Due Diligence | Part 1 | An Introduction to the Series
“By failing to prepare you are preparing to fail.” This great Benjamin Franklin quote is a helpful point of reference for understanding why due diligence is so important in the purchase and sale of a business. The buyer needs to make sure he or she knows exactly what he or she is purchasing. Due diligence offers the purchaser an opportunity to get to know the seller’s company and avoid being caught off guard by an undisclosed or undiscovered issue after the company is acquired. If the buyer fails to thoroughly complete the due diligence process, it is very likely that person will be disappointed in his or her investment.
The due diligence process allows the purchaser to identify the risks with the proposed transaction before completing the transaction. Throughout the due diligence process the purchaser seeks material information the owner has not disclosed in preliminary discussions. Unintentional omissions are frequent, especially where the seller is inexperienced with the due diligence process. Failure to thoroughly investigate the seller during due diligence can lead to otherwise avoidable and often expensive “surprises” down the road.
The due diligence process can also be important for the seller, particularly when the seller is receiving stock from the purchaser as part of the transaction. In such an instance, the seller will also be making an investment in the purchaser’s company. Even if the seller is receiving cash as part of the transaction, the seller usually wants to make inquiries into the purchaser for the benefit of the seller’s stakeholders including its shareholders, employees, customers, suppliers, and distributors. Often the transaction will be less appealing to the seller if it is discovered that the purchaser has a track record of liquidating assets and winding up acquired businesses.
If issues are uncovered as a result of the due diligence process, the parties have options to mitigate the identified risks. The parties could back out of the deal; sometimes the best deals are the ones you don’t do. The parties could restructure the transaction—for example, the purchaser may insist on purchasing the assets of the company rather than the entity as a whole (purchasing the entity involves greater risk for the purchaser). The parties could renegotiate the purchase price. The parties could also contractually assign particular risks to a certain party.
Due diligence generally starts from the beginning, but it begins in earnest after the business owner and the business purchaser execute a letter of intent. Typically due diligence will include a thorough review of all of the business’ written documents, as well as an on-site review of the business. Some purchasers choose to conduct interviews with employees during the on-site review. During due diligence, the purchaser is concerned with many issues, including:
- Legal Issues: any legal issues surrounding the business, including governing instruments, securities matters, regulatory matters, and pending or potential litigation or legal expenses;
- Financial Issues: the financial condition of the company, including financial statements, accountants’ reports, bank holdings, debt, and tax matters;
- Operational Issues: how the company is currently operated, including employee and labor-related matters, customer and supplier-related matters, and products or services the company offers;
- Intellectual Property Issues: often the most expensive asset a company holds is its intellectual property, including software, copyrights, trademarks/service marks, patents, trade secrets, and any IP agreements;
- Material Contracts and Information: who the company is contracting with and what obligations are owed, including licensing agreements, R & D agreements, documents related to joint ventures/acquisitions, a schedule of major competitors by product, non-compete agreements, and any other material contracts;
- Miscellaneous: this includes real property, environmental matters, insurance, news releases and marketing materials, reports filed with government agencies, indemnification agreements, and any other significant information.
As part of our blog series on the purchase and sale of a business, over the next few weeks we will review each of these due diligence topics, pointing out the most important aspects you should be aware of when selling or purchasing a business.