20 Key Due Diligence Activities in an M&A Transaction
By Richard D. Harroch and David A. Lipkin
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. By planning these activities carefully and properly anticipating the related issues that may arise, the target company will be better prepared to successfully consummate a sale of the company.
Of course, in certain M&A transactions such as “mergers of equals” and transactions in which the transaction consideration includes a significant amount of the stock of the buyer, or such stock comprises a significant portion of the overall consideration, the target company may want to engage in “reverse diligence” that in certain cases can be as broad in scope as the primary diligence conducted by the buyer. Many or all of the activities and issues described below will, in such circumstances, apply to both sides of the transaction.
1. 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?
- Are the margins for the business growing or deteriorating?
- Are the company’s projections for the future and underlying assumptions reasonable and believable?
- How do the company’s projections for the current year compare to the board-approved budget for the same period?
- What normalized working capital will be necessary to continue running the business?
- How is “working capital” determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance of the dollar number.)
- What capital expenditures and other investments will need to be made to continue growing the business, and what are the company’s current capital commitments?
- 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?
- Are there any unusual revenue recognition issues for the company or the industry in which it operates?
- What is the aging of accounts receivable, and are there any other accounts receivable issues?
- Should a “quality of earnings” report be commissioned?
- Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
- Has EBITDA and any adjustments to EBITDA been appropriately calculated? (This is particularly important if the buyer is obtaining debt financing.)
- 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?
2. 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)?
- Is the company a party to any source or object code escrow arrangements?
- What indemnities has the company provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
- Are there any other liens or encumbrances on the company’s intellectual property?
3. 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?
4. 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?
- Will the company provide key people (is this an acqui-hire?) and if so what is the likelihood of their retention following the closing?
- 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?
5. 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
- Settlement agreements
- Past acquisition agreements
- Equipment leases
- Indemnification agreements
- Employment agreements
- Exclusivity 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
- License agreements
- Powers of attorney
- Franchise agreements
- Equity finance agreements
- Distribution, dealer, sales agency, or advertising agreements
- Non-competition 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
6. 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
- Evidence of compliance with IRS Section 409A in connection with stock option issuances
- Summary of management incentive or bonus plans not included in above as well as other forms of non-cash compensation
- Likelihood of need for compliance with IRS Section 280G (golden parachute) rules in connection with any potential acquisition
- 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
- Actuarial reports for past three years
- 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?
7. 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
- Attorneys’ letters to auditors
- Insurance covering any claims, together with notices to insurance carriers
- Matters in arbitration
- Pending or threatened governmental proceedings against the company (SEC, FTC, FDA, etc.)
- Potentially speaking directly to the company’s outside counsel
8. Tax Matters. Tax due diligence may or may not be critical, depending on the historical operations of the target company, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carryforwards and their potential benefit to the buyer may be important. Tax due diligence will often incorporate a review of the following:
- Federal, state, local, and foreign incomes sales and other tax returns filed in the last five years
- Government audits
- Copies of any correspondence or notice from any foreign, federal, state, or local taxing authority regarding any filed tax return (or any failure to file)
- Tax sharing and transfer pricing agreements
- Net operating losses or credit carryforwards (including how a change in control might affect the availability thereof)
- IRS Form 5500 for 401(k) plans
- Agreements waiving or extending the tax statute of limitations
- Allocation of acquisition purchase price issues
- Correspondence with taxing authorities regarding key tax items
- Settlement documents with the IRS or other government taxing authorities
9. Antitrust and Regulatory Issues. Antitrust and regulatory scrutiny of acquisitions has been increasing in recent years. The buyer will want to undertake the following activities in order to assess the antitrust or regulatory implications of a potential deal:
- If the buyer is a competitor of the target company, understanding and working around any limitations imposed by the company on the scope or timing of diligence disclosures
- Analyzing scope of any antitrust issues
- If the company is in a regulated industry that requires approval of an acquisition from a regulator, understanding the issues involved in pursuing and obtaining approval
- Confirming if the company has been involved in prior antitrust or regulatory inquiries or investigations
- Addressing issues that may be involved in preparing a Hart-Scott-Rodino filing (if thresholds are met) and effectively responding to any “second request” from the Department of Justice or Federal Trade Commission
- Considering Exon-Florio issues if the transaction involves national security or foreign investment issues
- Other Department of Commerce filings if the buyer is a foreign entity
- Understanding how consolidation trends in the company’s industry might impact the likelihood and speed of antitrust or regulatory approval
10. 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
- D&O insurance
- Intellectual property insurance
- Car insurance
- Health insurance
- E&O insurance
- Key man insurance
- Employee liability insurance
- Worker’s compensation insurance
- Umbrella policies
11. 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
- Lists of all security holders (common, preferred, options, warrants)
- Stock option agreements and plans, including both standard documents and any deviations therefrom
- Warrant agreements
- Stock sale agreements
- Stock appreciation rights plans and related grants
- Agreements granting restricted stock units
- Stockholder and voting agreements
- Stock-related preemptive rights, registration rights, redemption rights, or co-sale rights
- Agreements restricting the payment of cash dividends
- Evidence that securities were properly issued in compliance with applicable securities laws, including applicable federal and state blue sky laws
- Recapitalization or restructuring documents
- Agreements related to any sales or purchases of businesses
- “No-shop” or exclusivity obligations
- 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
12. Environmental Issues. The buyer will want to analyze any potential environmental issues the target company may face, the scope of which will depend on the nature of its business. Where an environmental review is conducted, it will typically include a review of the following:
- Environmental audits, records and reports for each owned or leased property, including results of tests or audits of the company’s properties and possibly neighboring facilities
- Hazardous substances used in the company’s operations
- Environmental permits and licenses
- Correspondence, notices, and files related to EPA, state, or local regulatory agencies
- Any environmental litigation, claims, or investigations
- Any known Superfund exposure
- Any contingent environmental liabilities or continuing indemnification obligations
- Any contractual obligations relating to environmental issues
- The use of any petroleum products on the company’s properties other than by passenger vehicles
- Any asbestos contained in any improvements located on the company’s properties
- Records from any public agency investigation of the company’s properties or any neighboring properties with respect to any environmental laws
13. 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 interest of any officer, director, stockholder, or employee of the company in any business that competes with or does business with the company
- Any agreements with any officer, director, stockholder, or employee that is entitled to compensation
- 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
14. 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
- Material reports to and correspondence with any government entity, municipality. or agency, including FDA, USDA, EPA, and OSHA
- Documents showing any certification of compliance with, or any deficiency with respect to, regulatory standards of the company
- Reports on the burdens and costs of regulatory compliance (including ERISA, labor and other federal, state, and local regulation)
- 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
15. 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
- Title reports
- Other interests in real property
- Financing leases and sale and leaseback agreements
- Conditional sale agreements
- Operating leases
16. 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
17. 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)
18. 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
19. Online Data Room. It is critically important to the success of a due diligence investigation that the target company establish, maintain, and update as appropriate a well-organized online data room to enable the buyer to conduct due diligence in an orderly fashion. The following are the common attributes and characteristics of an effective data room:
- The target company makes it available to the buyer as early in the process as possible, at the latest immediately following the parties finalizing the letter of intent or term sheet
- The data room has a logical table of contents or directory and full text search capabilities (which requires scanning of all documents with optical character recognition software)
- The data room permits bookmarking within the application
- Subject to confidentiality concerns, the buyer is permitted to print documents for offline review
- The data room is keyed to any due diligence checklist provided by the buyer to facilitate cross-referencing and review
- Ideally, access to the data room is accompanied by delivery by the company to the buyer of a draft disclosure schedule and all materials referred to in the disclosure schedule are in the data room
- Updates to the data room are clearly marked or trigger email notifications to the buyer’s counsel, to help ensure that nothing is missed as supplemental materials are added during the process
20. Disclosure Schedule. As part of any M&A transaction, the target company will be required to prepare a comprehensive disclosure schedule addressing many of the key diligence topics described above, and identifying any exceptions to the company’s representations and warranties in the acquisition agreement. Careful preparation of this disclosure schedule is extremely important and time-consuming for the company. It is not unusual for the company to have to revise and update the document a number of times before it is ready for delivery to the buyer. That means that is essential for the company to begin preparing the disclosure schedule very early in the planning stages of an M&A transaction. The buyer and the buyer’s counsel will be looking for the following in the disclosure schedule, among many other items:
- Does the disclosure schedule accurately tie into the representations and warranties set forth in the acquisition agreement?
- Are all material contracts and amendments listed, with dates and counterparties?
- Are all contracts listed in the disclosure schedule contained in the target’s online data room, and have those contracts been reviewed?
- Have all patents issued and pending been summarized and listed?
- Are any important contracts affected by a change in control? Will consents be obtained from the counterparty before or after the change in control?
- If litigation is listed, has an analysis been done of the potential exposure?
- If there are liens on any assets, how will those liens be removed at closing?
- Are there any unusual employment agreements or severance arrangements?
- Is the outstanding capital stock, options, and warrants of the company properly listed?
- Do the company’s continuing contracts provide for any issues for the company moving forward?
- Are there any material matters set forth in the disclosure schedule that are inconsistent with statements previously made on behalf of the company, or with the valuation that the buyer has placed on the business being acquired?
- Does the disclosure schedule include any broad disclaimers or generalized disclosures that would prevent the buyer from raising legitimate claims following the closing if individual representations and warranties turned out to be untrue?
- Are there disclosures or statements in the disclosure schedule that are internally inconsistent with each other?
An M&A 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.
Copyright © Richard D. Harroch. All Rights Reserved.