The reader should note that throughout this article where the author uses the phrase "the seller" or "the buyer" it is implied the phrase also means their respective company representatives and M & A team advisors, including, without limitation, their business consultants, investment bankers, accountants and M & A legal counsel.
1. The Purpose of Due Diligence.
A. Buyer. The buyer needs to get a thorough and accurate "snapshot" of what the buyer is purchasing. A due diligence review should give the buyer insight into the target's operations, culture, human resources, supplier and customer relationships, competitive positioning and future outlook, among other things. Potential financial, legal and regulatory exposure needs to be assessed, and the buyer needs to obtain hard data as it goes on a fact-finding mission to investigate the seller's business before a final decision is made whether to proceed with the transaction. Indeed, immediately after the closing of the transaction the buyer will be responsible for operating the business it has acquired. Done fully, due diligence can give future management a holistic view of the company being acquired and its culture. This also informs the buyer on how to integrate people, platforms, cultures and align all of the business interests and opportunities.
It should be noted if a third-party, such as a bank or private equity firm, is providing some of the financing for the transaction, that the financing or investing party will want to participate in the due diligence process and obtain a "snapshot" of the business of the seller as well.
B. Seller. The seller needs to determine what "change of control" provisions exist in its contracts that may be triggered by the transaction, and what stockholder consents or other third-party notices or consents may be required to enable the seller to sign and close the definitive acquisition agreement (the "Acquisition Agreement"). In addition, the seller needs to ensure that the representations and warranties of the seller and/or owner(s) in the Acquisition Agreement (and the related disclosure schedule (the "Disclosure Schedule"), which complements those representations and warranties and is part of the Acquisition Agreement) are accurate and do not lead to post-signing and/or post-closing buyer indemnification claims and purchase price claw-backs. After all is said and done, it’s important for the buyer and seller to be content with the transaction financially and culturally. Avoiding lawsuits and claw-backs is paramount to a successful transaction outcome.
C. A "Win-Win" Process. Each party in an M & A transaction is obliged to protect and further its own self-interest. When the due diligence process is a "win-win" for all parties involved, the process is faster, easier and less expensive. The disclosure of information, representations and written statements adds great clarity to the overall M & A transaction, and helps avoid misunderstandings that could otherwise lead to disputes after the deal closing. Through performing the due diligence process, which is arguably a cooperative process, surprises and future disputes are minimized and hopefully completely avoided, which saves time, money and aggravation for all parties involved.
2. Beginning of the Due Diligence Process. The due diligence process begins, or at least should begin, virtually immediately after the signing of the letter of intent ("LOI"). For why the seller should have an LOI, please see this author's article entitled WHY YOU, THE PROSPECTIVE SELLER OF A PRIVATELY-HELD BUSINESS, WANT AND NEED YOUR OWN HIGHLY CUSTOMIZED LETTER OF INTENT ("LOI").
The seller, with a satisfactory LOI signed (with an appropriate confidentiality provision therein, or an adequate separate buyer-signed Non-Disclosure Agreement), should want to move the M & A transaction forward as quickly as possible. A smart seller will hurry so as not to allow any unrelated "Black Swan events" to potentially take place that could for any number of reasons unravel the M & A transaction before the Acquisition Agreement is signed, closed and paid out.
The buyer, though it will want to be diligent and thorough in getting a clear "snapshot" of what it will be purchasing, will not want to exceed the exclusivity period it negotiated and the seller agreed to as set forth in the LOI or in a separate standalone agreement. Exceeding that time period would allow the seller to open discussions with other potential buyers, which any serious buyer wants to avoid. Meeting deadlines secures exclusivity and keeps the process moving towards everyones’ desired goals.
All that said, both the seller and the buyer should have prepared themselves structurally and financially far in advance before the due diligence process even begins, and before any LOI (letter of intent) is proffered by either party.
A. Advance Due Diligence Preparation by the Seller. As discussed in this author's prior article entitled BUILD AN EXPERIENCED, HIGH-QUALITY M & A TEAM AND PREPARE EARLY, the seller should work with its consultants and advisors such as accountants and tax lawyer on its financial due diligence materials, and with its M & A lawyers and potentially other experts on its business and legal due diligence materials, as early and as far in advance as possible in order to (i) "clean-up" and fix what needs fixing and is fixable, and (ii) take advantage of as many potential tax advantages and related transaction structuring possibilities as the seller's situation will allow. Optimizing the investment or transfer readiness of a business well in advance of the initial offering stage is a very wise and cost effective strategy. Being in such a state of readiness can help increase the price offered and it speeds and eases the entire process.
Ideally, long before the LOI is signed the buyer's lawyers should proactively provide the seller with a due diligence checklist that will typically be nearly identical to the ultimate due diligence checklist that the buyer presents to the seller after the signing of the LOI. Assuming the seller has worked with the seller's legal counsel and others to organize and perfect the disclosure materials related to seller's business, the seller will be prepared to virtually immediately respond to the buyer's due diligence checklist requests with thorough, organized and accurate responses.
These prompt thorough, organized and accurate due diligence request responses will make the seller's business appear professionally organized and well-run, provide the buyer with confidence in the acquisition, hasten the pace of the M & A transaction, and save all of the M & A transaction participant's time and money. It should also increase the odds of a successful signing and closing, the goal of all serious M & A transaction participants who, as time goes by, will be increasingly invested in the process and successful outcome of the M & A transaction.
B. Advance Due Diligence Preparation by the Buyer. The buyer uses the buyer's due diligence review to not only get a "snapshot" of the target business, but also, to the extent it finds surprises or problems with the business, to understandably attempt to "re-trade" the deal earlier agreed upon in the signed, but generally legally non-binding, LOI. In such a re-trade the buyer may ask for a lower purchase price or better deal terms, such as more extensive indemnification rights, often coupled with a higher purchase price holdback or escrow amount. If the due diligence surprises are bad enough, the buyer may decide to "walk away" from the M & A transaction entirely, causing a loss of time and money for all M & A transaction participants.
C. Potential Consequences of Due Diligence Delays by the Seller. To the extent the seller is unprepared and is unable to promptly provide the buyer with the due diligence materials requested in the buyer's due diligence checklist, the buyer is in a position to attempt to renegotiate the exclusivity period deadline contained in the LOI or separate standalone agreement. Indeed, the buyer will say it is ready, willing and able, and given the document production delays it is unfair to hold the buyer to the exclusivity timeline given that the buyer negotiated the exclusivity period deadline with the expectation it would be provided with the requested standard due diligence materials promptly. At some point delays by the seller will give the buyer concern about the viability or trustworthiness of the overall transaction, which can lead to the buyer walking away and the transaction cratering.
As with riding a bicycle, an M & A transaction needs ongoing forward momentum to be able to remain balanced and moving forward to reach the intended destination. Without that ongoing forward momentum, like a bicycle, the M & A transaction often totters and crashes down. Accordingly, the readiness and trustworthiness of each party is critically important. Being “on time” every step of the way helps to demonstrate readiness and trustworthiness. Without adequate enthusiasm and trust, it is unlikely that your deal will come to fruition.
3. How the Due Diligence Process Usually Works.
A. The Buyer’s Due Diligence Checklist. The buyer will provide the seller with a due diligence checklist which is typically very detailed and rather generic but somewhat customized to seller's business. The seller will provide the buyer with information responsive to the buyer's checklist requests, either stating the item requested is not applicable, or providing materials that are responsive. Generally speaking, it is in the seller's interest to disclose as much as possible to avoid post-closing buyer surprises that may lead to indemnification claims and purchase price claw-backs.
B. The Seller’s Electronic Data Room. More often than not, the seller pays a third-party provider to set up an electronic data room for the due diligence review portion of the M & A transaction. The seller can control and limit who receives data room access and accordingly gets to review the seller’s confidential due diligence materials contained therein. In addition to saving everyone the time and expense of traveling to review the due diligence materials on-site, the seller’s data room also provides the seller with the ability to see which authorized individuals have entered the data room when, for how long, and what specific data was reviewed. If the buyer is not actively reviewing materials in the data room, the seller can reasonably assume that the buyer has only limited interest in the transaction.
At the end of the transaction the seller can get a CD-ROM containing everything that it posted in the data room, which is useful for both historical records and in the event of a post-closing buyer indemnification claim. A thorough historical record is beneficial to all sincere parties.
4. Due Diligence Process and the Acquisition Agreement. In most M & A transactions the due diligence review does not delay the negotiation of the draft Acquisition Agreement, and both processes occur concurrently. These M & A processes can occur concurrently in part because to the extent the representations and warranties in the Acquisition Agreement do not accurately reflect the business of the seller/owner, in addition to the negotiation by the seller and the buyer of their revision, they also can be "fixed" by adding schedules to the Disclosure Schedule (which begins as a blank document). For example, if Section 4.21 of the draft Acquisition Agreement prepared by the buyer is a representation and warranty of the seller stating, incorrectly, that there is no current litigation, Section 4.21 of the Disclosure Schedule prepared by the seller can cure the inaccuracy by listing the current litigation (assuming it is made clear in the portion of the Acquisition Agreement with the representations and warranties that they are modified by the corresponding schedules set forth in the Disclosure Schedule, a provision which is very typical and standard).
The Disclosure Schedule is initially prepared by the seller, and is subsequently reviewed and commented on by the buyer. The seller and buyer work together on perfecting the Disclosure Schedule, which is why both the seller and buyer are in a sense due diligence review partners. Accuracy and a “win-win” mindset are beneficial to everyone involved.
To competently prepare the Disclosure Schedule the seller must know its own due diligence materials inside-out. Those materials must be complete and accurate if the seller is to protect itself from potential post-closing indemnification claims and purchase price claw-backs. For this reason it is imperative that the seller’s due diligence materials are organized and reviewed in detail by the seller and its representatives in advance so as to avoid potentially costly mistakes and to save time and money for all.
5. Variations on the Theme.
A. When There is No LOI. In some cases there is no LOI between the seller and the buyer. The parties go directly to negotiating the Acquisition Agreement, typically with the thought of saving time and money (although in this author's experience it rarely works out that way). Once again, the due diligence process begins immediately, while the Acquisition Agreement is being negotiated. Typically, without the main business points decided in advance, as occurs with a signed LOI, the Acquisition Agreement takes longer to complete and sometimes never gets completed at all.
B. When the M & A Consideration is the Securities of the Buyer. Not all M & A transactions use cash as the sole form of consideration for the seller. For example, it may be agreed that the buyer may use its own securities as all or a portion of the consideration for the seller. Alternatively, the seller may be provided with consideration in the form of an "earn-out," pursuant to which the seller is paid the seller's consideration (be it cash and/or securities) over a period of time after the closing based on the post-closing performance of whatever is agreed upon by the parties (typically the performance of what the buyer purchased). There are numerous other examples not listed above. In such situations the seller needs to conduct either a partial or complete due diligence review of the buyer, since the seller is in a sense also purchasing the buyer, and accordingly needs its own "snapshot" of the buyer. Everything in this article described above applies in this situation. When properly performed, due diligence is a two-way street. Everyone needs to be ready, accurate and trustworthy.
C. When An Owner will be an Employee or Consultant of the Buyer Post-Closing. In an M & A transaction in which post-closing an owner will become an employee or consultant of the buyer, it is important that the owner perform some due diligence review of the buyer, at least to understand the business process, infrastructure, culture and key personnel at his or her potential future employer. Hopefully some of these matters will be addressed in the LOI between and/or among the M & A transaction parties.
6. Summary and Conclusion. M & A due diligence is a key part of every M & A transaction that is necessary, and is arguably of material benefit to both the buyer and the seller alike. It can and should be cooperative and need not be a zero-sum game.
Thorough and competent advance preparation for M & A due diligence is necessary to saving both time and money, and for maintaining the ongoing forward momentum necessary to keep the M & A transaction balanced and flowing toward a successful signing and closing, the goal of all committed M & A transaction participants.
The views in this article express the personal views of the author and do not represent the views of any other person or entity and do not constitute legal advice.
Scott J. Lochner is a very experienced and pragmatic business lawyer who has helped his clients for over 30 years to cost-effectively achieve their goals. Scott has specialized in providing legal assistance in buying and selling businesses in individual transaction value from several million to several billion dollars. He also has extensive experience in intellectual property ("IP") matters, helping clients to develop, protect and commercialize their IP and brands, both in consumer products and high technology. He is known for being entrepreneurial and thinking like a business person as well as a seasoned business lawyer. In addition to practicing law, Scott is an inventor who has successfully monetized two U.S. patents he owns related to computer wireless technology, and has a score of license agreements with prominent name-brand domestic and foreign multi-billion dollar companies related thereto. Scott writes and speaks frequently on business law matters, and has been involved in improving state business law to create a better business environment to benefit everyone.
Contact: Scott J. Lochner
© Scott J. Lochner 2014