Due Diligence:  A Deep Dive Into A Company's Business

Due diligence  . . .   You've probably heard about it, and perhaps those words were followed with an eyeroll and a groan.  Perhaps you have the impression that due diligence is a long, expensive, complex and potentially insurmountable process. 

There is no doubt that due diligence is complex.  After all, it does not lend itself to a "one-size fits all" approach, and it can be broad and nebulous.  Significantly, material adverse legal and financial implications can arise if due diligence is not performed correctly.  As a result, a due diligence process should always be executed with proper legal and other third party guidance, and according to specific standards.

In this Blog post, we demystify due diligence and discuss its importance in specific contexts.      In our other Blog post, we dive in further and discuss seven important considerations for successful due diligence.  

First, the basics

What is due diligence?   

• Due diligence means doing reasonable and appropriate (in other words, "due") research and analysis of a counterparty (in a word, "diligence"), in preparation for a business transaction.
• Done in many types of commercial transactions, including merger and acquisition (M&A) deals, real estate deals, lending transactions, purchase and sale of goods or services, and more.   
• May be performed by the prospective purchaser in a transaction, and also by other interested parties such as investors, insurers and lenders. 
• Performed by a party for its own informational purposes, as a way of obtaining knowledge and comfort regarding the assets and risk being acquired or assumed, and regarding the reputation and wherewithal of the counterparty to the transaction. 
• Performed on a proposed JV or other equity partner and their management, to ensure that they will not trigger issues with the federal government under the new Corporate Transparency Act.
• Constitutes part of the equation for protection and risk-mitigation in a transaction (with the other part being robust contractual provisions from the counterparty to the deal, such as contract representations, warranties and indemnities).
• Typically includes review and analysis of financial information, market conditions, contracts, agreements and documents, public records, regulatory matters, third party reports (such as environmental assessments, appraisals and engineering reports), site visits, management meetings/interviews, and more.
• The information acquired from due diligence informs the purchaser as to whether to proceed with the transaction or terminate negotiations; and as to whether an adjustment to the purchase price and/or other deal terms is warranted.

From the seller's perspective, a seller is responsible for accurately and adequately responding to the due diligence requests.   If the seller fails to sufficiently cooperate in due diligence, the buyer might choose to terminate negotiations, or might seek to modify the pricing and other deal terms in a manner that better reflects the transactional risk.   Moreover, in certain egregious scenarios, erroneous or fraudulent due diligence materials provided by or on behalf of the seller  could lead to legal liability on the part of the seller or its principals. 

In an M&A deal, the purchaser will perform legal, financial and operational due diligence on the target company and its sellers, including the counterparty's financial results, legal status, operational performance, employee matters, commercial attributes, contracts, compliance and more.  In a real estate deal, a buyer will perform due diligence relating to the subject property, such as environmental conditions, status of title, and local land use requirements.     

For other commercial contracts, a purchaser of goods or services may perform due diligence on the vendor or service provider, to gain comfort that the counterparty will be a legitimate and reputable business partner who possesses the means to meet its contractual obligations. An insurer performs due diligence on the proposed insured risk as part of its underwriting, and a lender performs due diligence on the borrower and the borrower's assets to confirm value of any collateral, creditworthiness and other compliance matters.

In a typical due diligence process, the purchaser's legal counsel takes the lead in performing legal due diligence, while other specialists perform tax, financial, operational, environmental and other types of due diligence, depending on the transaction.  Depending on the circumstances, it's not unusual for a due diligence process to take 30, 60, 90 days, or even much longer.

Why perform due diligence?

Parties perform due diligence in order to understand what they are buying or investing into, or to better understand who they are partnering with.   By performing due diligence, parties are better able to make informed decisions about whether to proceed with a proposed transaction and on what terms, and to understand the risks involved in the transaction.  Due diligence results guide parties on whether to proceed with a transaction, pricing of the transaction, deal structure, and other important terms. 

As an example, if a purchaser discovers during due diligence that several of the seller's material contracts will soon be terminating and not renewing, the prospective purchase might use this information as a basis for terminating the transaction or reducing the offered purchase price.   As another example, a purchaser might learn through due diligence that there are several material lawsuits pending against the seller which will not be resolved before the scheduled closing date of the transaction.  In this case, the purchaser might use this information as a basis for requiring an escrow holdback of a portion of the purchase price pending resolution of these claims. 

Pro Tip:  Due diligence constitutes part of the equation for risk-mitigation and protection of a prospective purchaser, with the other part of the equation being robust contract provisions, including representations, warranties and indemnities in favor of the purchaser.  To protect the purchaser, it is essential to conduct thorough due diligence and to have strong contract terms.  

As-Is Transactions

Performing robust due diligence is especially important in "as is" transactions, in which the seller provides no (or limited) contractual representations, warranties and indemnities in favor of the buyer.  This is so because in an as-is deal, the buyer may have literally no recourse whatsoever against the seller after the closing (other than, potentially, for fraud), and thus must rely solely on its own due diligence in the evaluation and protection of the investment.  By performing robust due diligence before the closing, the buyer will at least be proceeding on an informed basis, with knowledge of potential risks it may be taking on.  Let the Latin expression and legal theory Caveat Emptor ("Let the buyer beware") serve as a reminder of the importance of due diligence.

Rep, Warranty and Indemnity Transactions

That said, robust due diligence is also very important in transactions which do contain representations, warranties and indemnities from the seller.  Relying solely on the seller's contractual representations, warranties and indemnities without performing robust due diligence is dangerous and is not a recommended path.  For one thing, proving breach of representation or warranty in litigation can be very difficult and can take a considerable amount of time and money to accomplish, if at all.    Secondly, even if breach is proven, actual monetary recovery under an indemnity can be very difficult, if not impossible, especially if the seller has spent the transaction proceeds or otherwise transferred the proceeds to a non-indemnitor party.  Moreover, depending on the terms of the underlying agreements, indemnity is sometimes capped, whether in amount, or by the passage of time, or both.    As a result, doing your due diligence is an imperative aspect of self-protection in any acquisition transaction (and in deed in many other types of transactions as well), even if the underlying contract provides for representations, warranties and indemnities.

Setting Yourself Up For Success

Due diligence can be time consuming, costly, arduous, and sometimes highly frustrating.   Seemingly endless back and forth questions, lost information, incomplete data, non-responsive sellers and unrealistic buyers are all elements that can make due diligence a painful process.  However, by understanding what to expect during due diligence, and by engaging in best practices and seeking professional assistance, parties can accurately set expectations and increase the likelihood for a mutually successful (and maybe even, dare we say, pleasant) closing transaction.   

Conclusion

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 best practices, so that the due diligence process can proceed in an organized and thorough manner while minimizing unnecessary frustration. 

Jennifer M. Settles, Esq. can help parties understand and perform due diligence, so that their transactions are poised for a successful outcome.  Contract Jennifer  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.

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