The Significance of Due Diligence Process when Acquiring a Business

Throughout the lifecycle of a business, it is important for a business owner to remain focused on increasing the profitability, competitive advantage and market reach of the business. An entrepreneur typically accomplishes these objectives by (i) reinvesting the profits of the business to increase its workforce, customer base and cash flow and (ii) using business profits (along with other financing) to acquire competing businesses. Such business acquisitions typically serve two purposes by eliminating competitors and increasing the growth rate, product and service offerings, and market share of a business.

This article focuses on the critical nature of the due diligence process in connection with a business acquisition.

A thorough due diligence review of the business being acquired (commonly known as the “target company”)is critical to identifying the risks, fixed and contingent liabilities, and problems (which are not otherwise disclosed by the seller in the acquisition agreement) that need to be evaluated carefully by the buyer, in addition to the value, efficiencies and synergies that the buyer can realize from an acquisition. The term “due diligence” broadly describes a detailed assessment of the many different functions, tangible and intangible assets, and liabilities of a business. A due diligence review is conducted by experienced lawyers and accountants, and this investigation will enable a buyer to accurately assess the following:

• When acquiring a business, will the buyer be able to realize unique competitive advantages from the acquisition?
• Are the employees of the target company subject to noncompetition, nonsolicitation and confidentiality obligations that protect the target company’s goodwill, customer list, and other important proprietary or confidential information? Are these contractual obligations assignable by the seller to the buyer?
• What third-party consents will need to be obtained in connection with a sale of the business? Is the target company a party to material contracts (including supply, employment, license and distribution agreements) that may not be assignable in connection with the transaction?
• What contingent and/or fixed liabilities of the target company need to be excluded from the transaction and retained by the seller?
• Will the buyer be able to retain the key customers and employees of the business?
• How much working capital does the business require?

The scope of a due diligence review should be thorough but appropriate for the transaction. This requires the buyer to consider how much time it has to conduct the due diligence review, how much it wants to spend on the review and the resources of the target company. A common misconception is that acquiring a smaller company is relatively easy; however, an acquisition of a smaller business may require additional legal due diligence due to the target company’s inadequate record keeping and limited resources to assist the buyer’s professional advisors with the due diligence process. Based on the information obtained from the target company in the initial stages of the review process, the scope of due diligence may become more or less comprehensive.

In conducting the due diligence review, the buyer’s legal team will obtain important information about the target company from both primary and secondary sources. Primary sources, which include the target company’s responses to written due diligence requests, management presentations, documentation set forth in a data room, and the target company’s disclosure schedules, may not be accessible until a later stage in the due diligence process. Consequently, it is important for the buyer’s legal counsel initially to obtain background information about the target company by reviewing secondary sources of information such as media articles, the target company’s website and judgment and lien searches covering the target company. Additionally, the buyer’s legal advisors will typically review the following categories of documents from the target company:

• Corporate Documents. In addition to the corporate organizational documents (i.e. articles of incorporation, bylaws, shareholders agreements, minute book, stock transfer book, etc.), the buyer’s legal counsel will want to determine whether the target company is qualified to do business in jurisdictions outside of its state of incorporation/organization. If the target company is not qualified as a foreign corporation in certain jurisdictions in which it does business, then the target company’s ability to sue and enforce agreements in that state may be impaired and the target company may be subject to certain compliance penalties.
• Financial Statements and Tax Returns and Reports. A review of the target company’s year-end financial statements and tax returns and will enable the buyer’s legal advisors to identify the existence of any material issues related to the target company’s financial operations or tax compliance measures.
• Litigation Documents. If the target company is frequently involved in similar types of litigation, there may be an underlying problem in the operation of the company. As such, the buyer’s legal counsel will carefully review all documentation relating to all actual or threatened litigation in which the target company has been involved within the previous three to five years to determine the extent of the target company’s liability.
• Regulatory Compliance. The operation of the target company’s business may be one in which the company is required to secure and maintain governmental authorizations, permits, licenses and certificates. The buyer’s legal counsel will review these permits and authorizations to identify any violations, and determine whether the target company is required to obtain any additional permits and/or obtain the consent of a governmental authority to transfer the permits to the buyer.
• Environmental Compliance. If the buyer is acquiring any real property in the transaction, then the buyer should engage an environmental consultant to conduct Phase I and Phase II environmental assessments of the property. Additionally, the buyer’s legal counsel will want to review any environmental permits and studies that have been issued to the target company.
• Title to Real, Personal and Intellectual Property. The buyer’s legal team will review all of the target company’s leases and other agreements that relate to the company’s real, personal and intellectual property (together with any security documents (i.e. mortgage liens and UCC filings) relating to the foregoing) to identify any encumbrances or liens on the company’s assets and determine whether the company will be able to convey clean title to all of its assets to the buyer.
• Employment and Employee Benefits Documents. An attorney who specializes in employee benefit matters will need to review any employee welfare and pension benefit plans of the target company to determine whether the plans have been properly operated and adequately funded. Additionally, the buyer’s legal counsel will review the target company’s employment agreements and collective bargaining agreements to assess the protection they provide and determine whether they can be assigned to the buyer.
  Insurance Documents. By reviewing the types and number of claims the target company has made under its insurance policies, the legal team will be able to determine whether similarities exist among the claims and whether the insurer is likely to deny coverage for future claims.
• Warranty and Product Liability. If the target company manufactures a product or provides a service, the buyer’s legal counsel will review any scope of the product warranties provided by the company and determine the existence of any actual or potential product liability claims against the target company.
• Other Material Agreements. While this category may seem like a “catch all,” it includes some of the target company’s most important agreements, including vendor and supply agreements, licensing and advertising agreements, agreements related to previous acquisitions and dispositions by the target company, non-competition agreements, employment agreements, and joint venture or partnership agreements. The buyer’s legal counsel will review these agreements to determine whether they are assignable by the buyer at the closing of the transaction, how and when they may be terminated by the parties to the agreement and whether the contemplated transaction would result in an event of default under the agreement.

As the due diligence process can be lengthy, the buyer’s legal counsel should provide the target company a comprehensive list of documents and issues the buyer needs to review and discuss with the target company at an early stage in the process. Once the buyer’s legal counsel has reviewed the initial documentation provided by the target company, it will likely submit to the target company follow-up document requests and questions. The buyer’s legal counsel will ultimately prepare a summary of its due diligence review, often in the form of a memorandum or a due diligence checklist, for the buyer to consider in evaluating the acquisition and negotiating the terms of the acquisition.

A comprehensive due diligence review is a critical step in protecting and assisting a buyer in connection with the potential acquisition of a business. The results of this review will make clear whether the buyer should proceed with the transaction and the important issues and terms that need to be negotiated in consummating the transaction. To avoid buyer’s remorse, it is important for a buyer to carefully assess the information that is derived from this review.