BACKGROUND

Due diligence is a key component of every sale or equity financing.  The purpose of this memorandum is to provide an overview of the due diligence process and to offer some practical suggestions.

Due diligence refers to the detailed examination of all aspects of your company, its business, legal and financial affairs, that will be undertaken by a prospective buyer or investor.  Typically, after signing a non-disclosure agreement (an “NDA”), a prospective buyer will start with financial due diligence (review of financial statements for the last three years and the current fiscal period, financial forecasts, etc.).  The prospective buyer will also do some “high level” due diligence regarding your products, services, etc.  The scope of the process will be impacted by whether the prospective buyer is a strategic buyer (often a competitor or company in your supply or distribution channels) or a financial buyer, who is primarily driven by the expected return on its investment.

However, it is worth noting that some prospective buyers may ask the seller for a great deal of additional information before offering a letter of intent (an “LOI”), on the premise that it is necessary to formulate a better proposal.  Unless the seller really needs to sell, it is advisable not to provide much information beyond financial information and other “high level” materials for two reasons.  First, doing so requires a significant amount of management time, before you even know the buyer is prepared to pay something consistent with management’s expectations.  Secondly, even with an NDA in place, it is usually not prudent to provide this level of non-public information and material, particularly to one who may be a competitor, until you receive an LOI with a price and terms that are reasonably acceptable.

If the prospective buyer is interested, a non-binding or partially binding LOI is typically the next step.  If the purchase price and terms are reasonably close to the seller’s expectations, more detailed due diligence typically follows.  Following detailed due diligence, the parties will typically negotiate and sign a comprehensive purchase agreement or merger agreement (the “Purchase Agreement”).  Among other things, the Purchase Agreement will contain detailed “representations and warranties” (factual statements about the company and its business as of the date of the agreement and as of the closing date), as well as “covenants” (promises of things that will or will not be done either before or after the closing.)

One of the reasons the due diligence process is so important for the seller is that the factual representations and warranties in the Purchase Agreement are qualified by factual information set forth in “disclosure schedules” attached to the Purchase Agreement.  For example, the Purchase Agreement will typically contain a representation that says, “Except as set forth in the disclosure schedule, there is no litigation pending or threatened in writing against the Company.”  In general terms, if the disclosure schedule lists a pending or threatened litigation matter, the buyer is on notice of the litigation and either will acquire the seller’s business subject to that potential liability or the Purchase Agreement will otherwise address the matter.  However, if there is litigation pending and it is not described in the disclosure schedules, the seller will remain responsible for that liability.  For those and other reasons, the due diligence process is critically important for both the seller and the buyer.

GETTING READY FOR THE DUE DILIGENCE PROCESS

If you are exploring the possibility of selling your business, the very first step in the process should be a thorough review of the company by its own management. According to the old cliché, “You only get one chance to make a first impression.” While that is certainly true in a social context, it is also true in the business world, where the stakes are usually much higher.

After an NDA and an LOI have been signed, a serious due diligence process will begin.  Most often, this starts with a due diligence checklist, to which you will be expected to respond with both information and documentation. The initial impressions created by your response to this due diligence checklist can have a profound impact on the ultimate terms, price and sometimes, whether the transaction closes at all.  For that reason, you should conduct your own internal due diligence review, correct any deficiencies and assemble the materials that you will likely be asked to produce by a potential buyer.

It is also important to keep in mind two things that shape the impression you make in responding to a due diligence request. The first is the quality and completeness of the information and documentation you provide. The second is how long it takes you to respond. A complete and well organized response is expected, but even a thorough response can create a negative impression if it takes too long to pull together the requested information and documentation.  Conversely, a thorough and timely response to a due diligence request can create a positive first impression about how the company is managed.

To assist in you in getting ready for the due diligence process, we will provide you with a due diligence checklist similar to what you can expect from a prospective buyer.

RESPONDING TO DUE DILIGENCE REQUESTS

It is critically important to manage and control the due diligence process because it can easily get away from the company if certain steps are not implemented from the very beginning. 

We strongly urge you to do the following:

1. A single person should be designated to respond to all due diligence requests on behalf of the company.  Everyone with knowledge of the proposed transaction should be instructed in writing to refer all due diligence requests to the designated person and not to send any material out themselves.
2. In almost all cases, due diligence responses are delivered by uploading them to a secure website (an “Electronic Data Room”) which permits us to control access by designated people in the company, the buyer and their advisors.  It also lets us see what was reviewed.  We feel strongly that this data room needs to be controlled by the company and PLDO.  That way materials cannot be removed or others given access without our knowledge and consent.  It also avoids use of DropBox and other commercial products with a questionable history of data security.   We can set that up for the company.  To properly protect the company, the description of what is uploaded to the data room needs to be reasonably specific.  (e.g., “office lease” is NOT enough.  An appropriate description would be “Office lease dated 3/12/2008 between company as lessee and XYZ”.)  If the company has more than one location, including offices, warehouses, etc., the entry also should include the address of the property. The reason this is important is that if the buyer claims (post-closing) that it was given an expired lease which showed a much lower rent, a log entry that says, “Office lease” and a disclosure schedule attached to the Purchase Agreement which says the same thing give the seller no protection whatsoever.
3. Respond to due diligence requests carefully and completely.  It is far better to provide “the good, the bad and the ugly” than to withhold material information and then be subject to an indemnification or fraud claim after the closing.
4. If you do not have the internal time or resources to rigorously manage the due diligence process, we are happy to be the contact person for all due diligence requests.

As noted above, the disclosure schedules attached to the Purchase Agreement are a critical defense to post-closing claims that might be brought up by the buyer against the seller or its shareholders.  Your deal team needs to control the due diligence process in a manner that ensures that the you and your legal advisors know exactly what information and documents were provided to the buyer so that the disclosure schedules ultimately attached to the Purchase Agreement are complete and accurate.

If we can provide any further information or assistance, please let me know.

This memorandum is intended to provide general information of potential interest to clients and others. It does not constitute legal advice. The receipt of this memorandum by any party who is not a current client of the Business Law Group LLC does not create an attorney-client relationship between the recipient and the firm. Under certain circumstances, this memorandum may constitute advertising under the Rules of the Massachusetts Supreme Judicial Court and the bar associations of other states.