Due Diligence in M&A Transactions: What it Means and How to Ease the Burden
Due diligence is a vital part of M&A transactions. The buyer wants to gather as much information as possible about a seller to understand and value its business, identify any potential risks of owning the business (such as pending litigation or employment-related liabilities) and identify any potential impediments to integrating the business into the buyer’s existing operations. The seller wants to be transparent in responding to a buyer’s requests, but also identify and mitigate issues about its business that might jeopardize the transaction or reduce the purchase price. While a buyer and seller have different motives and objectives, due diligence is an important but time-consuming process for both parties. So, what exactly is due diligence, what are the differences in conducting due diligence as a buyer versus responding to due diligence inquires as a seller, and how can buyers improve the due diligence process and sellers better prepare for, and ease the burden of, due diligence?
Due diligence is the process of disclosure and review of the seller’s business, which often includes its financial statements, corporate and organizational records, contracts, real and personal property, intellectual property, litigation, permits and authorizations, and employment policies and benefits. The scope of the due diligence process varies among transactions and depends on the industry and complexity of the business, financial resources and risk tolerance of the buyer and timing of the transaction. The buyer generally requests specific information about the seller’s business. The seller can respond in several ways, including by providing documentation directly to the buyer, posting information to an online electronic data room, and having management and other key personnel meet with the buyer’s transaction team.
Buy-Side Due Diligence
The buyer’s objective in conducting due diligence is to find out what it will get when it purchases the business, including any potential issues or liabilities it would acquire, and help avoid costly surprises after completing the acquisition. Think about when you buy a home - you walk through the home and note any apparent issues, you determine your initial offer, then, once under contract, you hire an inspector to uncover less apparent issues. If the inspector finds costly problems, you may decrease your offer, or you may even back out of the purchase altogether. Buying a business is similar. Generally, the buyer conducts high-level due diligence to confirm its interest in the target company, and then, once the buyer has made a purchase offer or entered into a letter of intent, the buyer and its counsel conduct a detailed review of the seller’s records to uncover any issues.
Issues that are uncovered during the due diligence process might impact the purchase price or the representations and warranties the buyer requests from the seller in the purchase agreement. Additionally, based on the results of its review, the buyer might require indemnification and reimbursement for specified losses that the buyer suffers after the acquisition resulting from the seller’s operation of the business and require a portion of the purchase price to be placed into escrow as security for the seller’s indemnification obligations. For example, the buyer might discover during the due diligence process that the seller’s employees are not properly classified as exempt workers entitled to overtime payments. With this liability identified, the buyer can negotiate for changes to the terms of the transaction, such as reducing the price it is willing to pay for the business, or requiring a larger portion of the purchase price to be placed into escrow as security for any liability associated with the misclassification.
Sell-Side Responses to Due Diligence Requests
The seller’s objective in responding to due diligence requests is to provide transparency to the buyer while also presenting its business in the best light. A seller’s responsiveness to a buyer’s requests can help ensure that the transaction will close and avoid post-closing purchase price adjustments. Additionally, purchase agreements typically include representations and warranties by the seller about its business, and the seller must ensure that the representations and warranties are accurate. To prevent future claims for indemnification based on a breach of such representations and warranties, the seller will disclose any exceptions to the representations and warranties. Using the example above, the seller would want to disclose any misclassification of employees for purposes of overtime to the buyer so that the buyer could not later claim that the seller breached the applicable representation and warranty, thereby allowing the seller to avoid a future indemnification claim that would reduce the purchase price. The seller’s disclosure of exceptions to the representations and warranties is typically accomplished by listing the exceptions on “disclosure schedules.” Often, the seller and its counsel will work closely together to prepare the disclosure schedules. Accurate and thorough disclosure schedules, which are prepared from materials that are gathered and organized during due diligence, are instrumental to limiting the seller’s liability after the transaction closes.
Tips for Buyers
Buyers and their counsel can make the due diligence process more efficient with the use of a few strategies. First, it is helpful to prepare a comprehensive due diligence request list that identifies all items that the buyer would like disclosed. The due diligence request list should be organized by topic (financial, contracts, employment, litigation, etc.) to aid in delegation of review to different departments within the company. The list may be over-inclusive, but it helps ensure that all materials are disclosed. Including space on the list for the seller to comment allows the seller to note when a request is not relevant to the business or when there is nothing to disclose. Second, especially when there are a lot of contracts to be reviewed as part of due diligence, it is helpful to use a thoughtfully created chart to track review, which should include any identification number assigned to a document in a data room to keep track of what has and what has not been reviewed. Also, it is better to flag more items in your initial review to prevent duplicative review later.
Tips for Sellers
Sellers can anticipate many of the requests from buyers and simplify the due diligence process by preparing in advance. For example, sellers can prepare for the due diligence process as follows:
- identify and correct any issues in advance of a transaction, which will save time and reduce costs at the time of the deal and help avoid concerns from an investor or acquirer; and
- deliver the company’s diligence materials in an organized, complete manner, which will expedite the transaction process.
As the review proceeds, a seller can build trust and confidence in its operations by providing timely, complete responses to a buyer’s requests. (For more information about preparing your business for the due diligence process, see our practice brief: Preparing Your Business Records for a Financing or M&A Transaction.)
Due diligence is a time consuming yet important mechanism to limit risk for both buyers and sellers, making due diligence one of the least glamorous but most important parts of any transaction. While buyers and sellers have different objectives during due diligence, both sides are benefited by thorough, efficient processes. Understanding the importance of due diligence to both parties in a transaction, employing the strategies discussed above, and investing the time required to conduct a thorough due diligence review early in a transaction will help prevent unwelcome surprises and potential liability for both parties.
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Christie A. Hartinger and David P. Creekman are attorneys in the M&A Practice Group of Wyrick Robbins, which represents clients across a broad range of industries in connection with their significant corporate transactions. The group publishes Practice Briefs periodically as a service to clients and friends. The purpose of this Practice Brief is to provide general information, and it is not intended to provide, and should not be relied upon as, legal advice.