ENL 12

Step 10, Due Diligence

Due diligence is merger and acquisition buzz words for "check out the other person or entity diligently."

The due diligence process takes place between the time of the agreement on the terms of the deal (Letter of Intent) and the signing of the final documents (Definitive Agreement). The letter of intent usually has a paragraph that gives each party the right to perform due diligence and obligates each to cooperate with the other.

Both the seller and the buyer should check representations made by the other party and study other factors that might affect the business.

The buyer perceives that he or she has more risk in the transaction than the seller because the buyer has more unknowns to investigate. The buyer has all the business variables to absorb and investigate, whereas the seller's main concern is getting paid.

Before the buyer starts due diligence, the seller needs to address the issue of telling key employees about the impending transaction. The due diligence process will usually involve the buyer or buyer representatives talking to those key employees. If the seller and buyer are confident that they will complete the deal, then the sooner the key employees know, the better.

If some item is not in place, such as third party financing, then disclosure to key employees may be risky. It is hard to finesse a full-blown audit, 1/3 of the way through the fiscal year with the key employees. They will know something is up. They will suspect the worse if the seller doesn't disclose the reason. Each situation has to be analyzed and acted upon based on the facts of that situation.

Buyer Investigation of the Seller and the Business

The buyer's prime focus is on the valuation of the business. Is the projected cash flow adequate to support the purchase price?

This means that the buyer wants to understand the historical financial statements, the sellers personal take-out and any non-recurring events that had an impact on past financial reporting.

The buyer will want to understand the operations, the products and services, the past and future markets and the organization's capabilities.

Based on the investigation, the buyer will prepare a business plan that projects the future cash flow and cash needs of the business.

The financial investigation may include an audit. If so, the seller should make sure that the payment responsibility and the rights to the audit reports are fully defined. Typically, if the buyer pays for the audit, the seller will not get to see the report unless the transaction is completed. (This is because the buyer doesn't want the seller using the audit report to market the business to a competitive bidder.)

The following is an outline due diligence check list for a typical buyer of a medium-sized business. This is not meant to be a comprehensive list. It is only for illustration to demonstrate the myriad of issues the buyer faces:

Financial

( ) Source and authenticity of financial data

( ) Balance sheet

( ) Analysis of working capital assets (cash, receivables, inventories, other)

( ) Analysis of fixed assets (furniture, fixtures, equipment, depreciation)

( ) Analysis of intangible assets

( ) Analysis of liabilities (payables, reserves, debt, defaults, other)

( ) Assumption of debt

( ) Bulk sale procedure

( ) Personal guarantees

( ) Financial operations analysis (sales, gross profit, expenses)

( ) Search of public records for liens or judgments

( ) Profits by product, division or other category

( ) Sales and employment tax releases

( ) Tax liabilities

( ) Anticipated tax refunds

( ) Review of tax audits (income, sales, payroll)

( ) Bankruptcies, foreclosures

( ) Off balance sheet assets and liabilities

( ) Fiduciary insurance and bonds

Legal

( ) Company and corporate background and history

( ) Corporate by-laws and minutes

( ) List of stockholders, their holdings and rights

( ) Shareholder agreements

( ) Intermediary agreements

( ) Indemnification agreements

( ) Licenses

( ) Lawsuits existing and potential

( ) Product liability insurance and continuation rights

( ) Compliance with all regulations and laws

( ) Pending changes in laws and regulations that might affect the business

( ) Governmental approvals required for transaction and transfer of permits

( ) Patent and Trade mark search for possible infringing products or names

( ) Patents, copyrights, trademarks

Operational

( ) Pending negotiations for purchase or disposition of assets

( ) Business and strategic plans

( ) Unresolved claims

( ) Customer warranty obligations

( ) Products (technical, brands, quality, future)

( ) Sales and marketing systems

( ) Market studies

( ) Confirmation of satisfaction from major customers

( ) URL ownership and website management

( ) Competition

( ) Product life cycle

( ) Product development

( ) Product pricing policies and procedures

( ) Existing customer contracts

( ) Backlogs

( ) Anticipated supplier rebates

( ) Distribution, franchising and licensing agreements

( ) Customer lists, percent of sales by customer, and ratings

( ) Risk analysis

( ) Supplier, sales and other contracts

( ) Production methods

( ) Quality control

( ) Materials control

( ) MRP systems

( ) Engineering, development and research

( ) Capital spending requirements

( ) Legal encumbrances and obligations on assumptions

( ) Contingent liabilities

( ) Trade secrets

( ) Ownership of technology

( ) Special industry laws and regulations

( ) Licenses and permits

Real Estate

( ) Leases (property and equipment)

( ) Assumption of leases

( ) Lease equity

( ) Leasehold improvements

( ) Landlord or creditor approvals required

( ) Zoning, use permits

( ) Landlord disputes

Personnel

( ) Organizational chart, census and position descriptions

( ) Data on key employees

( ) Confirmation that key employees will stay

( ) Employment contracts

( ) Deferred compensation plans

( ) Employee succession planning

( ) Personnel and compensation policies

( ) Employee manuals

( ) Employee medical and industrial hygiene

( ) EEO, handicapped, immigration, other government mandates

( ) Pension and profit sharing plans

( ) Unfunded pension liabilities

( ) Stock options

( ) Other benefits

( ) Family members in the business or other special personal relationships

( ) Independent contractor relationships

( ) Workmen's compensation status, history and pending refunds

( ) Unions and union contracts

( ) Employee morale

( ) Employee morale programs

( ) Retiree obligations

( ) Accrued vacation and liability sick leave

( ) Insurance (health and life)

Environmental

( ) Safety records and OSHA compliance (citations?)

( ) Environmental compliance

( ) Environmental audit

( ) Criminal liability for breach of environmental laws

( ) Toxic and hazardous waste compliance

( ) Asbestos exposures

( ) Underground storage tanks

( ) Material Safety Data Sheets on products

( ) Future environmental risk evaluation

The buyer's due diligence task is formidable. If the buyer is wrong, there is no title insurance to fall back on.

Just organizing the due diligence process is formidable. I have found, as an intermediary, I can help by getting the buyer to list the documents and tasks required. I take the list and with the seller, assign responsibilities and schedules for each document and task. I use the list for periodic progress reporting and expediting.

Seller Investigation of the Buyer

When the transaction is dependent upon third party financing, the seller should demand the right to approve the financing (in the Letter of Intent). First, because the seller needs to know the buyer has the financing to complete the transaction and second, if there are any future payments, the lender may put restrictions on monies the seller can receive.

Many transactions have monetary post-closing obligations. The seller needs to make sure that the buyer will honor these commitments. A typical deal will have a management agreement, a non-compete agreement, a consulting agreement, possibly an earn-out based on future performance and possibly royalties.

The seller needs to check the integrity and financial capability of the buyer.

First, the seller should get all of the credit and financial information that the buyer will supply directly. This includes personal and company financial statements, banking references, and permission to check credit and to verify assets and liabilities on the financial statement.

If there is a third party guarantor, the seller should get the same information from the guarantor.

Next, the seller should check the buyer through the standard credit and financial reporting agencies, and follow-up on the banking references.

If public stock is involved, then the seller should get and review the 10K's and 10Q's. If the buyer is a privately held corporation, the seller should check its financial viability and capability. This may mean a complete review and understanding of the buying corporation.

For most sellers, there is more than money in a successful transaction. The buyer must be technically capable of operating the business. The seller must verify this capability.

If the buyer is an individual, the seller should review the buyer's resume and check past employers. If the buyer is a company, then the seller should check the company's capabilities and compatibility.

And for most sellers, there is that intangible that I call chemistry. The chemistry must be right or the transaction won't close. It may take several meetings between seller and buyer before each begins to feel comfortable with the other. If this doesn't happen, the chemistry isn't right, and the deal shouldn't proceed.

Due diligence can be an expensive part of the process. A seller would be well advised to point out any negatives about the business early on. If the negatives are deal-breakers, the sooner they are exposed, the better for all.

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Tip of the Month

The time to develop your exit strategy is the day you start the business. If you missed that date, the time is now!

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