One of the most important and tedious tasks that a buyer and seller has to complete during the M&A process is due diligence.

Overview

Due diligence is an evaluation process in which a prospective buyer inspects a seller’s business, financials and operations to better understand the assets they are buying and the potential liabilities they may incur as the new owner of the business. This process is particularly important in private company acquisitions since the private companies have not been subject to the scrutiny of the public markets and buyers have little (if any) ability to obtain information about the company from public sources.

When does due diligence begin?

Due diligence usually commences after the parties have signed a formal letter of intent. A letter of intent is a non-binding statement of understanding between the seller and buyer setting forth the terms upon which they intend to enter into an agreement. At this point, the parties are pretty serious about wanting to transact and are willing to put the time and money into completing the due diligence review and negotiating a purchase agreement. Therefore, letters of intent often require the buyer to stop entertaining offers from other buyers until the due diligence is completed. The facts discovered during the due diligence period may affect the purchase price and will be used by the prospective buyer to determine which seller representations and warranties to draft into the purchase agreement.

The NDA

Regardless of whether or not a letter of intent has been signed, sellers should have a non-disclosure agreement in place with the prospective buyer before starting the due diligence process. Given the depth of access the seller will be giving the prospective buyer into the inner workings of their company, this is particularly important if the buyer and seller are competitors.

Due Diligence Checklist

At the start of the process the buyer will typically send the seller a "due diligence checklist" consisting of a list of things they would like to see from the seller. This may include the following items, among others:

-company documents (articles of incorporation, operating agreements, bylaws, amendments or similar documents;

-list of members, shareholders, owners, managers, directors and officers;

-copies of minutes and resolutions;

-ownership books, records and capitalization tables;

-outstanding options, warrants, vesting agreements and other equity rights;

-outstanding debts, obligations and liabilities;

-company financials (balance sheets, income statements, tax returns);

-list of assets, inventory, equipment and intellectual property;

-information related to all employees, independent contracts and benefits plans;

-documents related to past or present litigation, tax claims, liens and proceedings;

-copies of reports, inspections, surveys and compliance records;

-any citations, notices of violations, deficiency notices, etc.;

-permits, licenses, consents, regulatory approvals and applications for the same;

-lists of your top customers, suppliers, vendors, etc.;

-leases, guarantees, real property interests, equipment leases;

-company policies, handbooks, programs, manuals; and,

-copies of all contracts and agreements.

Next Steps

A Seller then gathers all requested documentation and provides it to the potential buyer. This is typically followed by multiple rounds of questions and additional document requests. Expect it to be a full-time job. Depending on the size and complexity of the business this process can take anywhere from weeks to months. The parties involved usually pay for their own costs associated with the process (investment bankers, accountants, attorneys and other consulting personnel).

How You Should Prepare

If you are a business owner preparing to sell your business, the best thing to do to prepare for due diligence is to get organized. If you don’t have a filing system in place, start one. If you operate by handshake agreements, get them in writing. Make sure signed copies of all your contracts. Make sure all your permits, licenses, HR records, meeting minutes and financials are up to date. By planning ahead in anticipation of the issues that may arise, a seller better prepares to successfully consummate the sale of his or her business.

The Data Room

Due diligence items into will typically be deposited or organized by seller in a central repository such as Dropbox, Google Drive or a data room. A good repository will have search capacities so the seller should scan all documents with optical character recognition software beforehand. The repository should also have bookmarking capabilities, the ability to print and comment on documents, and a notification system that lets the parties know if there have been any changes or additions.

Some sellers may be hesitant to air their dirty laundry to a potential buyer. However, it is in both parties’ interest to disclose everything and its better for a seller to share potential issues early in the due diligence process than to have them come as a surprise later on. Also, a failure to disclose will likely result in post-closing indemnification claims, payment setoffs and a headache for both parties. Potential buyers may also see a seller’s shortcomings as potential ways to increase profitability and get a better ROI. On the other hand, if a seller proactively addresses these issues prior to sale, they can likely increase their purchase price.

Due Diligence is Mutual

In some cases, the seller may want to also do due diligence on the buyer. This is particularly true when part of the transaction consideration includes stock of the buyer or when the full purchase price isn’t paid up front in cash (for example, where a portion is paid via a promissory note or there is an earn-out) you may want to conduct your own due diligence on the buyer. In such instances, the Seller will want to make sure that the buyer is a financially sound, viable and growing business.

Expect there to be bumps along the road and involve your attorney and accountant from the beginning and in no event, later than the negotiation of the letter of intent.

While the due diligence process is certainly an important and stressful time period, if you have a signed letter of intent in hand, the deal is very likely to close. So, if you are a buyer or seller that is about to go through the due diligence process, the attorneys at Business Lawyer Austin can help you. Congratulations, you are close to the finish line. Hang in there.