One of the more common engagements for our firm is to assist with business sales and acquisitions. This article is the third in a series of articles which will walk through and generally discuss the steps typically associated with the sale of a business. In Part 1, we discussed the breakdown of the business, the identity of the relevant parties, the role advisors play, and brief discussion of the two primary types of sales that take place. In Part 2, we discussed preliminary negotiations and the letter of intent. This Part 3 discusses the due diligence process.
Overview of a Business Sale
A typical transaction will generally entail the following steps:
- Initial Negotiations;
- Letter of Intent/Term Sheet;
- Due Diligence;
- Definitive Agreements;
- Transitional and Post-Closing Matters; and
- Tax Reporting.
What is Due Diligence?
Merriam-Webster defines due diligence as the research and analysis of a company or organization done in preparation for a business transaction. When buying or selling a business, the parties use the due diligence process to gather information about the nature of the business being bought or sold as well as the assets and/or liabilities that are part of the sale. While there are times where a seller should conduct due diligence (discussed below), the primary party who conducts due diligence during a business transaction is the buyer. Some of the primary information the buyer might seek to determine about the seller during the due diligence process include:
- Confirming good title to stock and or assets;
- Gathering information about the nature and amount of any liabilities, including any contingent liabilities that might be out there which could pose a risk down the road;
- Verify or determine the value of the stock or assets being purchased;
- Learn and understand the business, including any operations, key employees or contracts, the marketplace in which the business operates, and what steps might be needed to integrate the business into an existing business, if applicable; and
- Identify any issues that might prevent the transaction from closing, including any consents needed, votes, covenants not to compete or contracts preventing transfer, and the transfer of any valuable contracts.
The Due Diligence Process
Scope and Organization
As discussed in Parts 1 and 2, the primary issue to be negotiated between the buyer and the seller, other than the purchase price, is the form of the transaction, whether it will be an asset sale or an equity sale. In general, the deal structure will determine the scope of due diligence. For an asset sale, the buyer might choose to focus more of its due diligence efforts on the assets themselves whereas, in a stock sale, the buyer will need to focus on the whole business including stock ownership and liabilities of the business.
Other factors affecting the scope include the industry the seller is in, whether the seller is national or international, the due diligence budget, time constraints, whether the buyer and seller are in competition and if so, whether the seller restricts access to information to certain individuals on the buyer’s team.
As far as organizing the due diligence effort, the primary factors to be decided are the team, the scope, discussed above, as well as the budget. The team will typical include members of buyer’s management team, accountants (both tax and audit specialists) and the legal team, which may be made up of multiple attorneys with special focuses or an attorney with a business and tax background well versed to handle multiple aspects of the due diligence process. In certain deals, the team may also consists of other key members such as an industry specialist or a real estate specialist who can advise on certain aspects of the deal.
Once the team, the scope, and the budget are determined, the buyer will want to discuss timelines and time constraints, whether outside specialists are needed, whether there are certain areas that should be of greater importance in the analysis, whether there are any deal breakers that should be addressed first, and what the process will be for communicating with the seller and with the individual member’s of buyer’s due diligence team.
Sources of Information
Documents will serve as the primary source of information for due diligence, and reviewing these documents is where the heavy lifting will occur. Members of the due diligence team will spend a large part of their time reviewing documents of the seller including contracts, organizational documents, financials, loan agreements, tax returns, and a variety of other documents that may be applicable to the particular industry or deal.
Management of the seller serves as another key source of information for the due diligence team. After reviewing the financial information and other documents discussed above, its common for the buyer to interview seller’s management team to answer any questions they may have as well as help get a better understanding of the operations of the business. Management can provide key information about a business that may not show up on paper.
Other great sources of information include employees, other businesses in the industry, and publicly available information from sources such as newspaper, the secretary of state’s office, and the company’s own website, which may have items such as investor materials that might be useful.
Review of Information: Common Items to Investigate
As part of the due diligence process, the team will typically review an array of different documents as discussed above. Some of the more common documents to be reviewed and some issues to look for in each are as follows:
Common contracts to be reviewed include employment contracts, service and operational contracts, and licensing contracts. The due diligence team will typical want to consider the following for each:
- Who are the parties?
- Is the contract assignable?
- When does the contract terminate?
- Does the contract provide an early out for change of control or assignment?
- Does the contract have any options for extensions?
- Is there a signed contract by both parties?
The financial documents for the entity being purchased are also a key component to due diligence. When reviewing financials, the due diligence team will want to know the following:
- Have the financials been prepared in accordance with generally accepted accounting principles (referred to as GAAP)?
- Have the financials been audited?
- Who is in charge of preparing the financials?
- Have there been any changes in methods that might cause the financials to not be consistent from year to year?
- Are there any irregularities that might warrant closer look?
The organizational documents include the certificate of formation, operating agreements or by-laws, shareholder agreements, any amendments to these documents, and any documents filed with taxing authorities regarding how the entity is to be taxed.
A review of the organizational documents can confirm existence and good standing, ownership, information about what consents and votes are needed for a transaction, whether there are any transfer restrictions, and whether there are tag-along, drag-along rights, or preemptive rights that might be applicable as part of the transaction. Documents filed with tax authorities can provide confirmation that a target is indeed taxed or eligible to be taxed in accordance with how it is filing its tax returns. For example, where the target is a Subchapter S corporation, the buyer will want to confirm that the Subchapter S election has indeed been properly made and that the entity has not violated any of the restrictions for such status, such as having an ineligible shareholder. Similar to confirming Subchapter S corporation status, if the target is taxed as partnership and has made a Section 754 election, the buyer will want to confirm that.
Litigation and Other Contingent Liabilities
The buyer will also want to know about any past, present or pending, and potential future litigation that may affect the seller. If claims are currently pending, what is the nature and estimated value that will be paid out? What’s the risk of contingent claims being out there or claims arising in the future? IF the seller sells products covered by a warranty, the seller will also want to know details about the warranty, the number of past claims, and any information about expected claims in the future.
Tax Returns and Tax Compliance
In addition to confirming any tax elections that have been made, the buyer will want to review prior year tax returns and confirm that the seller has filed all necessary state and federal returns in the past. The buyer will also want to know the details of any past audits and the results of the same, as well as whether any returns are currently under audit and if so, what items are being looked into and what is the exposure there.
How Does Due Diligence Affect the Transaction?
The findings and results of the due diligence process may affect the transaction in a variety of ways. In extreme situations, information uncovered in the due diligence process will cause the deal to terminate. More commonly, any hiccups of seller that arise in the due diligence process can be addressed with adjustments to the purchase price as well as through the representations and warranties and indemnification provisions and the related disclosures schedules which are incorporated into the definitive agreement.
Seller’s Due Diligence
The focus of this article has been on the buyer’s side as the due diligence is typically performed for the most part by the buyer. However, there are times when a seller will want to perform their own due diligence. For example, if the seller is a party to merger, the seller will want to confirm certain information about the buyer prior to closing the deal. If the buyer is issuing stock to the seller, the seller will want to confirm that the buyer is authorized to issue such stock. If the buyer and the seller are merging assets, the seller will want to confirm the valuation of the buyer, learn more about the buyer’s operations and management team that may stay on board, and determine whether any of buyer’s contracts may cause any impediments to the transaction and the integration of the merging businesses. Additionally, sellers who are preparing to go to market and seek out a buyer will often perform due diligence on themselves to get out in front of any issues that might arise and address them prior to a deal taking shape. As a practical matter, a seller will likely want to verify or receive some type of assurance that the buyer is capable of completing the transaction contemplated and has due authorization to undertake the transaction.
In the next part of this series, we will continue to discuss the transaction process in more detail, including the definitive agreements and closing and post-closing issues and adjustments.
Our firm is regularly engaged to handle many types of business transactions from simple equity sales to complex asset sales and mergers involving publicly traded corporations. With significant analytical, business, and tax expertise, our firm is well equipped and ready to assist our clients with their business transactions.