Why is Due Diligence Important Before Signing a Contract? | LegalVision UK (2024)

As a business, you should always be cautious about who you go into business with. This applies to both customers and suppliers of products and services. Before entering a contract, research the other party and understand their motives for entering the agreement. Doing so can help you decide whether you want to work with them and highlight any risk issues you should note. This article explores why due diligence is important before signing a contract.

Risk Management Process for Contracts

Contracts, when entered into correctly, are legally binding documents. You take on unknown business risks and potential liabilities each time you enter into a new contract. For example, failing to meet your contractual obligations could result in your customer suing you and claiming damages. As such, it is vital to think carefully before entering into contracts.

Consider whether you can comply with your obligations, what risks the contract will involve and whether you can develop good working relationships with the other party.

What is Due Diligence?

Generally, there are various steps to take when forming new commercial relationships, including:

1. researching the other party by carrying out due diligence;
2. negotiating and signing a contract with the other party; and
3. starting and running the project as per your agreed contract terms.

In a contractual context, due diligence is your research and investigation of a business counterparty before entering into a contract with them. Due diligence is an initial step to gather information and help manage contract risks.

As a supplier, immediately signing new customers to your business can be tempting. However, it is essential to conduct research before you do so to identify potential problems and particular areas of risk.

What Questions Should I Consider?

As part of your customer due diligence, you should research and consider the following key questions.

When is Due Diligence Necessary?

Customers should also carry out due diligence on prospective suppliers. Before working with a new supplier, you should research the supplier’s track record by checking reviews, past experience and market reputation. This can give you an understanding of whether you wish to work with them.

In some circ*mstances, due diligence can help you comply with a legal obligation. For example, data controllers must be satisfied that data processors who will process data on their behalf have appropriate security measures. Diligence investigations can help demonstrate that a controller has conducted a diligence review to identify potential risks to personal data. This can help evidence compliance with the UK GDPR requirements.

It is also a good idea to conduct due diligence on potential business partners, for example, before entering into a joint venture or collaboration agreement with a third party. Due diligence can help you identify any red flags and make an informed decision before proceeding with the business relationship. For instance, if intellectual property is a big part of your project, you can investigate which intellectual property rights the potential third party partner owns.

Due diligence is also vital for sales and purchase transactions, where you are selling or buying a target business.

How Can Due Diligence Help You Before Signing a Contract?

By answering the questions above, you will be well-equipped with the knowledge required to mitigate contract risks. You can place legal contracts that protect you from any potential liabilities you may have identified during the due diligence process.

Below are some examples of how due diligence can help you.

Help You Decide Whether to Pursue the Contractual Relationship

You may not want to proceed with a commercial relationship if your due diligence identifies major red flags. For example, due diligence may reveal that a supplier has poor service reviews and often fails to deliver products on time. As such, as a customer, you may decide to work with a different supplier.

Whilst disappointing, it is far better to determine this early rather than enter into a contract and face problems from the supplier later down the line.

Help You Consider the Risks Your Contract Should Protect Against

If your due diligence reveals certain risk areas, you can use your findings to include robust protection in your legal contracts.

For example, as a supplier, you may have doubts over the creditworthiness of a particular customer and worry about them defaulting on payment. If you wish to give them the benefit of the doubt and work with them, you can include robust payment terms in your contract.

Amongst other terms, your contract could include a clause requiring the customer to pay:

• a deposit so you have some security; or
• interest for late payments, which could help prompt them to pay you on time.

This way, you can help prevent against the risks of what could go wrong by including specific protections in your contract.

Key Takeaways

Taking pre-contractual steps to identify risks and carrying out due diligence is important. By carrying out due diligence before entering into a contract, you can avoid unpleasant surprises later down the line. Doing due diligence is a good idea to help you understand whether you could have a good working relationship with the other party and gauge if you want to proceed with signing a contract. If you identify risks you are concerned about, you can protect yourself by including robust legal provisions in your contract.

If you need help with a contract or advice on legal issues around entering a contract, our experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.