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

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.

Alexander J. Davie About Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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