Company Law

Contents

1. What is the Due Diligence Process?

2. Due Diligence Review

3. History of Due Diligence

4. What Types of Due Diligence Are There?

5. Why is Due Diligence Important?

6. What are the Challenges of Due Diligence?

7. Conducting Due Diligence

8. Due Diligence Checklists

9. Due Diligence Process Steps, Policies and Procedures

10. How Long is the Due Diligence Period

11. How Many Due Diligence Requirements Are There

12. How to Do Due Diligence in a Private Company

13. Conduct the Due Diligence Process the Right Way

14. Key Due Diligence Activities In A Merger And Acquisition Transaction

15. Conclusion

1. What is due diligence process?

Due diligence is the process of gathering and verifying relevant information about a company or person to enable the ordering party to make an informed decision. The ordering party can be the buyer or the seller – due diligence has value for both parties in any M&A scenario.

Due diligence should enhance the quality of any information that the parties already hold, but should also provide additional information, for example, that relating to ultimate beneficial ownership (UBO), media coverage, litigation, enforcement actions or reputational concerns.

⮚ For buyers, thorough due diligence reduces the risk involved in purchasing another company. Adequate due diligence gives the buyer transparent oversight and enables an accurate valuation of the target company based on the risks and opportunities it brings to the table. Access to detailed, relevant information equips buyers to make informed decisions as to whether or not to proceed, adjust the terms of a potential deal or walk away.

⮚ For sellers, due diligence indicates their company's real market value, which in turn allows them to set realistic purchase price expectations. Moreover, the seller can obtain detailed, relevant information on the prospective buyer, which will help them decide if entering into the agreement would be beneficial, both from a financial and a reputational perspective.

2. Due Diligence Review

The due diligence process throws up lots of information on the target company, across all of its operational areas. The goal of the due diligence review is to piece together all of this information into a coherent story.

This usually involves the people in charge of the due diligence process convening and deciding if there’s anything that was disclosed in the process that changes their initial opinion on a deal.

3. History of Due Diligence

The term due diligence originated in the 1930s, though the practice was most likely already in action during the mid-fifteenth century.

The legal term originally comes from the US, where the process is referred to as ‘reasonable investigation’ in the US Securities Act of 1933. The act endorses a law against dealers accused of disclosing inadequate information regarding purchase of property or securities to investors.

4. Types of due diligence

In mergers and acquisitions, we typically think of four major types of due diligence:

● Financial due diligence: Focusing on the financial performance of the company until the present date and ensuring that the numbers presented in the financial statements are accurate and sustainable. Financial due diligence is a crucial assessment of the financial health of the business where the company’s historical and current financial performance is scrutinized. Its aim is to establish future forecasts with any and all potential risks. A key part of financial due diligence is reviewing financial statements, assets, debts, cash flow and projections to determine whether they are true and accurate. This helps the buyer get a better understanding of the company’s core performance metrics.

● Legal due diligence: Focusing on all legal aspects of the company and its relationships with its stakeholders. It is an exercise in risk assessment to investigate any potential liabilities of the target company that could impact a successful transaction. Legal due diligence will typically include a careful examination of all material contracts, including partnership agreements, licensing agreements, guarantees, and loan and bank financing agreements.

● Operational due diligence: Focusing on the company’s operations - essentially looking at how the company turns inputs into outputs. This is generally considered to be the most forward looking type of due diligence. In M&A transactions, operational due diligence assesses whether operational improvements could create additional value in the transaction, or if there are operational risks that should be addressed.

● Tax due diligence: Focusing on all of the company’s tax affairs and ensuring that its tax liabilities are paid in full to date. Corporate tax due diligence is a review of all the taxes a company is required to pay. It assesses the company’s total tax liability and the level of compliance with tax laws. This includes the validation of documents like tax returns (usually for the last three to five years), information pertaining to tax audits, and agreements with tax agencies. It aims to ensure all the company’s taxes are being paid and reported. Due diligence in tax also looks at how a merger would affect the tax liabilities of the new entity created by the transaction.

● Intellectual Property due diligence: IP due diligence is an in-depth assessment of the quantity and quality of a target company’s intellectual property assets. While these assets are intangible, they are often an important contributor to the company’s overall value and something that can set them apart from their competition. In IP due diligence, patents, copyrights, trademarks and brand are evaluated, along with how well they are protected and covered.

5. Why Is Due Diligence Important?

From a buyer’s perspective

Due diligence allows the buyer to feel more comfortable that their expectations regarding the transaction are correct. In mergers and acquisitions (M&A), purchasing a business without doing due diligence substantially increases the risk to the purchaser.

From a seller’s perspective

Due diligence is conducted to provide the purchaser with trust. However, due diligence may also benefit the seller, as going through the rigorous financial examination may, in fact, reveal that the fair market value of the seller’s company is more than what was initially thought to be the case. Therefore, it is not uncommon for sellers to prepare due diligence reports themselves prior to potential transactions.

6. What are the Challenges of Due Diligence?

Gaining an in-depth understanding of a company can be a highly specialized process beyond most people without experience in the field.

There tend to be a myriad of challenges, but the following are usually among the most commonly encountered:

● Not knowing what questions to ask: It is vitally important to know in advance what the issues are and what diligence questions need to be asked to investigate them properly. If some vital questions are not put forth, it can lead to misinformation.

● Slowness of execution: Asking sellers to acquire documentation or information can take time, often with the consequence of delaying the transaction’s closing. Due diligence is a time-taking process and the results might not be received as soon as expected.

● Lack of communication: Sellers, even willing sellers, tend to regard due diligence as a hassle, leading to impatience, poor communication, and even friction. Sellers may withhold necessary information and this might lead to uncertainty.

● Lack of expertise: There is a good chance that you’ll have to bring in some hired hands for at least some parts of the due diligence process (e.g., an IP expert). These experts might be a little expensive and if people who lack knowledge in the field take part in the due diligence process, it can affect due diligence in a negative manner.

● Cost challenges: Due diligence can be expensive, running into months and extensive specialist hours, making many erroneously think that they can cut corners.

7. Conducting Due Diligence

Conducting due diligence is an essential component of any M&A transaction. To conduct due diligence means to thoroughly analyze a commercial business. It is done typically by a potential buyer prior to business transactions.

How to conduct due diligence on a company differs by transaction, but there are certain steps that are common to each deal. As a general rule, the larger and more complex the deal, the more due diligence will be required.

The following steps are thoroughly examined in all due diligence processes:

● Income statements

● Balance sheets

● Partnership agreements

● Existing contracts

● Profit/loss records

● Annual reports

● Tax filings

● Business and operational practices

8. Due Diligence Checklists

Due diligence is defined as the research and analysis of a company or organization done in preparation for a business transaction. A due diligence checklist incorporates all the necessary information a company must acquire from their target before moving forward with a deal.

a. Legal Due Diligence Documents

● Shareholder certificate documents

● Local/state/federal business licenses

● Occupational license

● Building permits documents

● Zonal and land use permits

● Tax registration documents

● Power of attorney documents

● Previous or outstanding legal cases

b. Financial Due Diligence Documents

● Up-to-date tax returns documents

● Audited financial statements (at least 3 years)

● Auditor's correspondence for last five years

● Copies of all loans and credit agreements

● Details of company investments (bonds, marketable securities, etc.)

● Capital structure

● Projections, capital budgets, and strategic plans

● Up to date tax and pension liabilities

● Details on when contracts and leases are renewed and whether the terms change

● Details of stockholders (percentage holdings, voting rights, etc.)

● Foreign exchange reserves

● List of unrecorded liabilities

● List of collateral for debt

● Details of owner withdrawals (if any)

● Revenue by client (if possible)

● Gross margins analysis

● Fixed/variable expenses analysis

● List of non-operational expenses

● General ledger

c. Sales and Marketing Due Diligence Documents

● Detailed overview of sales and marketing strategy

● Marketing/sales coordination protocols

● Revenue listed by customer

● Exhibit relationship between marketing expense and revenue growth

● Details of existing sales contracts (and when they expire)

● List of top 10 suppliers

● Sales reports by category of product or service

● Details of credit terms with customers

● Current market share (if possible)

● Percentage of sales owing to each sales channel (e.g. online, offline, direct sales, etc.)

d. Human Resources Due Diligence Documents

● Provide a list of current employees and independent contractors

● Employee rules of conduct handbook and safety policies

● Detail past employee disputes (if any)

● Detail employee and independent contractor terms of employment

● Detail updated employee resumes

● Outline policy of working with labor union (if any)

● Outline training conducted with existing employees

● Worker's compensation/unemployment claims history

● Outline policy of bonuses, incentives, commissions and deferred commissions

● Detail policies for sick days, paid holidays, paid vacations and overtime pay

e. Property, Plant, and Equipment Due Diligence Documents

● Equipment

● Real estate

● Technology

● Inventory

f. Contract Due Diligence Documents

● Customer contracts

● Supplier contracts

● Joint venture/partnership agreements

● Settlement agreements

● Franchising agreements

● Accounts receivable schedule

● Accounts payable schedule

● Equipment leases

● Non-compete agreements

● Employee contacts

● Loans, credits, and guaranties agreements

g. Intellectual Property Due Diligence Documents

● Trade secrets

● IP claims and litigation

● Domain names

● Issued patents

● Patent applications

● Design patents

● Design patent applications

● Industrial designs

● Industrial design applications

● Liens on intellectual property

● Copyrights

● Licenses

● Licensing agreements

● Trademarks

● Agreements/documents regarding ownership and rights of use of advertising copy, trade-marks, logos, and slogans

h. Company's Good Standing and Organization Due Diligence Documents

● Organizational Chart

● Shareholders/percentages owned

● Voting trusts, subscriptions, calls, puts, options, and convertible securities agreements

● State of incorporation status reports for the last three years

● Assumed names

● Company minutes book

● Company bylaws and amendments

● List of the states and countries where the company has employees, owns assets, leases assets, and does business

● The Articles of Incorporation/amendments.

● Annual reports for the last three years.

● A Certificate of Good Standing from each Secretary of State where the company conducts business

How to Find a Complete Due Diligence Checklist for your Deal

Every deal is different, therefore no two due diligence checklists will be identical. The above list is just a general guideline of some materials collected during due diligence. For your own process, check with your team if you have conducting similar deals in the past to begin your checklist.

For example one deal may need the following categories - administrative, financial, asset, human resources, environmental, intellectual property, taxes, and legal.

Many of the documents will be partially or fully available straight away (for example, details of your employees and their training to date) while others, such as the audited financial statements, will by their very nature, take longer to put together.

If your company has high quality CRM, ERP or BI systems, they can be used to bring together all kinds of useful data used in due diligence. The feedback provided by these systems also gives reassurance to potential buyers that there’s no human error in the data they’ve received.

When Should You Provide Due Diligence Documents to the Buyer?

Keeping thorough and updated due diligence documents allows you to get relevant information over to the buyer of your business efficiently and with as little friction as possible.

The world of M&A is full of tire kickers who enjoy finding out about businesses simply to see what’s out there. Asking you for due diligence documents rarely costs them anything (hence the reason why some bankers push for charging buyers for due diligence).

The best policy is to begin by providing audited financial statements - a great signaling device for any owner looking to sell their business that their ship is in order - and send over documents as they’re requested by the buyer, who should have signed an NDA in advance.

9. Due Diligence Process Steps, Policies and Procedures

1. Evaluate Goals of the Project

As with any project, the first step delineating corporate goals. This helps pinpoint resources required, what you need to glean, and ultimately assure alignment with the firm’s overarching strategy.

This involves introspective questions revolving around what you need to gain from this investigation.

2. Analyze of Business Financials

This step is an exhaustive audit of financial records. It ensures that documents depicted in the Confidentiality Information Memorandum (CIM) were not fluffed. Additionally, it helps gauge the company’s asset health, asses overall financial performance and stability, and detect any red flags.

Some of the Items inspected here include:

● Balance sheets and income statements

● Inventory schedules

● Future forecasts and projections

● Revenue, profit, and growth trends

● Stock history and options

● Short and long-term debts

● Tax forms and documents

● Valuation multiples and ratios in comparison to competitors and industry benchmarks

● The detailed financial due diligence checklist could be found here.

3. Thorough Inspection of Documents

This due diligence step begins as a two-way conversation between buyer and seller. The buyer asks for respective documents to audit, conducts interviews or surveys with the seller, and goes on-site visits. Responsiveness and organization on the seller’s end are key to expediting this process. Otherwise, it may create an arduous experience for the buyer.

Following this, the buyer examines the information collected to ensure proper business practices as well as legal and environmental compliances. This is the major part of due diligence process. Overall, the buyer gains a better understanding of the firm as a whole and can better appraise long-term value.

4. Business Plan and Model Analysis

Here, the buyer looks specifically at the target company’s business plans and model. This is to assess whether it is viable and how well the firm’s model would integrate with theirs.

5. Final Offering Formation

After information and documents are gathered and examined, individuals and teams collaborate to share and evaluate their findings. Analysts utilize information collected to perform valuation techniques and methods. This substantiates the final dollar you are willing to offer during negotiation.

6. Risk Management

Risk management is looking at the target company holistically and forecasting risks that may be associated with the transaction.

7. How Long is Due Diligence Period

While road mapping, it may seem difficult to forecast how much due diligence is enough. Despite its comprehensive nature, the due diligence process should only last between 30 and 60 days. This is achievable if delegated to an efficient, dynamic team from multiple business functions. Ultimately, you want to close the deal as soon as possible, while also being thorough.

But, in reality, it is impossible to uncover all issues and potential complications during the investigation. Some items will not be uncovered until integration. However, the same idea applies to potential benefits. This reinforces the importance to be energetic and efficient while maintaining quality to meet the due diligence period deadline.

8. How Many Due Diligence Requirements Are There

Cultivating good organization and strategizing is key when trying to navigate due diligence process and meet the necessary requirements. So you can stay systematic, outlined below is a typical due diligence management folder structure for M&A transactions:

● Transaction Related Documents

● Corporate Documents

● Contracts and Agreements

● Customers, Sales, and Marketing

● Procurement (Suppliers)

● Property and Equipment

● Environmental

● Legal, Litigation, and Regulatory

● Intellectual Property

● Financial

● Tax

● HR and Employees

● Insurance

● Operations

● Information Technology

● Industry and other

9. How to Do Due Diligence in a Private Company

No two M&A deals are the same. Each incorporates its own character of size, business owner and leadership personalities, culture, and industry to create a unique transaction.One factor that makes transactions more complex and due diligence process more complicated is when a company is privately held. Unlike publicly traded companies, private companies are not auctioned and traded conventionally on the stock market.

Investors cannot easily buy shares unless they are founders, employed there, or have invested via venture capital or private equity firms. To save some headaches down the line, detailed here are some best practices for the private equity due diligence process:

● Understand Your Financial Situation - Before even researching companies or drafting out an LOI, you need to look at your own books. Do you have enough resources to complete the transaction and bounce back if it does not work out? If not, maybe consider a smaller scale investment or wait a little while.

● Accounting Procedures and Financial Statements - Publicly held companies must abide by GAAP and IFRS and are audited regularly to ensure compliance. Regulations on privately held companies are not as strict. This allows them to use different accounting procedures or even practices off the beaten path. Rather than traditional accrual accounting, it may not be unusual to see cash-basis or something else more arbitrary.

● Size - Private companies are almost always smaller than public. This doesn’t only mean fewer employees and less office space, but also likely smaller revenues.

● Human Resources Practices - Smaller, younger businesses may not have standardized HR processes. Here, you want to check out items such as questionable terminations, harassment charges, hiring practices, and if/what workplace policies exist.

● Legal - The last thing you want from any investment is to soon find that it is riddled with legal issues. Some details to consider here are tax compliance, any past or outstanding lawsuits, and overall obedience to applicable jurisdictions.

● Valuation - Valuation methodologies are the same between private and public companies. However, you have to adjust for lack of liquidity and publicly available market caps.

● Management and Leadership - The company you are considering buying could have been the brainchild of siblings or friends. Meaning, they could be a little protective. You will want to meet and get to know them to determine if there is any hostility associated with the transaction. By and large poor, disgruntled management will trickle down the m&a buy side due diligence process and negatively impact the business.

● The Business - Overall, do you believe in the company, their strategy, and mission? Is this something you see as truly being successful?

10. Conduct the Due Diligence Process the Right Way

Conducting proper due diligence is an important, yet tedious process. Here are a few helpful tips:

● Use Diligence Management Software - Diligence management software combines the features of a traditional virtual data room with project management capabilities. This allows users to not only securely store data but effectively manage and share files as well.

● Start Early - The diligence process can be extremely time-consuming. It’s best to get started early in an organized manner

● Utilize Checklists - When teams use a diligence management software, they can easily create organized checklists. For example, rooms can be broken down into different stages of diligence. Users can efficiently check items off as they are completed.

● Address Potential Risks Throughout the Process - If potential bottlenecks and risks arise during diligence, teams should address them promptly.

● Employ Experts - Hiring M&A professionals such as investment banks and consultants make the due diligence process more efficient. Deal teams have experience with conducting diligence and know the necessary steps to take.

11. 20 Key due diligence activities in M&A transaction

Mergers and acquisitions typically involve a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying and what obligations it is assuming, the nature and extent of the target company’s contingent liabilities, problematic contracts, litigation risks and intellectual property issues, and much more. This is particularly true in private company acquisitions.

A. Financial Matters. The buyer will be concerned with all of the target company’s historical financial statements and related financial metrics, as well as the reasonableness of the target’s projections of its future performance.

B. Technology/Intellectual Property. The buyer will be very interested in the extent and quality of the target company’s technology and intellectual property.

C. Customers/Sales. The buyer will want to fully understand the target company’s customer base including the level of concentration of the largest customers as well as the sales pipeline.

D. Strategic Fit with Buyer. The buyer is concerned not only with the likely future performance of the target company as a stand-alone business; it will also want to understand the extent to which the company will fit strategically within the larger buyer organization.

E. Material Contracts. One of the most time-consuming (but critical) components of a due diligence inquiry is the review of all material contracts and commitments of the target company.

F. Employee/Management Issues. The buyer will want to review a number of matters in order to understand the quality of the target company’s management.

G. Litigation. An overview of any litigation (pending, threatened, or settled), arbitration, or regulatory proceedings involving the target company is typically undertaken.

H. Tax Matters. Tax due diligence may or may not be critical, depending on the historical operations of the target company, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carryforwards and their potential benefit to the buyer may be important.

I. Antitrust and Regulatory Issues. Antitrust and regulatory scrutiny of acquisitions has been increasing in recent years.

J. Insurance. In any acquisition, the buyer will want to undertake a review of key insurance policies of the target company’s business.

K. General Corporate Matters. Counsel for the buyer will invariably undertake a careful review of the organizational documents and general corporate records (including capitalization) of the target company.

L. Environmental Issues. The buyer will want to analyze any potential environmental issues the target company may face, the scope of which will depend on the nature of its business.

M. Related Party Transactions. The buyer will be interested in understanding the extent of any “related party” transactions, such as agreements or arrangements between the target company.

N. Governmental Regulations, Filings, and Compliance with Laws. The buyer will be interested in understanding the extent to which the target company is subject to and has complied with regulatory requirements.

O. Property. A review of all property owned by the target company or otherwise used in the business is an essential part of any due diligence investigation.

P. Production-Related Matters. Depending on the nature of the target company’s business, the buyer will often undertake a review of the company’s production-related matters.

Q. Marketing Arrangements. As part of diligence, the buyer will want to understand the target company’s marketing strategies and arrangements.

R. Competitive Landscape. The buyer will want to understand the competitive environment in which the target company’s business operates.

S. Online Data Room. It is critically important to the success of a due diligence investigation that the target company establish, maintain, and update as appropriate a well-organized online data room to enable the buyer to conduct due diligence in an orderly fashion.

T. Disclosure Schedule. As part of any M&A transaction, the target company will be required to prepare a comprehensive disclosure schedule addressing many of the key diligence topics described above, and identifying any exceptions to the company’s representations and warranties in the acquisition agreement.

Conclusion

The due diligence process is never easy, but that doesn’t mean it has to be inefficient and disorganized. With the proper software and workflows in place, diligence can be straightforward and productive. After all, the information that is discovered during diligence is critical to a deal’s success.