the prices differ from market prices and this difference is not satisfactorily documented, the tax administrator will assess the difference, including penalties. Transfer prices have long been in the crosshairs of the Financial Administration, and late payment interest can reach high amounts.

The solution is to have high-quality transfer pricing documentation (Master File and Local File). Although Czech law does not strictly prescribe a mandatory form of this documentation for all entities, defending oneself before the tax office without it is extremely difficult.

VAT and Its Complexity

Value-added tax is an area with frequent errors, and it is necessary to check the eligibility of claims for VAT deduction. It is also important to check the correct reporting of cross-border transactions.

Risky areas include the defensibility of the right to deduct VAT on received supplies and the correct determination of the place of supply for services. It is also necessary to check for liability for unpaid tax by a supplier, i.e., the institute of the unreliable payer.

Tax Deficits from Past Periods

The standard statute of limitations for tax assessment is 3 years, but it can be extended up to 10 years. If you buy a company with a hidden tax liability from the past, the tax office will collect the tax from that company, meaning effectively from your new investment.

Typically, tax periods for which the statute of limitations for tax assessment (preclusion period) has not yet expired are reviewed. This usually covers the last 3 to 4 years, and longer (up to 8–10 years) for companies with tax losses or investment incentives.

The Due Diligence Process in Practice: From Data Collection to Conclusions

The course of due diligence requires a systematic approach, with the first step being the preparation of a list of required documents (Request List). This list is always tailored to the specific industry and the specifics of the transaction.

Preparation and the Data Room

The seller or their advisors prepare a Data Room, which is a secure electronic repository for uploading contracts and statements. Access to this repository is controlled and monitored to ensure the confidentiality of information.

Experts from ARROWS law firm regularly work with virtual data rooms, which ensures efficiency, data security, and a clear process.

For transactions with an international element, the scope of the review is expanded to include issues that do not arise in purely domestic business—the governing law of individual contracts, compliance with regulations of multiple jurisdictions, and the tax implications in the country of the target company's registered office as well as in the buyer's country.

This is particularly sensitive for real estate portfolios spread across multiple countries, where both land registry systems and rules for the acquisition of real estate by foreign entities differ; what is a standard mortgage in one country may be unregistrable in another. Thanks to our own international network, ARROWS International, we handle these cases in a coordinated manner from a single point, so the client does not have to piece together outputs from several independent firms.

Q&A and Management Presentations

After reviewing the documents, the questioning phase (Q&A process) follows, where the buyer's advisors ask clarifying questions about any ambiguities. This often includes interviews with key managers to help understand the business model and strategy.

Analysis and Evaluation (Red Flag Report)

The output is not just a description of the situation, but primarily an identification of risks categorized by severity. The report usually classifies findings as Deal Breakers, high-risk areas requiring indemnification, and less serious risks that can be addressed in the normal course of business. The entire discussion so far has been from the buyer's perspective. However, the seller goes through the same process—just from the opposite side of the table, and often significantly less prepared.

The core of the problem is information asymmetry. The seller knows their company; the buyer is just getting to know it. As soon as the buyer's advisors encounter an unexpected finding, price negotiations begin—and this is not the buyer's fault, but a consequence of the seller either not knowing their weaknesses or being unable to document them clearly. In practice, we see the same thing over and over: companies that are great at business but are not prepared for a sale. They haven't mapped their risks, documented their assets, or resolved their legal and tax thorns.

The defense is not to claim that "everything is fine." The defense is thorough and documented preparation. If a seller has their own review done before opening the company up to a buyer, they can eliminate many findings before they become leverage on the price. For example, if they discover unsettled liabilities to employees for unused vacation, they can resolve them calmly. If they come across a clause that allows a key customer to terminate the contract upon a change of ownership, they can negotiate an addendum with the partner—at a time when the transaction deadline is not yet pressing.

This procedure is called vendor due diligence, and we cover it separately in the article due diligence from the seller's perspective. What specifically to clean up before opening the data room is discussed in the text how to prepare a company for a review.

The entire process of preparing a company for sale from the owner's perspective—from valuation to signing—is described in the book How to Sell a Company with Real Estate, written by ARROWS managing partner Jakub Dohnal. A separate chapter is dedicated to due diligence from the seller's point of view.

Change of Control and Its Consequences

A significant risk are Change of Control clauses, which give the other party the right to terminate a contract in the event of a change of ownership. These contractual provisions can also lead to a demand for immediate repayment of debt.

Where These Clauses Are Found

Change of Control clauses are typical in loan agreements, where banks reserve the right to accelerate the loan. They are also found in contracts with key suppliers, in lease agreements in premium locations, or in license agreements.

Solutions in Practice

The team at ARROWS law firm systematically searches for these provisions during legal due diligence. If they are identified, it is necessary to obtain written consent from the affected partners before completing the transaction, or to arrange for refinancing of the loans.

Legal Due diligence: The Foundations of a Safe Purchase

Legal due diligence focuses on the validity of the company's existence, ownership of shares, and contractual relationships. The goal is to verify that the company is legally sound and that there are no obstacles to its transfer.

Key Areas of Legal Review

• Corporate history : Verifying that the company was duly established and that all historical transfers of shares were valid.

• Ownership of shares/interests : Checking the chain of title.

• Labor law : Contracts with key employees and non-compete clauses.

• Intellectual property (IP): Verifying copyrights to software and licensing arrangements.

• Litigation : Analysis of ongoing and threatened proceedings.

Historical Title Defects

A risk is the invalidity of historical share transfers, for example, due to a missing general meeting approval. In such a case, the seller may not be the true owner, and it is necessary to rely on the institute of acquisitive prescription or to arrange for special insurance.

Seller's Guarantees and Their Role in Transactions

The results of due diligence are directly reflected in the purchase agreement in the form of representations and warranties. These mechanisms serve to allocate risk between the buyer and the seller.

Representations & Warranties

In the purchase agreement, the seller represents that the company has certain characteristics, for example, that it has no tax arrears. If the opposite turns out to be true, the buyer is entitled to a discount or compensation for damages.

Indemnities – Direct Compensation

For specific identified risks, such as an ongoing tax audit, a so-called Indemnity is agreed upon. Here, the seller undertakes to reimburse the buyer for every crown of damage arising from that risk.

Disclosure Letter

The seller is released from liability by informing the buyer of defects in a so-called Disclosure Letter. What is stated in it is generally not the seller's responsibility, because the buyer was aware of the risk.

Employees and Labor Law Aspects

In a share transfer, the employer remains the same, whereas in a sale of a business, there is an automatic transfer of rights and obligations. This process is governed by the Labor Code and protects employees from a deterioration of their conditions.

Information Obligation

The Labor Code imposes an obligation to inform employees about the transfer and to discuss its consequences with them in sufficient time. A breach of this obligation is subject to a penalty from the labor inspectorate of up to CZK 200,000.

Earn-Out and Transaction Insurance

If the parties cannot agree on a price, an earn-out is used, where part of the purchase price is paid out later. The condition is that the company achieves set financial targets in the following years, usually within one to three years.

In modern transactions, W&I insurance (Warranty & Indemnity Insurance) is increasingly used. In the event of a breach of the seller's warranties, the damages are paid not by the seller, but by the insurance company, allowing the seller a clean exit.

Conclusion

Financial and tax due diligence is a complex process requiring expertise. Neglecting this phase can lead to fatal losses and personal liability for management.

The lawyers at ARROWS law firm can identify risks, propose solutions, and reflect them in the contractual documentation. We have experience from many transactions and will ensure that your investment is safe.

If you are planning an acquisition, don't take risks and turn to professionals. Contact us at konzultace@arws.cz for a no-obligation consultation on your project.