Due Diligence - An Overview

DUE DILIGENCE - AN OVERVIEW

            You wouldn't buy a used car before you test drove it.  You might hire a professional inspector to walk through a house before you made a purchase offer.  You certainly would insist on meeting your daughter's date before he took her to the prom.  Given the time, care and energy you would spend on these personal matters, it makes perfect sense for you to conduct a minimum amount of due diligence before your business enters into a transaction with another company.  Whether that transaction is as straightforward as qualifying a new supplier, or as involved as a wholesale purchase of a target company, you will certainly want some basic information about your counterpart.  Yet a surprising number of businesses conduct a bare minimum of due diligence or skip the process altogether, relying instead on the counterpart's reputation and general instinct prior to executing a contract.  The cost associated with conducting a thorough due diligence review is frequently cited as the number one reason for avoiding the process.  Due diligence conducted by outside legal counsel or third-party consultants is rarely inexpensive, but the upfront cost that your business pays for this service may well be the best investment you make prior to signing on the dotted line.

             This article summarizes the general topics that should be reviewed by every company prior to entering into a significant transaction with a counterpart.  These topics are specific to a transaction in which your company is considering acquiring a target company, but they are also applicable to a broader universe of transactions.  Varying amounts of emphasis will be attached to some areas over others, depending on the nature of the transaction and the other party to the transaction.  In every case, whether you allocate a few thousand or tens of thousands of dollars to the process, the information you uncover in your due diligence review will inevitably justify that expenditure.

             In every case, you will want to confirm that your counterpart is in good standing in its state of incorporation and that all corporate documents have been timely and properly filed.  If the company has a national or international scope, you will want to confirm that it is properly qualified to do business in the states and regions in which it operates.

            Your accounting team should review basic financial information, including audited financial statements (if available), credit reports, budgets, schedules of receivables and payables, as well as the target company's internal accounting control procedures.

             If the transaction affects physical assets, you should examine a schedule of those assets and determine if any of them are subject to UCC filings, liens or other claims.  Your accounting team should analyze capital equipment purchases and depreciation schedules for that equipment.  If the transaction involves real estate, you should examine all leases, deeds, and mortgages which may affect that real estate.

             Intellectual property is a significant part of virtually every transaction.  You should examine schedules of patents, trademarks and copyrights, any available descriptions of "know-how", invention assignment  and non-compete agreements, and any claims or threats which may affect the status and viability of the target company's intellectual property.

             Hidden issues involving employees and employee benefits can arise to complicate any transaction.  You should review lists of employees and relevant associated data from the target's human resources function, any employee handbooks, schedules of unemployment and other employee claims, and descriptions of employee benefits.

            If the target company is subject to any regulatory control, you should examine any licenses, permits or consents that may be required for the target company to conduct its business.  Licensing and permitting may have a significant affect on environmental issues involving the target company, and anything which impinges on environmental issues or controls should be thoroughly reviewed.

             If you accounting team did not have an opportunity to see the target's tax filings with its financial statements, you should request copies of all federal and state tax returns for at least the prior three years.

            If you anticipate benefiting from material contracts which the target company has previously executed, you need to see copies of those contracts as well as all subsidiary, partnership or joint venture relationships executed by the target company.   If the target company uses standard form contracts in its business, you should see copies of those as well.

             You will want to see all relevant information about the company's product or service lines, and its customer and client base.  Marketing and advertising programs will give you clues regarding your counterpart's marketing and sales strategies.

             Unless you are not concerned with buying into a problem, you will want to see schedules of threatened, pending and settled litigation.  Insurance coverage is an increasingly important component of litigation indemnity, and the targets insurance policies should be analyzed as well.

             The target company will likely have engaged the services of a variety of professionals during its existence, and will have been the subject of articles and press releases.  Schedules of this information will round out your due diligence analysis.

             A proper and thorough due diligence review of all of these topics will obviously be time-consuming and expensive, yet the assurances which the review generates will offer a payback that has an even greater value.  Your legal counsel can assist you to determine the extent to which due diligence should be conducted in any transaction.  As cautioned by the time-worn cliché, a decision to forego a due diligence review may well be pennywise, but pound foolish.