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Selling Your Business – Practical Tips for Sellers – Part 5: Due Diligence

February 28, 2013 By Leave a Comment

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] [Read more...]

Filed Under: General Business Law Tagged With: , , , , , , , ,

Drafting Nondisclosure Agreements in the M&A Context: Consider What Will Happen When the Deal Goes South

October 11, 2012 By Leave a Comment

Let’s say you’re buying a business. As a condition to receiving more information, you are required to sign a nondisclosure agreement that contains all of the usual blather. You then start to sift through the mountains of information provided (and have your accountants and lawyers do the same, at considerable expense) to decide whether the company is worth purchasing, and on what terms. You like what you see, so you negotiate a letter of intent, and continue your due diligence investigation. You spend five or six months in negotiations and due diligence to the tune of many thousands of dollars (or more).

Then, let’s say at the eleventh hour you discover something really unfavorable about the company – in fact, three such issues emerge, so significant that you would never have considered buying the company at all if you had known about them. You didn’t suspect their existence, because you had been told verbally at the beginning of the process that there were no such issues. However, once found, these issues cause you to terminate negotiations.

What about the money you spent on negotiations and due diligence? Might you be able to recover that? Does it matter whether the seller intentionally withheld information about the negative issues until the last minute or simply forgot to provide it earlier?

For possible remedies, turn to the nondisclosure agreement. Let’s suppose it contained provisions something like the ones below:

The “Non-Reliance Disclaimer” Provision

Purchaser understands and acknowledges that neither Seller nor any Seller Representative is making any representation or warranty, express or implied, as to the accuracy or completeness of the Evaluation Material or of any other information concerning Seller provided or prepared by or for Seller, and none of Seller nor the Seller Representatives will have any liability to Purchaser or any other person resulting from Purchaser’s use of the Evaluation Material or any such other information. Only those representations or warranties that are made to a purchaser in the Sale Agreement when, as, and if it is executed, and subject to such limitations and restrictions as may be specified [in] such a Sale Agreement, shall have any legal effect.

The “Waiver of Claims” Provision

Purchaser understands and agrees that no contract or agreement providing for a transaction between Purchaser and Seller shall be deemed to exist between Purchaser and Seller unless and until a definitive Sale Agreement has been executed and delivered, and Purchaser hereby waives, in advance, any claims . . . in connection with any such transaction unless and until the parties shall have entered into a definitive Sale Agreement.

A plain reading of these provisions seems to preclude you from bringing any claim based on seller’s failure to provide information prior to the execution of a definitive sale agreement. Perhaps your best argument is that the most reasonable interpretation of the first provision above is that it bars claims based on mistakes or negligence in providing accurate and complete due diligence information, but not outright fraud, or is at least ambiguous on this point. You could shore this up with the argument that a court should refuse to enforce these provisions on policy grounds — courts should not enable a party to use a contract to shield itself from liability for its own fraud.

In RAA Management, LLC v. Savage Sports Holdings, Inc. [1], the Delaware Supreme Court, applying New York law (and holding that the result would be the same under Delaware law), recently rejected these arguments by a potential buyer in a case involving facts similar to those set forth above and affirmed the Superior Court’s holding dismissing the buyer’s case.

The Superior Court held that “where a sophisticated investor like RAA Management agrees to perform due diligence with the understanding that the seller disclaims any warranty of accuracy or completeness in the information it provides to the potential buyer, the due diligence is governed by . . . a buyer beware notion, that even absolves the seller from intentional fraud” (emphasis added).

The Superior Court pointed out that the language in the first provision above does not distinguish between information that is inaccurate or incomplete because of negligence or mistake and information that is inaccurate or incomplete because of alleged fraud or because it was intended to be so; therefore, the argument that the language should be construed as providing an exception for “fraudulent” or “intentional” misrepresentations has no merit. The Superior Court also found the language unambiguous, examining prior cases construing similar provisions.

The policy argument also cut no ice with the Superior Court, which reviewed prior cases that set forth Delaware’s “public policy in favor of enforcing contractually binding, written disclaimers of reliance on representations outside of a final sale agreement.” Sophisticated parties cannot negotiate such disclaimers and then claim that they in fact did rely on such representations and are entitled to relief.

The obvious lesson of RAA Management is one for potential purchasers – if your nondisclosure agreement contains provisions similar to those above, don’t proceed in reliance on the information you receive during the due diligence process; if anything does go wrong, don’t expect to recoup any of your expenses.

Is there any lesson for lawyers drafting nondisclosure agreements (other than to be aware of the issues so you can advise potential purchasers appropriately)? Could, or should, lawyers attempt to carve out fraud and intentional misstatements or omissions from a provision disclaiming reliance on information provided? Disclaimers and waivers such as those in the RAA Management nondisclosure agreement are customary and a seller’s attorney would likely make the usual noises about what is market and where the risks should be allocated. Sellers have little incentive, anyway, to withhold intentionally negative information until late in the process. Furthermore, intent would be difficult to prove – but a carve-out for intentional misstatements or omissions would at least enable a disappointed purchaser in RAA Management’s situation to avoid a dismissal.

Footnotes

[1] RAA Management, LLC v. Savage Sports Holdings, Inc., No. 577, 2011 (Del. May 18, 2012)

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© 2012 Jennifer Wilson — 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.

Filed Under: General Business Law Tagged With: , , , , , ,

Looking to Invest? How to Determine Whether an Investment Is Worth It

May 4, 2012 By 4 Comments

This article was originally posted on business.com on May 1, 2012.

Investing in a new venture can be exciting. In addition to the potential to make a profit, many people invest in start-ups for the thrill of being involved with helping a fledgling company make its mark. The possibility of funding a breakthrough company is enough to get many investors enticed, committed, and involved.

However, it’s also a fact of life that many, if not most, start-up companies fail. Alongside that, some investment opportunities are fraudulent, being promoted by people only looking to swindle you out of your money and then move on to pursue other ventures (and victims).

This can be the case even if it appears on paper that the company has a fantastic business model, an intricate plan, or even an extensive list of key assets. While not all promoters of start-up investment opportunities are out to do such a thing, the smart investor needs to gather important information before considering investing in a business – good or bad.

  • Determine if the Promoters are Legitimate: Conduct a Google search on the person promoting the opportunity. If the person is in the financial industry or works as a securities broker, check out his profile on brokercheck.finra.org. If you find any history of securities law violations, fraud, lawsuits, or criminal conduct, it should function as a huge red flag. A history of bad conduct means the company is likely to continue with such actions in future endeavors.
  • Ask for the Company’s Offering Memorandum or Financial Statements: If the company doesn’t have some kind of offering memorandum or due diligence packet, that’s a red flag, as it alerts you that the company either is unwilling to provide information to potential investors or simply lacks the patience to put in the work the goes into compiling such information. That being said, a small company may not have the money to produce a formal offering memorandum; in this case, you should ask for its financial statements. These should be prepared by an outside accountant in order to provide some degree of independent verification. The reliability of such documents is further enhanced if they’re audited. Finally, it’s also a good idea to require copies of past tax returns in order to verify their claims.
  • Obtain a Copy of the Company Business Plan: A company’s business plan is the ultimate road map that will guide a company to success. Not only does it provide the main objectives of the company, it also tells you the demographic they’re marketing their goods or services toward, along with the resources it will take to accomplish the company’s plans. Companies that take the time to prepare a business plan have demonstrated that they have put some thought into how they are going to use your investment to produce a profit.

As an investor, you should have an informal team consisting of a lawyer, an accountant, and an investment adviser (one who’s paid a fee to advise you, not a broker who receives a commission on the sale). Your lawyer(s) should specialize in business law – don’t use the family lawyer who wrote up your will. Having a team can be very important to you, as an investor, in several ways:

  • Negotiations between You and Company: If the deal is negotiated between you and the company, rather than a prepackaged securities offering made to a number of investors, a lawyer experienced in start-up finance can help you negotiate protections and better terms.
  • Understanding the Contents of Legal Documents and Disclosure: Your team also will be able to help you understand both the economics and the legal terms of the transaction. Having an investment team is important when it comes time to review the documents binding you to the start-up. If you don’t understand something, your team of advisers is there to help. You pay them to help you sort through confusing and complicated issues.
  • Establishing Credibility: Having a team is not only smart for legal reasons, but it also lends you a level of immediate respect. Parties without lawyers show they don’t take themselves seriously, or don’t have the means to prepare their documents in a professional manner. In addition, if the other party drafted the documents without a lawyer, the documents will likely contain serious problems and key issues will be overlooked.

If you’re an individual with a high net worth, it’s beneficial to join an angel investing group. These are local organizations comprised of individuals looking to invest in promising companies. Joining such a group is beneficial, as it allows you to compare your notes about the companies with other potential investors. It also allows you to invest more money as a group.

While investing in a start-up company can be a gamble, proper investigation and preparation, from researching the promoters to working with your investment team, will allow you to make smarter and more profitable investments. The better investments you make, the more likely you are to invest in that breakthrough company.

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© 2012 Alexander J. Davie — 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.

Filed Under: Startups and Venture Capital Tagged With: ,

Due Diligence for Buying a Business 101 – Part 4: Operational Due Diligence

February 1, 2012 By 1 Comment

Previously, I wrote about the need for the purchaser of a business to conduct due diligence on its prospective acquisition target.  As I discussed, due diligence on a business can be split into three sections: legal, financial, and operational.  This post will explore what is involved with the operational portion of due diligence.

The operational portion of due diligence involves ensuring that the business will be able to function as the purchaser expects after it has been acquired.  The business, in the hands of the seller, may be generating a handsome profit; however, upon transfer that profitability may be impaired due to a whole host of reasons.  Key employees may quit or key contracts may be non-assignable and thus end up being terminated upon the sale of the business, or worse yet, may even go into default. This is especially true in the context of leases and existing indebtedness.  Leases and loan documents often prohibit the transfer of the agreement, even indirectly through a stock purchase.  In addition, if applicable, the buyer will also need to make an inquiry into the ownership of the IP of the company, including the company’s trade names.

Below, I’ve created a non-exhaustive list of the types of documents that a buyer should request as part of the operational portion of due diligence.  Obviously, every deal is different, so there are likely to be additional documents that would be necessary in any particular deal.

  1. List of directors, officers, and key employees and their compensation.
  2. Employment agreements of directors, officers, and key employees, including any confidentiality or non-competition agreements.
  3. Confidentiality and non-competition agreements to which employees and consultants are parties with their prior employers.
  4. Any collective bargaining or labor agreements.
  5. Personnel manuals and employee handbooks.
  6. All loan documents for any indebtedness of the company or indebtedness which encumbers company assets.
  7. All other financing documents, such as documentation of sale and leaseback transactions, installments sales contracts, letters of credit, vendor financing programs, and capital lease agreements.
  8. License agreements of any intellectual property, including software, patents, copyrights or trademarks.
  9. Lease agreements (as landlord and tenant).
  10. Contracts with outside brokers, agents, distributors, or franchisees.
  11. Supplier and vendor contracts.
  12. Customer contracts.
  13. Maintenance agreements and warranties for any essential equipment.
  14. Any agreements which place any material limitation on the method of conducting or scope of the Company’s business.
  15. All other material agreements, such as: (i) joint venture and partnership agreements, (ii) agreements which have a value over a certain dollar threshold, and (iii) agreements which have a term over one year.
  16. All documents evidencing title to real estate, including title insurance policies.
  17. Any environmental reports on company real estate.
  18. Documentation of all patents, trademarks, service marks, copyrights, and other intellectual property owned or used by the Company.
  19. Evidence of ownership or rights to all proprietary software.
  20. Evidence of ownership of all domain names.
  21. Correspondence dealing with actual or alleged infringement by the company of others’ intellectual property or by others of the company’s intellectual property.
  22. If material to the company’s business, the Buyer should also conduct its own independent evaluation of the company’s intellectual property to evaluate its validity and potential for infringement.

Conducting due diligence for a business acquisition involves reviewing a large amount of documentation.  It is a major undertaking, but a necessary one to ensure that the buyer is buying what he thinks he is.

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© 2012 Alexander J. Davie — 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.

Filed Under: General Business Law Tagged With: , , , ,

Due Diligence for Buying a Business 101 – Part 3: Financial Due Diligence

January 24, 2012 By 3 Comments

Previously, I wrote about the need for the purchaser of a business to do due diligence on its prospective acquisition target.  As I discussed, due diligence on a business can be split into three sections: legal, financial, and operational.  This post will explore what is involved with the financial portion of due diligence.

The financial portion of due diligence involves ensuring (a) that the financial information used to make the decision to buy the business and to determine the purchase price is accurate; (b) that the buyer has a thorough understanding of the target company’s finances so that it can include future potential contingencies in its projections and financial models; (c) that there are no customer collection or cash flow issues; and (d) that the buyer has a full understanding as to any future unfunded liabilities like pension benefits for current and future retirees and promised bonuses to employees.  Financial due diligence differs from legal due diligence in that it may require a larger team to conduct.  For legal due diligence, the buyer and its attorney(s) are usually the only necessary parties.  Depending on the sophistication of the buyer and the size of the deal, it may be necessary to hire accountants or other financial advisers to assist with the financial portion of due diligence.

Below, I’ve created a non-exhaustive list of the types of documents that a buyer should request as part of the financial portion of due diligence.  Obviously, every deal is different, so there are likely to be additional documents that would be necessary in any particular deal.

  1. Audited financial statements for the last three to five fiscal years and any interim unaudited financial statements, if available.
  2. Any reports by and correspondence with the company’s accountants, including any management letters to the company.
  3. Any financial projections or plans produced internally by the company.
  4. Monthly income statements, balance sheets, and cash flow statements for the last twelve months.
  5. Trial balance and general ledger statements as of most recent month end.
  6. A detailed description of any add-backs that explain the differences between the company’s tax returns and its financial statements.  In general, since businesses try to minimize their taxable income, it is understood that the actual net income used in financial statements may differ from taxable income, but it should also be clear what methodology is being used in calculating those differences.
  7. Details on any transactions with related parties (i.e. owners, affiliates, their immediate families).
  8. If the company has multiple lines of revenue, then the revenue and gross profit of each category should be separated out.  This should be done for the last 12 months at least, but preferably over the entire period of financial statements received.
  9. Revenue from the 20 largest customers for the past 12 months.
  10. Purchases from 20 largest vendors for the past 12 months.
  11. Detailed A/R aging as of the most recent month end.
  12. Detailed A/P aging as of the most recent month end.
  13. Monthly inventory reports for the most recent month end, if applicable.
  14. List of all leases for real property or equipment, together with basic terms of each lease.
  15. The currently used budget for capital expenditures.
  16. List of all bank accounts.
  17. Monthly bank statements and reconciliations for the past 12-24 months.
  18. Current organization chart.
  19. A copy of any incentive compensation arrangements for employees including bonuses and sales commissions together with a list of employees covered.
  20. Description of any retirement plans together with a copy of the plan documents.
  21. Copies of the documents related to any stock plans, ESOPs, and other profit-sharing plans together with a list of employees covered.

As you can see, doing due diligence on a business acquisition involves reviewing a large amount of documentation.  This post, together with my previous post on legal due diligence, discussed the first two-thirds of the process.  In a future post, I’ll discuss the last section: operational due diligence.

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© 2012 Alexander J. Davie — 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.

Filed Under: General Business Law Tagged With: , , , ,
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