7 Fundamentals to Due Diligence You Need to Know
Being open about your business practices and financial statements can lead to a better takeaway for both the buyer and seller.
According to Bizbuysell.com, there were a total of 1,840 businesses transactions that took place worldwide during the first quarter of 2016. Businesses were either bought and sold or mergers and acquisitions took place in that first quarter.
People buy and sell or merge businesses for different reasons, but there are always a wide variety of preliminary activities that must take place prior to closing the deal.
In almost all cases, an attorney who is fluent in due diligence for mergers and acquisitions is required to ensure that the transaction takes place based on the laws that have been put into place by FINRA or other regulatory agencies.
1. Historic and Projected Financial Information
The seller should be providing financial documents for the past three years. The buyer will need to perform due diligence concerning the company’s historical financial information and supporting documentation.
The seller will need to provide documents for the buyer to perform an assessment of the company’s financial statements so they can make note of any financial trends, spikes or decreases in sales and revenue, consistencies or inconsistencies in cash flow activity, the company’s current debt, receivables and other assets, as well as all other aspects of the company's financial performance.
In addition to performing due diligence on the historical financial information, the buyer will also need to perform due diligence on any future financial activity as well. Carefully checking to ensure reasonable financial projections of the company’s future performance were made. Some of those areas involve whether or not the projections are based on reasonable assumptions whereby a clear path to achieving those results is laid out and linked to the actual financial activity in a practical, succinct manner.
- Is the projected financial information sound and believable?
- Were the documents succinct?
- How much working capital is necessary to continue running the business beyond its current state?
- Are there additional capital expenditures or other required investments that need to take place to ensure the future growth of the business?
2. Technology Developments and Intellectual Property
The seller will need to provide the buyer's attorney with information about any current or pending intellectual property, technology developments, copyright and patent ownerships that the company may have.
If the company has patent applications and potential trademarks, the buyer should ensure that the appropriate registration has taken place. When materials are used in marketing or technological advances, the company must have the rights and control the copyright or risk lawsuits. If they haven't, it could be a risk for the buyer who will take on any liability based on prior violations.
Trade secrets are vital to the success of some companies, so as the seller, you'll need to ensure that the secrets have been preserved appropriately and other companies' secrets have not been infringed by your company and be able to prove that to the buyer.
3. Customers and Revenue Streams
Before purchase, the seller will have to detail the various revenue streams of the business. This includes the company's satisfied customers, and what they purchase. The buyer should have a grasp of who the customers are as well as how revenue is generated by these customers especially the top 20 percent who will account for much of the business.
Another consideration is the satisfaction of the customers after a change in ownership. Are there going to be problems with new ownership that will impact the business' revenue going forward?
Along with evaluating customer loyalty and spending habits, the seller will be giving the buyer information about the backlog of issues. Are there warranty problems that are not being handled properly? Do there seem to be a high level of exchanges and refunds being issued? The seller should already have this information and be able to tell the buyer why there were problems.
4. Contract Agreements and Insurance
A review of all pending and active contracts and agreements should be a part of the due diligence process as well as a review of insurance coverage.
The key areas include some of the following:
- Outstanding loans, personal guarantors and note payables
- Outstanding customer and vendor contracts
- Partnerships, joint venture or operating agreements
- Outstanding or pending settlement agreements
- Equipment or vehicle lease agreements
- Independent contractor and employment agreements
- General liability and worker’s compensation insurance
- D&O / E&O and key man insurance
- Intellectual property insurance
- Vehicle insurance
- Health insurance
- Umbrella policies
5. Staff and Key Management
The buyer will need to perform diligence activity for all staff, independent contractors, and key management. This should include looking into scheduled pay raises, equity shares, profit distributions, 401(k), commissions, bonuses and other employment related issues. This means the seller will need to have opened their human resource files and be willing to have a buyer comb through the documents.
Along with the functionality of the human resources department regarding compensation, there should be a detailed audit of the history of labor disputes. If there's even been a threat to stop working for any reason, that could be a red flag, but the buyer will need to look into the issues that caused the employees to be disgruntled.
6. Legal and Compliance
One of the biggest headaches for a buyer can be legal tangles, which include any current, pending or settled litigation, arbitration or other proceedings. Any compliance- or regulation-related issues can be a problem, too. This is where the buyer's attorney should be forecasting the result of the litigation as well as investigating claims and threats against the company. The seller can help by being as forthcoming as possible and talking to their own attorneys about the legal future of any claims.
With detailed due diligence procedures for acquisitions, a seller can avoid serious legal problems in the future by looking at the prior, current, and future potential for legal threats. There might even be matters in arbitration at the moment that could resolve into a problem for the new owner. In some cases, a buyer might come back and sue a seller for fraud if they weren't forthcoming with certain information.
7. Tax Issues
It’s important to perform a tax due diligence to determine whether the company has any tax liability issues. This process should include a review of tax returns that have been filed within the past five years including the federal, state and local returns. The buyer's accountants and attorneys should be checking for net operating losses. Credit carryovers should be investigated to ensure that the change in ownership won't impact the relationship with the creditor.
If there have been agreements, waivers or tax communications with the IRS, the buyer should understand exactly what that means for acquiring the business. If there have been settlement agreements with the IRS or other agencies, the seller will want to let the buyer know that those will not impact the new ownership negatively, and might not carry over to the new buyer.
Due diligence in merger and acquisitions requires that a substantial amount of activities take place from both sides prior to making a full commitment to the transaction. It’s a means for the buyer to do some fact-checking, so that he or she is fully aware of what is actually being purchased.
By carefully planning these and other related activities for the due diligence in mergers and acquisitions process, the buyer will feel confident in his decision and will be prepared to proceed with the purchase of the business. The seller will be able to say that they provided all the information the buyer needed to make a sound decision.