Business Sale 101: Due Diligence
For many business owners, due diligence is one of the most frequently misunderstood aspects of a business sale transaction. Due diligence is important for both the purchaser and the seller of a business, as it enables both parties to better evaluate the proposed terms, the assets and liabilities included in the sale, and the ability of the respective parties to consummate the deal. This article will briefly discuss the due diligence process, the type of information that typically is requested during the due diligence process, and the importance of adequate preparation prior to the buyer conducting its due diligence review.
Due diligence is a thorough and detailed investigation of the financial, legal and operational records of a business. Additionally, it includes collecting other information that will affect the seller or the purchased business after the sale transaction has been completed. A prior Business Briefs article in this series, Business Sale 101: The Letter of Intent, addressed the importance of growing business operations, strengthening the company’s financials, completing and maintaining accurate and current legal records, and preparing a properly drafted letter of intent prior to a potential sale. These factors become even more important during the due diligence process, as it is during due diligence that this information is provided to the potential purchaser. For this reason, it is important that a sale agreement or letter of intent provide adequate confidentiality and non-disclosure provisions, which will remain binding in the event the sale transaction is not consummated. These provisions will protect both seller and purchaser from disclosure of sensitive information. During due diligence, the purchaser will have access to most of the information critical to successful operation of the seller’s business. The due diligence process should be controlled in a manner that minimizes renegotiation of the main deal terms during or after the purchaser’s due diligence has been completed.
Due diligence should not begin until most of the principal deal terms have been established, including price, terms of payment, security, and perhaps even some of the most important warranties and representations. Due diligence typically begins with the “Due Diligence Request” or “Due Diligence Checklist,” prepared by the purchaser’s lawyer. It is important that the seller work with its lawyer and accountant during the assembly and review of requested information. A well prepared Due Diligence Request will seek documentation regarding the following:
- Corporate records;
- Financial and tax information;
- Corporate indebtedness;
- Employment and labor matters;
- Real property owned or occupied by the business;
- Personal property utilized by the business;
- Contracts and agreements to which the company is a party;
- Supplier and customer information;
- Compliance with laws;
- Pending or threatened litigation; and
- Other critical and sensitive information.
Within each of the above categories, numerous documents will need to be assembled, reviewed, and provided to the purchaser. It is necessary to review all of the information provided to the potential purchaser prior to disclosure. This is due to the fact that the existence of certain types of documents and information may cause the seller to unknowingly violate a provision in the sale agreement if not modified before the transaction documents are finalized, or may violate other agreements previously entered into by the Company.
The prospective purchaser will need to have full access to all of the relevant materials to carry out its investigation. Current financial and tax information, customer and supplier contracts, contractual obligations of the business, and potential liability typically constitute the focus of a purchaser’s due diligence inquiry. Purchasers want to be confident that the success of the target business will continue long after the purchase is completed. It is important that the financial and tax information provided during the due diligence process accurately reflects the business operations and trends.
From a purchaser’s standpoint, the main objective of due diligence is to obtain knowledge about the important areas of the proposed transaction. Obtaining more detailed information relating to the affairs of the target business will not only reveal any potential risk areas requiring further investigation, but also any potential benefits for the prospective purchaser arising from the proposed acquisition. Further, and of critical importance, the sale agreement will typically include numerous warranties and representations that make specific reference to information gathered and disclosed during the due diligence process. In addition, many schedules will be prepared and attached to the sale agreement that include data gather during due diligence. Counsel to both buyer and seller will need to be very familiar with those schedules so that they are confident in the accuracy and completeness of the information presented. For these reasons, it is important for the attorneys to actively participate in the gathering, organization and review of due diligence disclosure. While performing a thorough due diligence review may seem to be a daunting task, a purchaser must appreciate that the cost of reviewing the information on the front end of the deal and renegotiating any terms of the transaction is far less than the cost of sorting out any problems, including claims of breaches of warranties and representations, arising after the transaction is completed.
Maintaining current corporate records and financial information can make the due diligence process easier, less expensive, and more beneficial to both buyer and seller. Current and complete corporate records (including annual minutes), detailed financial information, and a well organized operational structure convey to the buyer that the business owner knows, controls, and is comfortable with every aspect of the business.
Future articles will explore additional aspects of business sales, such as transaction structure, tax implications, contract terms, and traps for the unwary. Our lawyers have extensive experience in handling business sales and acquisitions of all sizes, successfully representing both buyers and sellers in these types of business transactions. Please contact us if we can be of assistance.