By Richard D. Harroch, David A. Lipkin, Richard V. Smith, and John Cook dinner
Mergers and acquisitions sometimes contain a big quantity of due diligence by the customer. Earlier than committing to the transaction, the customer will wish to make sure that it is aware of what it’s shopping for, what obligations it’s assuming, the character and extent of the vendor’s contingent liabilities, problematic contracts, litigation dangers, mental property points, and far more. That is significantly true in personal firm acquisitions, wherein the vendor has not been topic to the scrutiny of the general public markets.
Latest M&A exercise and litigation have highlighted the necessity for a purchaser to conduct cautious due diligence as to potential dangers, particularly investigating monetary statements, information breach and cybersecurity points, mental property points, and potential employment regulation and sexual harassment legal responsibility.
The next is a abstract of probably the most important authorized and enterprise due diligence actions the customer will undertake in a typical M&A transaction involving a privately held firm. A purchaser will make use of extra extremely specialised due diligence actions, past these set forth beneath, when investigating firms in regulated industries, similar to telecom, banking, insurance coverage, or finance.
By planning for the customer’s due diligence actions fastidiously and correctly anticipating the associated points which will come up and dangers that the customer might determine, the vendor will likely be higher ready to barter mitigation measures and efficiently consummate a sale of the corporate.
1. Monetary Issues
The customer will likely be involved with all the vendor’s historic monetary statements and associated monetary metrics in addition to the reasonableness of the goal’s projections of its future efficiency. Matters of inquiry or concern will embody the next:
What do the vendor’s annual, quarterly, and (if obtainable) month-to-month monetary statements for not less than the final three years reveal about its monetary efficiency and situation?
Are the vendor’s monetary statements audited, and, if that’s the case, for a way lengthy? Does the audit report embody a “going concern” qualification?
Do the monetary statements and associated notes set forth all liabilities of the vendor, each present and contingent?
Are there inside controls over monetary reporting points?
Are the revenues and margins for the enterprise rising or deteriorating?
Are the vendor’s monetary projections for the longer term and underlying assumptions affordable and lifelike?
How do the vendor’s projections for the present yr examine to the board-approved funds for a similar interval?
What normalized working capital will likely be essential to proceed operating the enterprise?
How is “working capital” decided for functions of the acquisition settlement? (Definitional variations may end up in a big variance of the greenback quantity.)
How a lot is the vendor investing in analysis and improvement? Is that this quantity ample?
What capital expenditures and different investments will must be made to proceed rising the enterprise, and what are the vendor’s present capital commitments?
What’s the situation of tangible belongings and liens thereon?
What indebtedness is excellent or assured by the vendor, what are its phrases, and when does it must be repaid?
Are there any uncommon income recognition points for the vendor or the business wherein it operates?
What’s the growing old of accounts receivable, reasonableness of reserve for uncertain accounts, and are there every other accounts receivable points?
Ought to a “high quality of earnings” report be commissioned?
Are the capital and working budgets acceptable, or have essential capital expenditures been deferred?
Has EBITDA and any changes to EBITDA been appropriately calculated? (That is significantly necessary if the customer is acquiring debt financing.)
Does the vendor have ample monetary sources to each proceed working within the peculiar course and canopy its transaction bills between the time of diligence and the anticipated cut-off date of the acquisition?
Do any of the letters from auditors trigger concern?
Do any of the letters from counsel to auditors trigger concern?
Does the vendor have web working losses? How a lot is obtainable to be used by the customer put up closing?
What seasonality in income and dealing capital necessities does the corporate sometimes expertise?
Are there any restrictions on the vendor’s money or repatriation taxes due in reference to overseas subsidiaries?
2. Expertise/Mental Property
The customer will likely be very within the extent and high quality of the vendor’s expertise and mental property. This due diligence will usually deal with the next areas of inquiry, amongst others:
What home and overseas patents (and patents pending) does the vendor have?
Has the vendor taken acceptable steps to guard its mental property (together with confidentiality and invention task agreements with present and former workers and consultants)? Are there any materials exceptions from such assignments (rights preserved by workers and consultants)?
What registered and customary regulation logos and repair marks does the vendor have?
What copyrighted merchandise and supplies are used, managed, or owned by the vendor?
Does the vendor’s enterprise rely upon the upkeep of any commerce secrets and techniques, and, if that’s the case, what steps has the vendor taken to protect their secrecy?
Is the vendor infringing on (or has the vendor infringed on) the mental property rights of any third get together, and are any third events infringing on (or have third events infringed on) the vendor’s mental property rights?
Is the vendor concerned in any mental property litigation or different disputes (patent litigation might be very costly), or acquired any provides to license or demand letters from third events?
What expertise in-licenses does the vendor have and the way important are they to the vendor’s enterprise? How would possibly these licenses have an effect on or limit the enterprise of the customer or any of its associates? Are royalty obligations affected by the sale of the vendor to the customer?
Has the vendor granted any unique expertise licenses to 3rd events?
Has the vendor traditionally included open supply software program into its merchandise, and, if that’s the case, does the vendor have any open supply software program points?
What software program is important to the vendor’s operations, and does the vendor have acceptable licenses for that software program (and does the vendor’s utilization of that software program adjust to use limitations or different restrictions)?
Has the vendor disclosed, or is it contractually required to reveal, any supply or object code?
Is the vendor a celebration to any supply or object code escrow preparations, and has any such code been launched from escrow?
What indemnities has the vendor supplied to (or obtained from) third events with respect to attainable mental property disputes or issues?
Are there every other liens or encumbrances on the vendor’s mental property?
Has the vendor acquired subsidies or assist from governmental authorities or universities? Is there any obligation to return subsidies upon a change of management of the vendor?
Has the vendor used any mental property owned or claimed to be owned by any college or different academic institute?
Does the vendor’s software program embody any disabling codes, bugs, viruses, or different materials issues or defects, and does the vendor use business commonplace practices to detect any such issues or defects?
Does the vendor have ample IT methods, together with pc, info expertise, and data-processing methods and amenities, for current and at the moment anticipated future wants?
three. Prospects/Gross sales
The customer will wish to totally perceive the vendor’s buyer base, together with the extent of focus of the most important clients in addition to the gross sales pipeline. Matters of inquiry or concern will embody the next:
Who’re the highest 20 clients and what revenues are generated from every of them?
What buyer focus points/dangers are there?
Will there be any points in protecting clients after the acquisition (together with points regarding who the customer is)?
How glad are the shoppers with their relationship with the vendor? (Buyer calls will usually be acceptable.)
Are there any guarantee points or obligations with present or former clients?
What restore, indemnification, and/or liquidated damages obligations does the vendor owe to its clients?
What’s the buyer backlog?
What are the gross sales phrases/insurance policies, and have there been any uncommon ranges of returns/exchanges/refunds?
How are salespeople compensated/motivated, and what impact will the transaction have on the monetary incentives provided to workers?
four. Match with Strategic Purchaser
A strategic purchaser is anxious not solely with the possible future efficiency of the vendor as a stand-alone enterprise; it’s going to additionally wish to perceive the extent to which the vendor will match strategically inside the bigger purchaser group. This can be the case the place the customer is a personal fairness purchaser that has a number of current portfolio firms in companies associated to these of the vendor. Associated questions and areas of inquiry will embody the next:
Will there be a strategic match between the vendor and the customer, and is the notion of that match based mostly on a historic enterprise relationship or on future expectations?
Does the vendor present merchandise, companies, or expertise the customer doesn’t have?
Will the vendor present key individuals (is that this an acqui-hire?) and, if that’s the case, what’s the probability of their retention following the closing?
What integration will likely be essential, how lengthy will the method take, and the way a lot will it price?
Will the transaction be accretive to or dilutive of the customer’s earnings?
What price financial savings and different synergies will likely be obtainable after the acquisition?
What marginal prices (e.g., prices of acquiring third-party consents) may be generated by the acquisition?
What income enhancements will happen after the acquisition?
5. Materials Contracts
Some of the time-consuming (however important) parts of a due diligence inquiry is the customer’s assessment of all materials contracts and commitments of the vendor. The classes of contracts which might be necessary to assessment and perceive embody the next:
Guaranties, loans, and credit score agreements
Buyer, reseller, and provider contracts
Agreements of partnership or three way partnership; restricted legal responsibility firm or working agreements
Contracts involving funds over a fabric greenback threshold
Previous acquisition agreements
Agreements imposing any restriction on the enterprise exercise of the vendor or the precise or means of the vendor (or purchaser after closing) to compete in any line of enterprise or in any geographic area with every other particular person
Agreements containing “most favored nation” provisions
Actual property leases/buy agreements
Powers of legal professional
Fairness finance agreements
Distribution, vendor, gross sales company, or promoting agreements
Union contracts and collective bargaining agreements
Contracts the termination of which might lead to a fabric hostile impact on the vendor (together with, for instance, acceleration of indebtedness upon a change of management or liquidated damages provisions)
Any approvals required of different events to materials contracts as a result of a change in management or task
6. Worker/Administration Points
The customer will wish to assessment various issues in an effort to perceive the standard of the vendor’s administration and worker base, together with:
Administration group chart and biographical info
Sexual harassment or discrimination insurance policies or allegations
Sexual misconduct allegations or tradition points
Abstract of any labor disputes
Info regarding any earlier, pending, or threatened labor stoppage, slowdown, picketing, or different related labor exercise
Employment and consulting agreements, mortgage agreements, and paperwork regarding different transactions with officers, administrators, key workers, and associated events
Schedule of compensation paid to officers, administrators, and key workers for the three most up-to-date fiscal years displaying individually wage, bonuses, and non-cash compensation (e.g., use of automobiles, property, and so on.)
Abstract of worker advantages and copies of any pension, revenue sharing, deferred compensation, and retirement plans
Proof of compliance with IRS Part 409A in reference to incentive fairness issuances
Abstract of administration incentive or bonus plans not included above in addition to different types of non-cash compensation
Probability of want for compliance with IRS Part 280G (“golden parachute”) guidelines in reference to any potential acquisition
Employment manuals and insurance policies
Involvement of key workers and officers in prison proceedings or important civil litigation
Plans regarding severance or termination pay, trip, sick go away, loans, or different extensions of credit score, mortgage ensures, relocation help, academic help, tuition funds, worker advantages, employees’ compensation, govt compensation, or fringe advantages
Appropriateness of the vendor’s therapy of personnel as unbiased contractors vs. workers
Carve-out plans within the occasion of a change answerable for the vendor
Worker compliance with obligations to prior employers (similar to non-compete and non-solicit provisions)
Compliance with employment guidelines, together with wage and hour, additional time, immigration, baby labor, employment discrimination, and incapacity guidelines and rules
Whether or not there are agreements/incentive preparations in place with key workers to be retained by the customer, and whether or not they are going to be ample to retain key workers
The extent to which layoffs and resultant severance prices will possible be incurred in reference to the acquisition, and whether or not the customer or the vendor bears these prices
Accrued however unpaid bonuses or commissions
Staff on medical, maternity, paternity, adoption, or different go away
Deferred compensation preparations
Historic worker and advisor turnover
Whether or not workers could also be contractually and legally terminated at will with out cost of severance or different funds
An outline of any litigation (pending, threatened, or settled) or arbitration involving the vendor is usually undertaken. This assessment will embody the next:
Filed or pending litigation, along with all complaints and different pleadings
Litigation settled and the phrases of settlement
Claims threatened in opposition to the vendor
Consent decrees, injunctions, judgments, or orders in opposition to the vendor
Attorneys’ letters to auditors
Insurance coverage protecting any claims, along with notices to insurance coverage carriers
Issues in arbitration or mediation
eight. Cybersecurity and Information Privateness
It has turn out to be more and more crucial purchaser contemplating an acquisition totally examine and determine cybersecurity and information privateness dangers and liabilities posed by the transaction. It’s equally necessary that the vendor anticipate cybersecurity and information privateness points. Notably, as a result of a vendor might not even concentrate on a previous or present compromise of the vendor’s information which may be pertinent to the deal, additionally it is incumbent upon the customer to have interaction skilled third events to conduct due diligence on this space. Applicable cybersecurity or privateness counsel must be consulted in any explicit M&A due diligence investigation.