One business dictionary defines due diligence as a comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and to evaluate its commercial potential.  While this term gets bandied around a great deal in the business world, it always means something different in each transaction.  This is because the buyer has to make an assessment of what it needs to verify, and to what extent that verification needs to go, in order to assure itself that the business has the assets, the lack of undisclosed liability, and potential that the buyer believes it has.  There is very little standardization of what this entails.  The point of this article is not to describe how to conduct due diligence but to better understand its role in the overall transaction process. 

Due diligence is an on-going process throughout the entire transaction cycle.  It has already begun when the parties identify each other to begin the discussion about the possible sale of the business.  Each has its own objectives in entering into the transaction and is effectively making a preliminary determination that the other may have the potential to satisfy those objectives. 

The seller, for example, will definitely want to be sure that the buyer has the financial wherewithal to perform under the agreement and may also be concerned about how the buyer will continue to operate the business—either for business or personal reasons.  For example, this might include protecting employees who might otherwise lose their jobs as a result of the sale.

The buyer needs to understand what types of risks are inherent in this particular industry.  In almost any business, there will be employment related issues, which can be both expensive and somewhat complicated.  But there also may be issues relative to intellectual property, such as software licenses, patents, and trademarks that need careful investigation in order to capture the business’s value.  The value and condition of hard assets are also important, as well as the quality of customer relationships and the ability to transfer important contracts from the seller to the buyer.  Required governmental licensing may also be a factor.  And undisclosed liabilities are always a concern.  So, a deep dive into past and pending litigation, environmental issues, business practices, and regulatory compliance will also be important.

When and how these investigations take place may be addressed in the letter of intent or may not be addressed until a definitive agreement is signed.  There is no right or wrong way to sequence due diligence into the process.  However, smoothing the way for it to take place needs to be addressed.  Some sellers are not willing to allow much investigation to take place until a definitive agreement has been reached.  Others rely on the confidentiality agreement to allow a great deal of due diligence on the front end with the idea that the definitive agreement will be better informed and easier to draft if most of it is out of the way early in the process.  The reality is that in most deals there is due diligence at all points, even through the post-closing phase of a transaction.

The buyer should carefully craft a due diligence checklist designed to address the business concerns it has in the transaction.  This checklist will be a dynamic document and will continue to expand as more is learned about the target company and as additional advisors are brought into play.  Thought should be given to who should be on the due diligence team.  Environmental testing may be important.  There will be legal considerations and so a lawyer should have input into the due diligence process.  And, of course, there are tax and accounting issues that can be benefitted by accounting professionals.  Appraisers may be necessary, particularly if there is bank financing involved.  Each of these disciplines will have informational needs.  To the extent possible, someone for the buyer should be tasked to coordinate all of these efforts and aggregate the information.  This is important to make sure the wheel is not being reinvented and to make sure information is made available to every member of the team who needs to evaluate it.

While due diligence is predominately a concern of the buyer, the seller does have some issues to think about.  Certain information may be so valuable that the seller does not want to let the buyer have access to it until there is a definitive agreement in place.  Also, the seller needs to be sure that it makes full disclosure in this process.  The seller also wants to keep a clear record of what the buyer had a chance to look at during the due diligence process.  These records may be invaluable to the seller if there is claim after the closing for breach of some warranty or the failure to make full disclosure. 

Confidentiality has been addressed, the parties have a general outline of the deal, and due diligence is moving apace, so now it will be time to talk about the definitive agreement that the parties will use to bind the transaction.  That will be the topic of our next article.