This post was jointly written by Jennifer Wilson and Casey W. Riggs.
This is the fifth in a series of posts discussing the sale of a business from the seller’s perspective. In the first four posts, we provided an introduction to this series and discussed asset versus stock sales, seller financing, earn-outs, and letters of intent. In this fifth post, we’ll discuss the beginning of the deal process (after signing of the LOI), which typically begins with a comprehensive review of the seller’s business by the buyer (generally referred to by those in the M&A industry as simply “due diligence”).[1]
The due diligence process can often overwhelm sellers who need to be focusing on more important aspects of the transaction. It’s incredibly stressful to be working on key aspects of the deal (and simultaneously running your business) while being bombarded with e-mail requests for more and more information, some of which may seem irrelevant or immaterial. To keep your sale progressing smoothly so you can focus on what’s important, you need to know what to expect and how to respond before you start the process. Here’s a description of the purposes of due diligence and a general outline of the process followed by some tips for handling it efficiently
The Purposes of Due Diligence
Due diligence is performed by the buyer to determine if it wants to go through with the purchase of the business. As the seller, you are privy to all sorts of information that the buyer doesn’t have and due diligence is the primary way the buyer has of getting at this information. While you may know with certainty that there are no potential environmental issues with your real properties, the buyer doesn’t know this but wants to find out in the due diligence process. So keep this in mind when the buyer is asking for all kinds of information, some of which may not be relevant. Due diligence is also used to put together the schedule of disclosures required in connection with the purchase agreement. We’ll begin discussing the purchase agreement in the next post.
The Due Diligence Process
Due diligence will likely begin with one or more diligence request lists. You may get one comprehensive list submitted by the buyer’s law firm which requests accounting, financial, and legal information. Or you may get separate lists (one from legal, one from financial/accounting). If you get a brief list, you can be pretty sure that a longer list is coming later. (If you want to see a sample diligence request list, send us a quick e-mail and we’ll be happy to provide one.)
When you get the request list, you will be expected to provide complete and accurate responses to all items requested, and most likely, this will be done by means of a virtual data room. Popular electronic data room providers range from those like Merrill, which offers a full-featured service with extensive security options (for example, documents can be made available on the site for printing only and users cannot download them to a local drive), to cheaper or free options, such as an in-house extranet service or cloud services such as Google Drive or Dropbox. Electronic diligence entails a lot of scanning and organization for you and means, generally, that the parties involved expect instant responses to requests and a constant awareness of what is provided.
The due diligence process, on the buyer’s side, will likely be run by mostly associate attorneys, many of whom may seem to exercise little or no common sense at times. You’ll know what I mean when you get repeated requests for a signature page to a postage meter lease. However, to be fair, the associates are charged by their senior partners with running down every contract, document, etc., and aren’t charged with making judgment calls about what is or is not important at the due diligence stage.
The due diligence process may at times seem grueling. It often continues right up to the point of closing with continuing requests for missing or additional information, all while you’re running a business, trying to negotiate a transaction, and attempting to maintain some sanity.
With this backdrop of the purposes and process of due diligence, here are some practical tips to make life easier in this phase of the deal:
Point 1 – Consider a Pre-Transaction Review — Consider having your law firm review your books, records, contracts, etc. before the deal process even starts. Your lawyer will have a good idea as to what information the buyer will be looking for and it can help tremendously to have your information organized and collect missing information before the deal starts. You’ll be glad you did this when you’re in the heat of the deal.
Point 2 – Provide Complete Responses — Many buyers will want to review everything (every contract, financial statement, customer list, accounting record, and on and on), and will expect it to be complete. When you hunt down the documents requested, before scanning them, check them over to be sure that they are the most current version and include all party signatures and all attachments, exhibits, annexes, schedules, and so on. You can be sure that the purchaser’s lawyers are going to come back and hassle you for anything that is missing.
Point 3 – Allocate Responsibilities — Decide on an allocation of responsibility within your company and between you and your lawyer. Some business owners take charge of going through their files and scanning and uploading all the documents to be provided. Others send boxes of disorganized papers and files to their law firms for junior associates to go through and organize. Yet others work out an arrangement somewhere between these extremes. Whatever you choose, make sure that everyone knows who is responsible for uploading new documents and informing the group that new documents are available.
Point 4 – Use Reference Numbers and Descriptive File Names — When organizing and delivering documents, consider using reference numbers and writing them right on the documents before you scan them. Also be sure to use file names that start with those reference numbers and that include a helpful descriptor. As in other areas of life, the file name “Scan00001” is completely worthless to anyone looking for a document and will lead to inefficiency and confusion. Instead, use a name such as “2A Tennessee real property lease”.
Point 5 – Always Load It in the Data Room — Don’t assume that just because you e-mailed a document directly to purchaser, or to your accountant, that anyone else involved in the transaction has seen it. Put all documents in the data room, even if any party asks that you e-mail a particular document directly. Above all else, remember to make sure your lawyer sees every single document you provide to anyone else.
Point 6 – Be Aware of Confidentiality — Be aware of where you are in the process and adjust disclosure accordingly. If you are at an early stage and wish to keep customer names confidential, for example, provide customer contracts with the customer names redacted. Number them so that you can provide a number-customer name key once you are ready to reveal the names. If you’ve allocated the responsibility of uploading documents to your lawyers, be sure to keep them in the loop as to documents that should remain confidential or that should be redacted before being uploaded.
Point 7 – Use “N/A” — If your company doesn’t have any of a certain type of document requested — for example, deeds to real property (because all of your offices are leased) — be sure to indicate that there is nothing to provide on the request list. If you have provided some documents in a given category, but others are coming, indicate that as well. It is easiest to do that right on the request list.
Point 8 – Keep the Due Diligence Information — Whether a deal closes successfully or fails to close, be sure to keep records of all documents you provided during the due diligence process. It is easy enough to burn a CD-ROM of the entire electronic data room. If the deal closes, you may need to refer to these documents from time to time, especially if any dispute or indemnification claim arises under the purchase agreement. If the deal doesn’t close, you can also use this to make the process go that much more quickly in your next attempt. Don’t lose sight of this important step in the aftermath of a deal that fails to close.
If you can keep these tips in mind while going through the due diligence process, you’ll be in a much better position to guide the transaction from a high level.
In the next post, we’ll begin discussing the purchase agreement.
Footnotes
[1] On this blog, we previously covered due diligence from the perspective of a buyer. Topics included: an overview of the due diligence process, a summary of legal due diligence, a summary of financial due diligence, and a summary of operational due diligence.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
