Due diligence is the buyer’s process of discovering and evaluating information about a seller’s business to confirm that acquiring the seller’s equity or assets is a sound investment. However, the process of conducting due diligence differs between transactions for a variety of reasons. Factors such as the deal structure (equity purchase versus asset purchase), cost, the unique qualities of the seller, and time constraints affect how the buyer’s deal team approaches due diligence.
At this point in the deal process, the buyer believes it has identified a worthwhile acquisition target and has likely conducted a preliminary due diligence review of the seller’s finances and operations. A non-disclosure agreement (NDA) is in place and the major deal points are solidified in a letter of intent (LOI). Now, the buyer is ready for its deal counsel to deliver formal due diligence requests to the seller so the buyer can thoroughly assess the seller’s business. This article by the Riggs Davie PLC Mergers and Acquisitions Practice Group discusses the buyer’s due diligence process from start to finish.
Planning for Due Diligence
Planning for due diligence helps streamline the diligence review process and reduce the likelihood that high-risk problems are overlooked. At the outset of the due diligence process, the buyer should collaborate with its deal counsel and other advisors to delegate responsibilities for reviewing the seller’s responses to diligence requests. The buyer’s executives (like its CTO or CFO), deal counsel, financial advisors, and other consultants all help the buyer assess materials disclosed during due diligence. Ideally, the buyer and its deal counsel will develop a due diligence plan, which should:
- Identify members of the deal team and any need for outside consultants;
- Establish a budget for deal counsel’s review of diligence material;
- Define the scope of due diligence review and responsibilities of the deal team;
- Set a target deadline for completing due diligence review;
- Individualize the due diligence request list to the features of the seller’s business; and
- List must-haves or dealbreakers to be flagged for the buyer.
Creating the Due Diligence Request List
The buyer’s deal counsel will typically approach each acquisition with its own model due diligence request list or one it has previously prepared with the buyer. The request list should be structured to help the buyer understand the seller’s business. Below, we’ve compiled common types of due diligence requests and the purpose behind the requests. Even though some of the diligence requests relate to business points, the buyer’s deal counsel will typically lead the due diligence process because business points often overlap with legal points.
Business Due Diligence – Due diligence requests target the seller’s operational, commercial, and financial performance. Common requests include employment organizational charts with job descriptions and salaries, customer and supplier contracts, pricing, financial statements, tax returns, bank accounts, accounts payable and receivable, lines of credit, debt, working capital requirements, customer feedback, marketing plans, and pricing strategy.
Legal Due Diligence – Legal due diligence helps confirm the seller has rights to the assets it has represented as owning and seeks to uncover the liabilities and potential liabilities associated with the seller’s business. For example, the following are commonly examined in depth for the buyer in an acquisition:
- Corporate governance and structure, including incorporation or formation documents and related shareholder or member agreements, ownership of the entity, and minutes of meetings and other resolutions.
- Customer and vendor contracts, including contracts for products and services sold by the seller and contracts for products and services purchased by the seller.
- Employment agreements and policies, including employee contracts, handbooks, and policies, non-compete and non-solicitation agreements, and independent contractor and consulting agreements.
- Intellectual property, including trademark, copyright, and patent registrations, trade secrets, and other proprietary information.
Conducting due diligence in the acquisition of a company in a specialized industry requires looking closely at other potential issues. For example, if the target is a software company, buyers need to confirm that the seller owns its software code. This would entail looking closely at the seller’s licensing agreements, use of exclusivity, chain of development and ownership, and internal access policies.
Reporting and Responding to Due Diligence Issues
As the buyer’s deal counsel reviews due diligence responses, it reports its progress and any issues to the buyer in a form agreed upon prior to the acquisition. This could be as informal as an email or as formal as a due diligence memorandum. Issues that are reported to the buyer can range from harmless to critical. Finding these issues early is important, but sometimes the seller does not disclose issues until late in the deal. To illustrate how this process works, let’s look at an example.
Example – Ownership of the Seller’s Software Code
The seller operates a software company founded ten years ago by three college roommates. The buyer wants to acquire the seller’s software, so its deal counsel has requested proof that the seller owns it. The seller has delayed responding to diligence requests. A few weeks before closing, the seller discloses that one of the original founders, Rachel, developed an important part of the software’s code while also employed by a competitor offering similar software. One year later, Rachel quit working for the competitor. Two years later, Rachel resigned from the seller’s company, and the seller has not heard from Rachel since. The seller recalls that Rachel developed the code on her own time at home, but it does not have any records governing the ownership of the software code. Although the seller has iterated on the code several times since then, parts of the code Rachel developed remain intact and are a crucial part of the software’s functionality. The buyer’s deal counsel has advised that Rachel could have been subject to a proprietary information and inventions agreement with the competitor. As a result, there is a possibility the competitor could claim ownership of the original software code and derivatives of it.
Few buyers would willingly assume the risk that the software it purchases from the seller is owned by someone else. This would pose a risk of litigation over the software code and a potential financial loss to the buyer after closing. To shift the risk back to the seller, the buyer’s deal counsel may propose to include a special indemnity in the purchase agreement. A special indemnity is an agreement by the seller to indemnify the buyer for a particular issue. In this case, the special indemnity could require the seller to indemnify the buyer for the losses it incurs in the event of a dispute over the ownership of the software code following closing. If the seller accepts the special indemnity, the parties can proceed to close the acquisition and deal with the uncertainty later.
However, due diligence issues vary in significance and call for different responses. For example, a buyer could request the seller fix the issue either prior to closing or within a certain amount of time after closing, reduce the purchase price to account for the risk, try to exclude the affected asset from the acquisition, or, in extreme cases, walk away from the deal. Experienced deal counsel will likely have encountered similar issues in prior deals and can propose solutions to reduce risk to the buyer.
Executing the Due Diligence Process Efficiently
Due Diligence is a fluid process completed alongside drafting the purchase agreement and disclosure schedule (a document containing certain disclosures by the seller, which is typically part of the purchase agreement). In our experience, an inefficient due diligence process disrupts progress on finalizing the principal deal documents and increases costs for both sides of the transaction. There will be challenges in every deal, but in our experience, buyers have a more efficient due diligence process when they:
- Set expectations with the seller about populating the data room. An unorganized data room can quickly compound the costs of examining disclosure materials. Communicating expectations to the seller regarding data room structure, file naming, and uploading preferences can streamline document review. This is particularly helpful when dealing with less-experienced sellers who may have incomplete or disorganized records and who lack experience with M&A customs.
- Include specific requests in addition to broad requests. In our experience, sellers often fail to disclose important information in response to broad requests. Specific requests prompt the seller to look for particular information that it might not have understood as being relevant from the broad request. For example, a typical broad request is to ask for copies of the seller’s material contracts, which is particularly challenging for sellers who have been operating for a long time. Including additional requests for contracts for the seller’s top ten customers by revenue and top ten vendors by expense can help verify the seller has uploaded the material contracts most fundamental to its business.
- Follow-up on unanswered requests. Waiting for extended periods of time on responses relating to critical deal points should be avoided when possible. When this happens, diligence can hold up a closing if it is material and has not been addressed.
- Communicate with their lawyers regarding key issues. A buyer’s lawyer needs to know what aspects of the business are most important and what to focus on, or what to move past. Effective and consistent communication between the buyer and its lawyer will help prevent issues from becoming a gating item to closing.
Summary
Allocating sufficient resources, preparing effectively, and working as a team on due diligence can minimize stress in a deal and move the deal forward efficiently. Having skilled advisors on your team can help you manage due diligence and run a successful deal. The mergers and acquisitions practice group at Riggs Davie PLC counsels clients through deals on the buy-side and sell-side in a wide range of industries, including technology, health care, health tech, fintech, professional services, financial services, real estate, business services, manufacturing, and distribution. For more information about our services, please visit www.riggsdavie.com or contact our practice group by email at dealteam@riggsdavie.com.
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.
