Too busy to read?

In addition to the bankruptcy context, the increasingly common use of auctions managed by investment banks or other financial advisors has affected early-stage due diligence activities. While sellers typically permit interested bidders to examine data room documents and submit follow-on questions, full-scale due diligence generally is not permitted until the seller has selected the winning bidder following a review of the prospective buyers' markups of a proposed acquisition agreement. Buyers frequently propose numerous additional revisions to the acquisition agreement based on their subsequent due diligence, but sellers often impose tight deadlines on the winning bidders and otherwise attempt to limit the due diligence-driven revisions to a bare minimum.

The science of due diligence is in the preparation of comprehensive and customized checklists of the specific questions to be presented to the seller, in maintaining a methodical system for organizing and analyzing the documents and data provided by the seller, and in quantitatively assessing the risks raised by those problems that are discovered in the process. One of the key areas is detection of the seller's obligations, particularly those that the buyer will be expected or required to assume after closing (especially in a stock purchase transaction or comparable merger; in an asset purchase, purchased liabilities are specifically defined, subject to a few successor liabilities that cannot be contractually avoided). The due diligence process is designed first to detect the existence of the obligations, and second to identify any defaults or problems in connection with these obligations that will affect the buyer after closing.

due diligence checklist, however, should be a guideline, not a crutch. The buyer's management team must take the lead in developing questions that pertain to the nature of the seller's business. These questions will set the pace for the level of detail and adequacy of the review. The key point here is that every type of business has...

due diligence is not a perfect process and should not be a tedious fishing expedition. Like any audit, a due diligence process is designed to answer the important questions and provide reasonable assurance that the seller's claims about the business are fair and legitimate.

Many deals are driven by the premise that it is less expensive to buy brand loyalty and customer relationships than it is to build them. Buyers are paying a premium for this intangible asset on the balance sheet, which is often referred to as goodwill.

the due diligence team is on a risk discovery and assessment mission, looking for potential problems and liabilities (the search) and finding ways to resolve these problems prior to closing and to ensure that risks are allocated fairly and openly after the closing.

The due diligence work is usually divided between two working teams: (1) the financial and strategic team, which is typically managed by the buyer's management team with assistance from its accountants, and (2) the legal team, which involves the buyer's counsel with appropriate assistance from technical experts such as environmental engineers and export compliance specialists, depending on the nature of the target's business. Throughout the process, both teams compare notes on open issues and potential risks and problems. The legal due diligence focuses on potential legal issues and problems that may prove to be impediments to the transaction. It also sheds light on how the transaction should be structured and the contents of the transaction documents, such as the representations and warranties. The business due diligence focuses on the strategic and financial issues in the transaction, such as confirmation of the past financial performance of the seller; integration of the human and financial resources of the two companies; confirmation of the operating, production, and distribution synergies and economies of scale to be achieved by the acquisition; and the collection of information necessary for financing the transaction.

The typical strategic growth options are as follows: organic, inorganic, or by external means. Examples of organic growth are hiring additional salespeople, developing new products, and expanding geographically. The best example of inorganic growth is an acquisition of another firm, something that is often done to gain access to a new product line, customer segment, or geography. Finally, external revenue growth opportunities include franchising, licensing, joint ventures, strategic alliances, and the appointment of overseas distributors, which are available to growing companies as an alternative to mergers and acquisitions as a growth engine.

There is a virtually infinite number of potential problems and exposure areas for the buyer that may be uncovered in the review and analysis of the seller's documents and operations. The specific issues and problems will vary based on the size of the seller, the nature of its business, and the number of years that the seller (or its predecessors) has been in business.

Some transactions are motivated by the need to transform a firm's corporate identity or even to be transformative for the buyer overall, where the target company may lead the buyer in a new direction or add significant new capability.

the seller's team must organize the documents and prepare the data room. Although electronic data rooms, which are especially important to cross-border M&A transactions, have improved the efficiency of the due diligence process, the seller still must commit substantial resources to assembling the documents.

this stage of the transaction, both the seller and the buyer (and their respective advisors) have developed a strategic plan and a tentative timetable for completion of the deal, have completed their analysis as to why the transaction is a strong financial and strategic fit for each party, and hopefully have taken the time to understand each other's perspective and the competing as well as aligned objectives. Buyers may enlist a financial advisor to assist in getting to this stage and helping the buyer ensure it is making decisions consistent with its financial and business goals. Thus, often the first agreement the buyer enters into in preparation of an acquisition is with its financial advisor, traditionally in the form of an engagement letter. The terms in an engagement letter must be carefully negotiated to account for the myriad of possible outcomes a buyer could encounter in the early stages of an acquisition.

The global village has forced many companies to explore mergers and acquisitions as a means of developing an international presence and expanding their market share. This market penetration strategy is often more cost-effective than trying to build an overseas operation from scratch.

Astute buyers typically employ comprehensive due diligence checklists that are intended to guide the company's management team while it works closely with counsel to gather and review all legal documents that may be relevant to the structure and pricing of the transaction; to assess the potential legal risks and liabilities to the buyer following the closing; and to identify all of the consents...

key objective of due diligence is not only to confirm that the deal makes sense (e.g., to confirm the factual assumptions and preliminary valuations underlying the terms by which the buyer negotiates the transaction), but also to determine whether the transaction should proceed at all.

The due diligence process involves a legal, financial, and strategic review of all of the seller's documents, contractual relationships, operating history, and organizational structure. Due diligence is not just a process; it is also a reality test--a test of whether the factors that are driving the deal and making it look attractive to the parties are real or illusory. Due diligence is not a quest to find the deal breakers; it is a test of the value proposition underlying the transaction to make sure that the inside of the house is as attractive as the outside.

Figure 4-3. Work Schedule for an Asset Purchase Transaction

Every company says that it wants synergy when doing a deal, but few take the time to develop a transactional team, draw up a joint mission statement of the objectives of the deal, or solve post-closing operating or financial problems on a timely basis.

a well-drafted letter of intent will provide an overview of matters that require further discussion and consideration, such as the exact purchase price. Although an exact and final purchase price cannot realistically be established until due diligence has been completed, the seller may hesitate to proceed without a price commitment.

Classic mistakes include a lack of adequate planning, an overly aggressive timetable to closing, a failure to really look at possible post-closing integration problems, and, worst of all, projecting synergies to be achieved that turn out to be illusory.

Mergers are the most effective and efficient way to enter a new market, add a new product line, or increase distribution reach,

Instead of creating a fixed price, however, the letter of intent will typically incorporate a price range that is qualified by a clause or provision setting forth all of the factors that will influence and affect the calculation of a final fixed price, such as balance sheet adjustments, due diligence surprises or problems, a change in the health of the company, or overall market conditions during the transaction period, and sometimes even an "upside surprise" in favor of the seller when a significant positive development occurs during the transaction period (e.g., the settlement of litigation, the award of important intellectual property rights, or a big new contract or customer commitment) that had not been included when the valuation range was established.

Clouds" in the title to critical tangible (real estate, equipment, inventory) and intangible (patents, trademarks, and so on) assets. Be sure that the seller has clear title to these assets and that they are conveyed without claims, liens, and encumbrances. Employee matters. There are a wide variety of employment or labor law issues or liabilities that may be lurking just below the surface but will not be uncovered unless the right questions are asked. Questions designed to uncover wage and hour law violations, discrimination claims, OSHA compliance, or even liability for unfunded persons under the Multiemployer Pension Plan Amendments Act should be developed. If the seller has recently made a substantial workforce reduction (or if you as the buyer are planning post-closing layoffs), then the requirements of the Worker Adjustment and Retraining Notification Act (WARN) must have been met. The requirements of WARN include minimum notice of sixty days prior to wide-scale terminations. The possibility of environmental liability under CERCLA or related environmental regulations. Unresolved existing or potential litigation. These cases should be reviewed carefully by counsel. A seller's attempt to "dress up" the financial statements prior to sale. Often this is an attempt to hide inventory problems, research and development expenditures, excessive overhead and administrative costs, uncollected or uncollectible accounts receivable, unnecessary or inappropriate personal expenses, unrecorded liabilities, tax contingencies, and other such issues.

There are many different styles of drafting letters of intent, which vary from law firm to law firm and from business lawyer to business lawyer. These styles usually fall into one of three categories: (1) binding, (2) nonbinding, and (3) hybrids, like the model in Figure 4-2. In general, the type to be selected will depend upon (1) the timing and the scope of the information to be released publicly concerning the transaction (if any), (2) the degree to which negotiations have been definitive and the necessary information has been gathered, (3) the cost to the buyer and the seller of proceeding with the transaction prior to the making of binding commitments, (4) the rapidity with which the parties estimate that a final agreement can be signed, (5) the valuation ranges for the seller's company that have been discussed to date, (6) the degree to which the buyer needs or wants a period of exclusivity (and the degree to which the seller is willing to grant an exclusivity period, (7) the relative status of the parties and leverage that both the buyer and seller have, and (8) the degree of confidence each party has in the good faith of the other party and the absence (or presence) of still other parties that are competing for the transaction. In most cases, the hybrid format, which contains both binding and nonbinding terms, is the most effective format to protect the interests of both parties and to level the playing field from a negotiations perspective.

In addition to creating a framework for any potential deal with the prospective buyer, an LOI is a catalyzing event in most deals. Receiving an LOI, even one that has unacceptable terms, gives the investment banker the opportunity to reach out to each of the target buyers and accelerate the "go/no-go" decision. In a normal process, the investment banker strives to keep the potential buyers on a common time frame. However, the first LOI drives the timing of the process and, furthermore, provides a solid framework for more specific price negotiations.

VII. Miscellaneous A. Press releases (past two years) B. Resumes of all key members of the management team C. Press clippings (past two years) D. Financial analyst reports, industry surveys, and so on E. Texts of speeches by the seller's management team, especially if reprinted and distributed to the industry or the media F. Schedule of all outside advisors, consultants, and so on, used by the seller over the past five years (domestic and international) G. Schedule of...

In analyzing the company for sale, the buyer's team carefully reviews and analyzes the following legal documents and records, where applicable. I. Corporate Matters A. Corporate records of the seller *Certificate of incorporation and all amendments *Bylaws as amended *Minute books, including resolutions and minutes of all directors' and shareholders' meetings *Current shareholders list (certified by the corporate secretary), annual reports to shareholders, and stock transfer books *A list of all states, countries, and other jurisdictions in which the seller transacts business or is qualified to do business *Applications or other filings in each state listed in (5), for qualification as a foreign corporation and evidence of qualification *Locations of business offices (including overseas) B. Agreements among the seller's shareholders C. All contracts restricting the sale or transfer of shares of the company, such as buy/sell agreements, subscription agreements, offeree questionnaires, or contractual rights of first refusal; all agreements for the right to purchase shares, such as stock options or warrants; and any pledge agreements by an individual share holder involving the seller's shares

PREPARATION OF THE WORK SCHEDULE Following the execution of the letter of intent, one of the first responsibilities of the purchaser's legal counsel is to prepare a comprehensive schedule of activities (work schedule) that will serve as a task checklist and assignment of responsibilities. This schedule should be prepared well before the due diligence discussed in Chapter 5 begins. The primary purpose of the schedule is to outline all of the events that must occur and the documents that must be prepared prior to the closing date and beyond. In this regard, purchaser's legal counsel acts as an orchestra leader, assigning primary areas of responsibility to the various members of the acquisition team as well as to the seller and its counsel. Purchaser's counsel must also act as a taskmaster to ensure that the timetable for closing is met. Once all tasks have been identified and assigned, and a realistic timetable for completion has been established, then a firm closing time and date can be preliminarily determined.

For the buyer, the key motivators in an acquisition (which will be discussed in more detail in Chapter 3) usually include one or more of the following: Revenue enhancement Cost reduction Vertical and/or horizontal operational synergies or economies of scale Growth pressures from investors Underutilized resources A desire to reduce the number of competitors (increase market share and reduce price competition) A need to gain a foothold in a new geographic market (especially if the current market is saturated) A desire to diversify into new products and services

In many cases, mergers and acquisitions are being driven by a key trend within a given industry, such as: *Rapidly changing technology, which is driving many of the deals in high technology *Fierce competition, which is driving many of the deals in the telecommunications and banking industries *Changing consumer preferences, which is driving many of the deals in the food and beverage industry *The pressure to control costs, which is driving many of the deals in the health-care industry *A reduction in demand, such as the shrinking federal defense budget, which is driving the consolidation in the aerospace and defense contractor industries

Successful mergers and acquisitions are neither an art nor a science, but a process. In fact, regression analysis demonstrates that the number one determinant of deal multiples is the growth rate of the business. The higher the growth rate, the higher the multiple of cash flow that the business is worth.

Strong revenue growth 2.Significant market share or a strong niche position 3.A market with barriers to entry by competitors 4.A strong management team 5.Strong, stable cash flow 6.No significant concentration in customers, products, suppliers, or geographic markets 7.Low risk of technological obsolescence or product substitution

In conducting the due diligence from a business perspective, the buyer's team is likely to encounter a wide variety of financial problems and risk areas when analyzing the seller. These typically include an undervaluation of inventory, overdue tax liabilities, inadequate management information systems, related-party transactions (especially in small, closely held companies), an unhealthy reliance on a few key customers or suppliers, aging accounts receivable, unrecorded liabilities (e.g., warranty claims, vacation pay, claims, and sales returns and allowances), or an immediate need for significant expenditures as a result of obsolete equipment, inventory, or computer systems.

Tangible and Intangible Assets of the Seller A. List of all commitments for rented or leased real and personal property, including location and address, description, terms, options, termination and renewal rights, policies regarding ownership of improvements, and annual costs B. List of all real property owned, including location and address, description of general character, easements, rights of way, encumbrances, zoning restrictions, surveys, mineral rights, title insurance, pending and threatened condemnation, hazardous waste pollution, and so on C. List of all tangible assets D. List of all liens on all real properties and material tangible assets E. Mortgages, deeds, title insurance policies, leases, and other agreements relating to the properties of the seller F. Real estate tax bills for the real estate of the seller G. List of patents, patents pending, trademarks, trade names, copyrights, registered and proprietary Internet addresses, franchises, licenses, and all other intangible assets, including registration numbers, expiration dates, employee invention agreements and policies, actual or threatened infringement actions, licensing agreements, and copies of all correspondence relating to this intellectual property H. Copies of any survey, appraisal, engineering, or other reports relating to the properties of the seller I. List of assets that may be held on a consignment basis (or that may be the property of a given customer), such as machine dies, molds, and so on