Due Diligence – What is it and why is it so important?
When you are buying a business, due diligence is essentially the process of reviewing the company you are about to buy. All too often not enough time, resources or attention are spent on due diligence.
If not given proper consideration, the buyer can wind up, at best, with a company less valuable than it anticipated, and at worst, exposed to significant liabilities and lawsuits. If done early and properly in the acquisition process, the findings in due diligence can be accounted for in the purchase agreement through carve-outs, indemnifications, representations and warranties, and price adjustments. While the scope of due diligence depends on a number of factors like the price, target, transaction type (stock vs. asset purchase), size, timing, and industry, there are some items that almost all buyers should take a look at prior to closing the deal. Once that closing takes place, you own it; make sure you know what you’re buying.
We’ve put together this quick checklist for buyers in business purchase/M&A transactions. These items should be reviewed by the buyer’s management, and its legal, and business advisors. They represent the backbone of the deal and substantiate (or don’t), the purchase price the Buyer is willing to pay.
A Due Diligence Checklist
1. Corporate Records
The buyer should have the right to examine the corporate records of the seller. If the buyer is acquiring the company through a stock (or membership) purchase agreement, this review should be detailed and extensive. Just a few of the items that should be reviewed:
- articles of incorporation/organization
- organizational charts
- state/international registrations
- stockholder agreements
- buy-sell agreements
- bylaws or operating agreement
- copies of all outstanding securities (including warrants)
- and a copy of the stock transfer ledger.
If the buyer is acquiring the company through an asset purchase agreement, this review can be modified significantly, but the buyer should still demand the appropriate incorporation documents, corporate authorizations, and consents approving the transaction.
What written agreements does the seller have in place? Namely, the key agreements regarding:
- real estate
- joint ventures
- and licensing
3. Intellectual Property
Often intellectual property is one of a company’s most valuable assets. If intellectual property is going to be included in the business purchase it pays to make a detailed examination of the underlying intellectual property rights that the seller holds, this includes:
- state and federal trade mark registrations
- and patents
A detailed review of the seller’s legal situation should be made and related representations and warranties should be drafted in the purchase agreement. Things like:
- security agreements
- UCC filings
- encumbrances on stock
- promissory notes
- and prior and pending lawsuits
The seller should provide at a minimum tax returns, audited financials, balance sheets, the status of any prior or existing tax audits, schedules of long term debt, lists and the age of accounts receivables, and any tax-sharing or tax-allocation agreements. The standard time period for these records is generally 3-5 years or longer.
List of all real property used by the seller’s business and the underlying ownership documents related to it.
- All leases (equipment and real property)
- ROFO’s and ROFR’s (right of first offers and right of first refusals)
- construction contracts
- title policies and other real estate commitments
- inventory of all personal property related to the business both owned and leased.
- Full list of all employees and their related contracts
- Employee manuals/handbooks
- Copies of all NDA’s (confidentiality agreements), non-competes, and non-solicitation agreements
- Commission agreements w non-employees
- Schedule of all employee compensation
- Copies of all executive compensation plans
- Documents related to all profit sharing, 401K, medical, dental and other benefit plans, etc.
- Description of employee turnover during the last 3-5 years
A schedule of all policies of insurance, or self insurance of the seller, including:
- workers comp
- general liability
- D&O (directors and officers)
- and key man life insurance
9. Regulations and Filings
- All reports filed with any state, local or federal agency
- Schedule of all governmental permits, licenses, etc.
- Description and status of any prior or pending state, local or federal inquiries or known non-compliance.
10. Broker Agreements
If brokers are being used, review copies of the finder’s fee or bonus comp arrangements with the Seller’s broker.
When buying a new business, the buyer wants good value, but also needs to be sure that the legal and financial risks of the transaction have been fully vetted and properly shifted/shared in the deal documents. These are just a few of the key areas that a buyer should consider when purchasing a business. Don’t allow the negotiation to become a buyer beware situation. Once the closing is done, unwinding the deal can become significantly more complicated, expensive, and labor intensive than drafting appropriate provisions in the purchase agreement. Keep in mind, many item can be handled with appropriate modifications to the deal’s price, the seller’s reps and warranties, indemnifications and hold-backs. Robust due diligence allows the parties to negotiate and make appropriate shifts in risks and exposure. For the buyer it pays dividends to become as informed as possible about the target business prior to closing. I hope we’ve provided some food for thought.
(Mallon Lonnquist Morris & Watrous, LLC, is a business, employment, real estate, and litigation law firm. Craig T. Watrous is a Colorado M&A attorney and partner at MLMW, based in Denver, Colorado. Craig regularly represents clients on both sides of business purchase transactions. Craig can be reached at email@example.com and (303) 722-2165.)