In June, I began a series of blogs regarding the most important legal considerations in the mergers and acquisition process. The first blog discussed the mergers and acquisition process at a global level generally laying out the six most important legal considerations in the process. In the second blog of the series, I dove deeper into the first step of the process, engaging a financial advisor and drafting the engagement letter. The third blog discussed the drafting of the nondisclosure agreement. The fourth blog detailed the negotiation and drafting of the term sheet or letter of intent.[1]
This fifth installment focuses on the due diligence process. In the context of the purchase, sale, or merging of companies, the due diligence process involves the potential buyer going through the records of the target company to see whether it is actually worth what the buyer hopes it is worth and determining whether there are potential risks that would warrant not going forward with the deal. If this step has been reached in the process, most likely the acquirer has already engaged in some level of informal due diligence on the target company to determine whether it is worth pursuing, but all of those steps are just prelude to the formal due diligence phase which will shape the final terms of the deal and whether the sale of your company will indeed happen at all.
Buying a business is a risky endeavor. What makes the process even more nerve-wracking is that a business is different from just about any other asset one can buy. When one purchases a house, car, or other tangible product, a buyer usually knows what they are getting, can inspect the product, and can inspect the goods, giving one a chance to uncover hidden problems (or pay an expert to find them). A business, in contrast, is largely intangible. While some aspects may be tangible, most are not. The business will likely have receivables, inventory, intellectual property, and goodwill/reputation. Many of these assets may not have the value that the seller claim they have, and may be very difficult to value objectively. The business will also likely have liabilities like hidden debts and potential lawsuits. Discovering the true extent of these liabilities is crucial in making sure the purchase of the business is worth pursuing. Finally, there are many intangible considerations that go beyond just the company’s balance sheet. How does the business operate as a whole? Is the management team effective and will they stay involved after change in ownership? How are the relations between business and customers?
Because there are so many hidden traps in buying a business, purchasers will usually engage in due diligence on their target acquisition. The main purposes behind due diligence are (1) verifying the information provided by the seller is accurate; and (2) uncovering any material information that the seller has not already provided, either intentionally or unintentionally. Surprisingly, unintentional omissions are actually quite frequent. Buyers often discover potential legal liabilities of their target or asset impairments due to previous regulatory violations or poor legal work of which the seller may not even be aware. Not performing proper due diligence can lead to surprises down the road that end up being far more expensive than the cost of doing the due diligence up front.
What the Purchaser or Acquirer will be looking for in the Due Diligence Process
In general, the acquirer will be looking at everything relevant to the company in due diligence. Specifically, the acquirer is looking for any facets of the target company previously unknown or disclosed. The following is a list of a few general issues the acquirer will be focusing on:
- Asset ownership: The acquirer will be looking at the tangible and intangible assets owned by the target company to gauge their worth, and to understand whether it truly owns them. This could involve evaluating the business equipment and inventory it owns and any lease agreements as well as understanding the nature, value, and questions of ownership regarding your company’s intellectual property.
- Company ownership: Many startups start with money from family and friends, and then proceed to successive stages of financing. The acquirer will look to obtain a comprehensive understanding of who owns what with regard to the target business and any surprise ownership claims and/or conditions of ownership.
- Contractual obligations: Employment agreements, vendor agreements, client agreements, and licensing agreements are just the start of what an acquirer will want to review to understand the obligations and rights it will be acquiring in the potential sale. Even contracts as seemingly minor as cell phone contracts and cleaning service agreements might be scrutinized.
- Potential liabilities and other undisclosed risks/surprises: This is related to the previous three topics, in that each one can present problems, but it bears repeating that the acquirer will want to have as complete an understanding as possible in determining what types of claims, demands, and lawsuits it might fact post-sale. This runs the gamut from making sure the target company’s taxes have been filed properly and correctly to whether it is in compliance with relevant federal and state laws, regulations, and other compliance requirements.
What to Expect in Due Diligence
With the understanding of what the acquirer is looking for, equally significant is how the acquirer and its agents will go about looking for it and what your role will be in that process. In many cases, due diligence is primarily conducted on the ground by junior-level associate attorneys from corporate law firms representing the acquirer. These attorneys may come from prestigious law school backgrounds, but they do not necessarily have a lot of experience in the corporate world and are at the mercy of demanding superiors who have the overriding goal of making sure nothing problematic is missed that might affect the acquirer’s value.
What can be expected are long lists of requests for information and paperwork, which will often feel redundant, exhausting, and even irrelevant or lacking in common sense. The target company must promptly respond to these requests by scanning and/or uploading the requested information to a virtual data room which will be maintained by the acquirer.
As the target company, if you already have a detailed system in place, this process might be less laborious. If not, now is the time to make sure your files are organized and clearly identified to make matters easier and reduce delays and frustration. One strategy one might consider is a “pre-transaction review” with your law firm and/or advisor to put together the documents/files that will likely be requested in as professional and comprehensive a manner as possible prior to due diligence.
Conclusion
Assuming the potential acquirer is reasonably satisfied with what it discovers in the due diligence process, the next step will be to proceed towards negotiating and drafting the definitive deal documents, including the purchase agreement and ancillary documents, seller financing documents, and any employment agreements. The next blog in this series will dive deeper into that stage.
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[1] Because the due diligence process is so important, I will be writing a blog series specifically tailored to the three crucial parts of the process: (1) legal due diligence, (2) financial due diligence, and (3) operational due diligence. Stay tuned for these blogs, which will be posted subsequent to this post but prior to Part VI of this series on negotiating the definitive agreements.