(Published in the September 11, 1998 issue of "Triad Business News." Used by permission.)
In our previous article on buying or selling a business, we discussed the importance of choosing -- and using -- your advisor team. Your financial advisor, accountant and attorney have knowledge and experience that are critical to the success of your transaction. We also compared and contrasted three different types of transactions often used when purchasing a business: mergers, asset purchase transactions and stock purchase transactions.
Now that the transactional team is in place and the structure of the transaction has been evaluated, it is time to review the background of the selling company (we will still assume that you are the buyer). This review is generally known as "due diligence." Conducting due diligence is important in order to understand the contracts, litigation, finances and various other business affairs of the selling company. The goal of this effort is to reveal any potentially damaging information regarding the business to be purchased as soon as possible.
In gathering and reviewing information related to the organizational structure and financial background of the selling company, it is critical to verify the accuracy of the information given by the seller during the negotiation process. The principal goal of due diligence is to ensure that all information regarding the selling company has been fully disclosed, and that there will not be any surprises after the transaction has been completed. Always avoid surprises -- few are good ones!
In order to limit future, unauthorized disclosures of confidential information, the parties should, if they have not already done so, sign a non-disclosure agreement. This type of agreement calls for the parties to keep confidential any non-public information revealed during the due diligence process. In our last article, we discussed the use of a letter of intent and, usually, it will, or should, contain nondisclosure provisions.
One of the many vital tasks of your attorney is conducting the due diligence review. The focus of organized due diligence will depend on the type of business of the selling company. For example, if you are acquiring an industrial company, your attorney might focus more on an environmental review than in the acquisition of a service-based company.
Your team may consist of attorneys specializing key areas (environmental, tax, employee benefits) and non-legal professionals (accountants, market analysts). A few of the main areas that the due diligence team may focus on during their review are corporate matters, real and personal property, environmental issues, litigation, employee matters, and intellectual property. The scope of the review will also depend on the size and diversification of the selling company's business.
Your due diligence team will review the selling company's corporate records in order to ensure that all corporate matters are in good legal order. The seller's corporate records may also contain important information regarding the seller's ownership in other corporate entities and key financing and other transactions. The selling company's stock records will reveal its stockholders and their equity interests.
The due diligence team may also review certain real and personal property matters of the selling company, including any necessary appraisals. This will reveal details of the real property owned by the seller and if there are any encumbrances on the property (i.e., mortgages, liens, easements). A review will also be made of the contracts pertaining to the leased personal property and ensure that there are no liens on the owned personal property. This is particularly critical in an asset purchase transaction.
Documents relating to any environmental or litigation problems of the selling company should be reviewed by an attorney specializing in that particular area of expertise. In an environmental review, it is critical to establish that all applicable environmental laws and regulations have been complied with and, if necessary, an environmental assessment or survey should be conducted. For the litigation review, all of the pleadings of any threatened and pending litigation should be considered.
You will also be given information about the benefit plans and employment and consulting contracts of the selling company, as well as details about any labor problems it faces. Similarly, information will also be presented pertaining to the daily workings of the business, including customer and supplier lists, as well as information related to its sales and distribution procedures.
Your accountant will probably assist in the review of the financial statements and related materials of the selling company. During the financial due diligence, a review of the financial statements for the past few years, as well as any bank loans, lines of credit or letters of credit, should be conducted. The main purpose of this review is to confirm the value of the assets of the business, the company's liabilities, and that you are entering into a sound business endeavor.
With the emergence of new technology, intellectual property and computer systems have become critically important. You will need to know what intellectual property (patents, trademarks, trade names, trade secrets, copyrights) that the seller owns; and it is also important to know about any patent agreements with employees. Since the purchase of a new computer system and related technology is costly, it is also critical to know the significant details of the seller's computer system (lease provisions, software contracts). This is particularly true given looming Year 2000 concerns, as discussed in prior articles in this column.
During the due diligence process, your attorney will review various contracts pertaining to the operations of the business. During the review, your attorney will identify which contracts will require the consent of a third party. This can be a crucial element in the timing of your purchase, as well as its cost. Especially in a stock purchase transaction or certain merger transactions, it is critical to obtain these consents in order to close the purchase transaction and in order to continue the daily operation of the business after the closing.
The due diligence process is critical in a successful business transaction to ensure that the buyer is getting the most for its money and that there are not any major surprises after the documents have been signed. A thorough review of what you are buying before it's yours is the best insurance against any unwanted surprises down the road.
This article was co-authored by Jessica Raab Southwick, a Corporate and Securities Practice Group paralegal in the Winston-Salem office of Womble Carlyle. Ms. Southwick assists Mr. Drake and other members of the firm in various merger and acquisition transactions.
Rich Drake is a Member of Womble Carlyle Sandridge & Rice, PLLC, practicing in the Corporate and Securities Group in Winton-Salem. Mr. Drake advises clients on practical approaches to achieve desired business outcomes in a variety of corporate, securities, financing and business technology matters.