Key Due Diligence Areas to Be Concerned With in Any Acquisition
Mergers and acquisitions typically involve a substantial amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying and what obligations it is assuming, the nature and extent of the target company’s contingent liabilities, problematic contracts, litigation risks and intellectual property issues, and much more. This is particularly true in private company acquisitions, where the target company has not been subject to the scrutiny of the public markets, and where the buyer has little (if any) ability to obtain the information it requires from public sources.
The following is a summary of the most significant legal and business due diligence activities that are connected with a typical M&A transaction. Many or all of the activities and issues described below will, in such circumstances, apply to both sides of the transaction.
- Financial Matters. The buyer will be concerned with all of the target company’s historical financial statements and related financial metrics, as well as the reasonableness of the target’s projections of its future performance. Topics of inquiry or concern will include the following:
What do the company’s annual, quarterly, and (if available) monthly financial statements for the last three years reveal about its financial performance and condition?
Are the company’s financial statements audited, and if so for how long?
Do the financial statements and related notes set forth all liabilities of the company, both current and contingent?
What is the condition of assets and liens thereon?
What indebtedness is outstanding or guaranteed by the company, what are its terms, and when does it have to be repaid?
What is the aging of accounts receivable, and are there any other accounts receivable issues?
Does the company have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?
- Technology/Intellectual Property. The buyer will be very interested in the extent and quality of the target company’s technology and intellectual property. This due diligence will often focus on the following areas of inquiry:
What domestic and foreign patents (and patents pending) does the company have?
Has the company taken appropriate steps to protect its intellectual property (including confidentiality and invention assignment agreements with current and former employees and consultants)? Are there any material exceptions from such assignments (rights preserved by employees and consultants)?
What registered and common law trademarks and service marks does the company have?
What copyrighted products and materials are used, controlled, or owned by the company?
Does the company’s business depend on the maintenance of any trade secrets, and if so what steps has the company taken to preserve their secrecy?
Is the company infringing on (or has the company infringed on) the intellectual property rights of any third party, and are any third parties infringing on (or have third parties infringed on) the company’s intellectual property rights?
Is the company involved in any intellectual property litigation or other disputes (patent litigation can be very expensive), or received any offers to license or demand letters from third parties?
What technology in-licenses does the company have and how critical are they to the company’s business?
Has the company granted any exclusive technology licenses to third parties?
Has the company historically incorporated open source software into its products, and if so does the company have any open source software issues?
What software is critical to the company’s operations, and does the company have appropriate licenses for that software (and does the company’s usage of that software comply with use limitations or other restrictions)?
What indemnities has the company provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
- Customers/Sales. The buyer will want to fully understand the target company’s customer base including the level of concentration of the largest customers as well as the sales pipeline. Topics of inquiry or concern will include the following:
Who are the top 20 customers and what revenues are generated from each of them?
What customer concentration issues/risks are there?
Will there be any issues in keeping customers after the acquisition (including issues relating to the identity of the buyer)?
How satisfied are the customers with their relationship with the company? (Customer calls will often be appropriate.)
Are there any warranty issues with current or former customers?
What is the customer backlog?
What are the sales terms/policies, and have there been any unusual levels of returns/exchanges/refunds?
How are sales people compensated/motivated, and what effect will the transaction have on the financial incentives offered to employees?
What seasonality in revenue and working capital requirements does the company typically experience?
- Strategic Fit with Buyer. The buyer is concerned not only with the likely future performance of the target company as a stand-alone business; it will also want to understand the extent to which the company will fit strategically within the larger buyer organization. Related questions and areas of inquiry will include the following:
Will there be a strategic fit between the company and the buyer, and is the perception of that fit based on a historical business relationship or merely on unproven future expectations?
Does the company provide products, services, or technology the buyer doesn’t have?
What integration will be necessary, how long will the process take, and how much will it cost?
What cost savings and other synergies will be obtainable after the acquisition?
What marginal costs (e.g., costs of obtaining third party consents) might be generated by the acquisition?
What revenue enhancements will occur after the acquisition?
- Material Contracts. One of the most time-consuming (but critical) components of a due diligence inquiry is the review of all material contracts and commitments of the target company. The categories of contracts that are important to review and understand include the following:
Guaranties, loans, and credit agreements
Customer and supplier contracts
Agreements of partnership or joint venture; limited liability company or operating agreements
Contracts involving payments over a material dollar threshold
Past acquisition agreements
Agreements imposing any restriction on the right or ability of the company (or a buyer) to compete in any line of business or in any geographic region with any other person
Real estate leases/purchase agreements
Powers of attorney
Equity finance agreements
Distribution, dealer, sales agency, or advertising agreements
Union contracts and collective bargaining agreements
Contracts the termination of which would result in a material adverse effect on the company
Any approvals required of other parties to material contracts due to a change in control or assignment
- Employee/Management Issues. The buyer will want to review a number of matters in order to understand the quality of the target company’s management and employee base, including:
Management organization chart and biographical information
Summary of any labor disputes
Information concerning any previous, pending, or threatened labor stoppage
Employment and consulting agreements, loan agreements, and documents relating to other transactions with officers, directors, key employees, and related parties
Schedule of compensation paid to officers, directors, and key employees for the three most recent fiscal years showing separately salary, bonuses, and non-cash compensation (e.g., use of cars, property, etc.)
Summary of employee benefits and copies of any pension, profit sharing, deferred compensation, and retirement plans
Employment manuals and policies
Involvement of key employees and officers in criminal proceedings or significant civil litigation
Plans relating to severance or termination pay, vacation, sick leave, loans, or other extensions of credit, loan guarantees, relocation assistance, educational assistance, tuition payments, employee benefits, workers’ compensation, executive compensation, or fringe benefits
Appropriateness of the company’s treatment of personnel as independent contractors vs. employees
What agreements/incentive arrangements are in place with key employees to be retained by the buyer? Will these be sufficient to retain key employees?
What layoffs and resultant severance costs will be likely in connection with the acquisition?
- Litigation. An overview of any litigation (pending, threatened, or settled), arbitration, or regulatory proceedings involving the target company is typically undertaken. This review will include the following:
Filed or pending litigation, together with all complaints and other pleadings
Litigation settled and the terms of settlement
Claims threatened against the company
Consent decrees, injunctions, judgments, or orders against the company
Insurance covering any claims, together with notices to insurance carriers
Matters in arbitration
- Insurance. In any acquisition, the buyer will want to undertake a review of key insurance policies of the target company’s business, including:
If applicable, the extent of self-insurance arrangements
General liability insurance
Intellectual property insurance
Key man insurance
Employee liability insurance
Worker’s compensation insurance
- General Corporate Matters. Counsel for the buyer will invariably undertake a careful review of the organizational documents and general corporate records (including capitalization) of the target company, including:
Charter documents (certificate of incorporation, bylaws, etc.)
Good standing and (if applicable) tax authority certificates
List of subsidiaries and their respective charter documents
List of jurisdictions in which the company and its subsidiaries are qualified to do business
List of current officers and directors
Stock sale agreements
Stock appreciation rights plans and related grants
Agreements granting restricted stock units
Stockholder and voting agreements
Agreements restricting the payment of cash dividends
Agreements related to any sales or purchases of businesses
Rights of first refusal or first negotiations in connection with a sale of the company or its business
Minutes of stockholders’ meetings since inception, including written consents to action without a meeting
Minutes of board of directors and any board committees since inception, including written consents to action without a meeting
- Related Party Transactions. The buyer will be interested in understanding the extent of any “related party” transactions, such as agreements or arrangements between the target company and any current or former officer, director, stockholder, or employee, including the following:
Any direct or indirect
Any agreements where any officer, director, stockholder, or employee has an interest in any asset (real estate, intellectual property, personal property, etc.) of the company
- Governmental Regulations, Filings, and Compliance with Laws. The buyer will be interested in understanding the extent to which the target company is subject to and has complied with regulatory requirements, including by reviewing the following:
Citations and notices received from government agencies since inception or with continuing effect from an earlier date
Pending or threatened investigations or governmental proceedings
Documents showing any certification of compliance with, or any deficiency with respect to, regulatory standards of the company
Any problems with such regulatory compliance (including ERISA, labor and other federal, state, and local regulation)
Material governmental permits and licenses required to carry out the business or operations of the company or its subsidiaries currently in force
Information regarding any of the company’s permits or licenses that have been canceled or terminated
Extent of evidence of the company’s exemption from any permit or license requirement
- Property. A review of all property owned by the target company or otherwise used in the business is an essential part of any due diligence investigation, with such review including:
Leases of real property
Deeds of trust and mortgages
Other interests in real property
Financing leases and sale and leaseback agreements
Conditional sale agreements
- Production-Related Matters. Depending on the nature of the target company’s business, the buyer will often undertake a review of the company’s production-related matters, including the following:
List of the company’s most significant subcontractors, including the dollar volume of business and the type of services or products supplied by each subcontractor
List of the company’s largest suppliers with the amount and type of products purchased from each during the most recent fiscal years and year-to-date, as well as whether or not the supplier is the sole source of such products
Monthly manufacturing yield summaries, by product
Schedule of backlog showing customers, products, and requested/scheduled shipping dates
Copies of inventory reports
Supplies or materials used by the company to produce or develop products that are in short supply or subject to shortages
Product service programs and copies of standard form of service contract and any contracts with service providers
Information regarding backlogs and levels of plant operation
All agreements and other arrangements related to the research, development, manufacturing, and testing of the company’s products
- Marketing Arrangements. As part of diligence, the buyer will want to understand the target company’s marketing strategies and arrangements, including through reviewing:
Sales representative, distributor, agency, and franchise agreements of the company
Standard company sales forms or literature, including price lists, catalogs, purchase orders, etc.
All other agreements related to the marketing of the company’s products
Surveys of the markets the company serves or plans to serve, whether or not compiled by or at the direction of the company
Press releases concerning the company (or any partnership or joint venture involving the company or any subsidiary)
- Competitive Landscape. The buyer will want to understand the competitive environment in which the target company’s business operates, including by obtaining information on the following:
The company’s principal current and anticipated competitors
Technologies that could make the company’s current technology or manufacturing processes obsolete
Advantages/disadvantages of the company’s products and technologies compared to those of competitors
A merger and acquisition transaction typically involves a significant amount of due diligence by the buyer and the buyer’s counsel and accountants. By being prepared for the due diligence activities that a target company will encounter, the process can go smoothly and quickly, serving the best interests of both parties to the transaction.
Boznos Law has been advising businesses for over 30 years on strategic combinations, mergers, acquisitions and divestitures. Call Bill Boznos today at (630) 375-1958 or contact us through our website at www.boznoslawoffice.com