The phrase “due diligence” comes up in a wide variety of contexts in our culture and can mean anything from the reasonable type of preparation research a person does before making any kind of decision (“I did my due diligence on Yelp before making Valentine’s Day reservations”) to the specific “due diligence defense” an underwriter can present when sued for securities violations following an IPO gone bad. In the context of the sale of an emerging growth company, 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 to determine whether there are potential risks that would warrant not going forward with the deal.
In previous installments in this series, we discussed the various processes associated with engaging a financial adviser to guide your company through the deal, creating a non-disclosure agreement with the potential buyer to protect your company’s confidential information that will come to light in due diligence, and creating an initial term sheet or letter of intent regarding the buyer’s proposed terms for the deal. If you have gotten this far in the sales process, no doubt the acquirer has already engaged in some level of informal due diligence on your company to determine whether it is worth pursuing, but all of those steps are just the 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.
What The Acquirer Will Be Looking For in the Due Diligence Process
In a sense, the acquirer will be looking at everything relevant to your company in due diligence and specifically looking for any facets of your business previously unknown or disclosed, but there are a few general issues it will be focusing on:
- Asset Ownership: Here, the acquirer will examine the tangible and intangible assets owned by your business to gauge their worth and, more importantly, understand whether it truly owns them. This could include 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: Did your company start with a $20k loan from your Aunt, or was that “loan” actually a 10% stake in the business? Many startups naturally start with money from friends and family and then proceed to successive stages of financing. The acquirer will be looking to obtain a comprehensive understanding of who owns what regarding your 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 the 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 be facing post-sale. This runs the gamut from making sure your 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 that 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 they are at the mercy of demanding superiors who have the overriding goal of making sure nothing problematic is missed that might affect your business’ value.
What this means for you is that you can expect long lists of requests for information and paperwork, which will often feel (if not actually be) redundant, exhausting, and even irrelevant or lacking in common sense. Your part is to nevertheless promptly respond to these requests (which often come in email form) by scanning and/or uploading the requested information to a virtual data room which will be maintained by the acquirer.
If you already have a detailed file system in place, this process might be less laborious, but if not, now is the time to make sure your files are organized and clearly identified (i.e., through reference numbers of descriptive file names) to make matters easier on the acquirer and reduce delays and frustration. One strategy you might incorporate is a “pre-transaction review” with your own law firm and/or adviser to put together the documents/files that will likely be requested in as professional and comprehensive a manner as possible prior to due diligence.
Moving Forward to Negotiating the Deal Documents
Assuming the potential acquirer is reasonably satisfied with what it discovers in the due diligence process, the next step will be to proceed toward negotiating and drafting the definitive deal documents, including the purchase agreement and ancillary documents, seller financing documents, and any employment agreements (as with much of the sales process, these steps may, of course, overlap to some extent). We will dive deeper into that stage of the process in next month’s post.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
