Performing robust due diligence is critical in M&A deals, real estate deals and many other forms of commercial contracts. In this blog post, we discuss seven important considerations for successful due diligence, from the perspective of both buyers and sellers.
In our other blog posts we discuss due diligence in different contexts and why it is performed.
7 Important Considerations For Successful Due Diligence
The following are seven important considerations for successful due diligence. For ease of reference, throughout this Blog post I refer to “the purchaser” as the party performing the due diligence, and “the seller” as the party against whom the due diligence is being performed. In reality, other parties in addition to purchasers and sellers can be involved in a due diligence process, including investors, lenders, underwriters, insurers and others.
1. Prepare In Advance
Before a due diligence process begins, the prospective seller and target company must ensure that their books, records, entity status, contracts, legal and business affairs are highly organized, orderly and presentable. After all, by embarking on a transaction that will involve due diligence, the seller and target company will be opening their books and records to a team of third party reviewers, including not only the purchaser itself, but also attorneys, lenders, underwriters and other specialists. A seller should approach due diligence with full transparency, on the assumption that the purchaser and its representatives will unturn every stone in connection with their investigation. As a result, seller's advance planning and thorough organization are critical for a successful and timely due diligence process. In reality, depending on the size and complexity of seller's business, it is not unusual for due diligence preparation to occur several months to several years in advance of commencement of the actual due diligence process.
From the purchaser's perspective, the purchaser and its advisors should spend time prior to launching a due diligence process assessing what questions to ask and what areas to probe. The purchaser will want to cast a broad net, yet also focus on specific, targeted areas depending upon the nature of the seller, the target company, the industry in question and other factors. Before commencing its due diligence, the purchaser should have a clear idea as to the initial scope of the diligence. Thereafter, as the due diligence process unfolds, the scope may increase or change as new information is revealed. Using a carefully tailored due diligence checklist is often helpful for keeping the buyer organized and on-track.
2. Due Diligence Approach - Multifaceted
A purchaser's due diligence generally entails a multifaceted approach, including written questions or due diligence questionnaires sent from the purchaser to the seller; detailed review of the documents, responses and other materials provided by seller in response to the questionnaires; public records searches; independent industry-specific or company-specific research; reputational investigations including social media; interviews and in-person meetings with management personnel; and the proverbial “kicking the tires” in-person site visits. Depending on the circumstances and complexity of the transaction and the seller's business, a broad and varied due diligence scope is typical.
3. Enter An NDA; Address Communication Strategy
Before sharing any confidential information, the purchaser and seller should enter into a non-disclosure agreement. This is especially important to the seller and target company, to ensure that their confidential information provided in due diligence will not be leaked to unauthorized parties. Once an NDA is in place, the parties must be careful to comply with its terms, and must ensure that their employees and other representatives understand the requirements and comply as well. Violation of an NDA by a party's employees or agents can be imputed to the party itself, is embarrassing (at a minimum) and can lead to liability.
From the standpoint of messaging, it's critical that the prospective purchaser does not communicate with the seller's employees, vendors, suppliers, contract counterparties or other third parties until the communication strategy has been agreed between the purchaser and seller. Prematurely tipping off employees, suppliers, customers or other third parties to the fact that a transaction is being considered could have highly damaging implications, and could even lead to liability on the part of the purchaser. Communications with such parties is typically restricted by the terms of the NDA in any event.
4. Use Of A Due Diligence Questionnaire
Given the magnitude of questions often involved in a due diligence process, its common for the purchaser to provide the seller with a written list of questions or a due diligence questionnaire. Due diligence questionnaires can vary in length from a few pages to dozens of pages, depending on the size and complexity of the transaction. The seller may consider engaging key employees, legal counsel and others to assist in responding to a due diligence questionnaire.
The seller should be thorough, transparent and organized in addressing the due diligence questions and should not “hide the ball” or otherwise be nonresponsive to the purchaser's requests for information. The seller's response, which generally includes both narrative descriptions and copies of documents, is typically provided by email, or, in more complex transactions where the materials are voluminous or where multiple parties need access to the data, can be uploaded to a digital platform, sometimes known as a war room or virtual data room (or VDR).
From the purchaser's perspective, it's important for the purchaser to use an appropriately tailored due diligence questionnaire - and not a “canned” list of questions taken from an online source or from an unrelated transaction. Purchaser, with the assistance of its advisors, should assess the topics that are relevant to the transaction, and should tailor the due diligence questionnaire accordingly. Requesting "everything but the kitchen sink" is rarely an effective strategy. Also, its incumbent on the purchaser to be persistent, pose follow-up questions where appropriate, and otherwise ensure that all of its questions are addressed to its satisfaction before proceeding to closing.
The topics covered in a legal due diligence questionnaire vary by transaction. In an M&A deal, for instance, legal diligence topics often include:
- financial, including financial statements, prior results, projections and budgets;
- commercial, including marketing, competition and customer agreements;
- legal and regulatory, including copies of material contracts, default history, entity status and litigation;
- the company's corporate/LLC governance practices;
- insurance coverage and claims;
- related party transactions;
- licenses and permits;
- compliance and ethics matters such as sanctions, anti-bribery and antitrust;
- reputational diligence, including social media profiles, lifestyle and professional credentials;
- labor relations and employment matters, employee benefit plans, collective bargaining agreements and management bio's;
- intellectual property;
- information technology, data privacy and cyber security;
- if real estate is involved, property condition, environmental, title, zoning and land use; and
- other business and industry-specific matters
Within each applicable topic, specific questions or requests are posed to the seller, tailored to the needs of the transaction and the buyer's risk appetite.
5. Management Meetings
In-person (or virtual or telephonic) management meetings are an important part of due diligence. Often, much can be accomplished though discussion and conversation which might otherwise be lost in the stream of emails. All meeting participants should be prepped in advance of the meetings, and such meetings should have clearly defined goals and objectives.
As noted above, NDAs must be complied with throughout the management meetings and indeed throughout the overall due diligence process.
Analyzing company management is essential in M&A due diligence, especially where the management team or key individuals will remain in place after the closing. After all, the management team can make the difference between a successful operation and one that fails. Moreover, the leadership teams from both organizations should get to know one another to facilitate a smooth transition following the acquisition.
6. Site Visits
Depending on the nature of the target company and the assets being acquired, site visits can be a very important part of due diligence. Site visits allow the buyer to ensure that the assets in fact exist, and to witness their condition first-hand. In other words, a due diligence site visit provides the buyer with comfort that he or she is not "buying swampland in Florida", as the expression goes.
Before a site visit occurs, the prospective purchaser must always ensure that it has the necessary permissions from the seller before entering the seller's property or place of business. In some instances, its normal that a purchaser may be required to provide the seller with evidence of insurance or other required documentation before entering the seller's property, as well as an indemnity in the event the purchaser causes damage to the seller's property during its due diligence studies.
7. Public Record Searches
In addition to relying on information provided by the seller and gleaned through buyer's own research, site visits and management meetings, prospective buyers should conduct public record searches, as an additional aspect of a thorough due diligence process. Public records can be very revealing and may lead to new lines of questions not previously addressed through the other aspects of due diligence.
Moreover, under certain state laws, a person may be deemed on notice of matters of public record from a legal perspective - whether the person is in fact aware of the public record or not. Thus, for example, if a seller fails to disclose a particular item in due diligence but the matter is part of the public record, the purchaser may nonetheless be charged with knowledge of the matter, even if the purchaser was not actually aware of it. Such imputed knowledge can have significant legal ramifications in a transaction.
Public record searches can include litigation, liens, bankruptcies, taxes, land records, registered sex-offender records, motor vehicle records, filings with public agencies such as the Securities and Exchange Commission, and more. Buyers need to decide upon the scope of the public records searches, including which jurisdiction(s) and agencies the searches should be conducted in, how far back in time the searches should extend, and the precise names of the entities or persons that are the subject of the search.
Pro Tip: Like other aspects of due diligence, determining the scope of a public records search is a judgment call. A greater scope is more informative and ultimately more protective to the purchaser than a smaller scope, but is obviously more time consuming and costly.
The importance of robust due diligence in acquisitions and other commercial transactions can not be overstated. A pending transaction should not proceed to closing unless the buyer is satisfied with its due diligence, and the underlying transaction documents must be carefully written to allow for same.
All parties involved in due diligence should take the time to understand and implement the important considerations listed above so that the due diligence process can advance in an organized and thorough manner, while hopefully minimizing unnecessary frustration.
The Law Office of Jenifer M. Settles can help parties understand and perform due diligence, so that their transactions are poised for successful outcomes. Contract Prime Legal Freelance today at (602) 617-3938, or through the Contact Form on our website, www.jsettleslaw.com, for a FREE initial consultation.
Jennifer M. Settles, Esq. is a corporate lawyer at the Law Office of Jennifer M. Settles. She advises clients on M&A transactions, commercial contracts, real estate matters, financing transactions, corporate law and governance. To schedule a free initial consultation with Jennifer, please call 602-617-3938, or complete the Contact Form on the website.