Due Diligence

CONTRACT MANAGEMENT TOPICS

A Guide to Legal Contract Management

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DUE DILIGENCE RESOURCES

Corporate Guidance for a Risk-Based Approach to Due Diligence

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M&A Due Diligence Checklist

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M&A Due Diligence Issues Reporting Template

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In an uncertain economic climate, a robust due diligence process matters now more than ever.

Stakeholders want the confidence to know an acquisition has withstood rigorous scrutiny. Because there is an even greater expectation of a more focused and deeper investigation upfront, expertly honed due diligence provides the rationale and comfort to proceed with a transaction despite larger market unknowns.

As mergers and acquisition (M&A) activity accelerates and deals pick up, organizations across industries can thrive with a revitalized due diligence process that streamlines contract management workflows, identifies the right targets, and collects relevant information that provisions for all probable outcomes.

What is due diligence in corporate law?

At its core, due diligence is the process by which a company reviews information from another company for the purpose of an acquisition, sale, or investment. Ultimately, due diligence helps corporate counsel answer the buyer’s question: “Is there any reason why we should not move forward with this transaction?”

Due diligence is also plain business sense. Because it precedes deal closure, the exercise helps parties confirm facts and financials, review risks and assumptions, and prepare for post-deal integration if the deal goes through. In effect, due diligence is the homework a company must do to make informed decisions.

Importance of due diligence

Essentially, nearly all business actions trigger due diligence considerations, with some derived from legal and regulatory mandates. These due diligence requirements compel a company to scrutinize customers, third parties, and – above all else – itself to detect, avoid, or manage legal, compliance, or ethical infractions.

While due diligence is important in cases where a company is considering a takeover or merger, it is equally relevant to all parties in any given transaction. For buyers, a focused and effective review should help verify information, identify potential issues, confirm valuation, and ensure the deal meets the stated investment criteria. Meanwhile, sellers can assess the buyer’s means to effectively finance the deal, their representations, and their own ability to remedy any red flags that might otherwise weaken the prospect of a strong bid price.

Buyer-side advantages of due diligence

From the buyer’s side, due diligence provides many tactical advantages, such as the ability to:

• Better understand the seller’s business and confirm the target entity aligns with the seller’s representations.
• Evaluate the merit of an acquisition through the identification and assessment of the deal structure, contract terms, liabilities, and risks.
• Identify any problems that require resolution prior to close or through future contract terms.
• Identify measures necessary for post-deal integration.
• Determine representations and warranties, as well as closing conditions and indemnification provisions, to include in the final agreement.
• Identify any other contractual or legal impediments to a successful close (e.g., any required consents that must be obtained).

In the end, due diligence done properly should help buyers decide whether to proceed with the deal.

Sell-side advantages of due diligence

While due diligence is often discussed from the buyer’s perspective, it is equally important for sellers to engage in a preliminary review well before a deal is closed.

Pre-sale (or “sell-side,” as it is also known) due diligence is an internal review of one’s own frameworks and assets. Although pre-sale due diligence resembles the due diligence process conducted by a buyer in a traditional M&A transaction, differences exist. Unlike buy-side access constraints, the seller doesn’t need approvals to access its own records or to meet third-party deadlines as part of its own review.

Sell-side due diligence analysis typically focuses on areas like:

• Corporate affairs.
• Financial, tax, and accounting.
• Litigation and disputes, as well as any regulatory compliance matters.
• Change of control provisions that a sale can trigger.

The latter case can help the seller identify the third-party contracts they have, with insights into contract assignment and consent. A seller might assess its own third parties for their views on a probable sale. While third parties may not be able to stop the transaction, they could still terminate their own contract with the seller in protest. But even if a third party didn’t want to stop the transaction, the underlying contract agreements might. Knowing this information in advance allows the seller’s legal team to strategize how best to work around these issues, obtain consent, and maximize buy-in.

Sell-side review fortifies the seller’s position in the M&A sales process in other critical ways. A seller may identify issues like tax liabilities and liens, which, if left unresolved, would reduce the bid price, dissuade bids, or leave the seller at a negotiating weakness. Conversely, through analysis of assets, products and services, and earnings, sell-side due diligence may also highlight strengths that bolster the acquirer’s valuation.

Increasingly, cybersecurity will be a top-of-mind issue for buyers, who will want to know about the seller’s cyber controls beyond just representations and warranties in the closing agreement. Expect questions on the sufficiency of technical systems and equipment, not to mention the privacy and security of data. For example, buyers may want to know if cyber controls follow industry standards and are audited, any identified issues, and the remediation status.

What should be included in due diligence?

Amid wider business and legal implications, companies must think beyond a uniform check-the-box due diligence exercise. Effective due diligence requires a comprehensive, yet targeted approach – tailored to address specific variables and circumstances.

Typically, parties will conduct legal and financial due diligence in business, but operational areas like supply chain, logistics, and procurement practices may also warrant in-depth review due to far-reaching legal and strategic considerations.

Balance, however, is equally important. To perform due diligence effectively, companies must also wisely manage time and resources, with the right targets investigated.

Risk-based due diligence analysis

Because not every target requires the same scrutiny, companies should rank entities to assess the needed due diligence. A risk-based approach recognizes that the due diligence scope may be limited by time and resources. As a result, the greater the risk, the greater the resources a company should expend on a due diligence review.

Due diligence process

The due diligence process varies for each transaction type. However, there are similar critical steps, regardless of the transaction type, outlined below. The process should start only once the parties have agreed to a deal in principle. The buyer’s due diligence process focuses on a review of information and documents furnished by the seller, while the seller focuses on confirming valuation and avoiding surprises.

Submit a document request list

To kick off this process, due diligence begins with the issuance of a due diligence request list from the buyer to the seller. The due diligence request list should be prepared for the specific transaction and is carefully focused to meet the buyer’s objective due diligence needs. To maximize objectivity, the buyer should be clear about what information they truly need from the seller.

Depending on the buyer’s objective and needs, a customized request list might include:

• Company and legal details – beyond the basics such as formation documents and operating agreements, these might include details on any ownership interest that the company holds in a third party, annual reports and periodic filings for a defined period (e.g., three to five years), and litigation and regulatory compliance matters, past and present.
• Financial information – in addition to items such as tax documentation, financial statements, and monthly bank statements (for current and closed accounts), the solicited information might include disclosure of any accounting issues and debts.
• Registration and licenses – copies of permits and all registration and licensing information.
• Insurance and liabilities – beyond a summary of insurance arrangements, information might include any pending claims and details on the cancellation of any insurance policies.

Additional request list items might span:

• Intellectual property information in terms of who owns the work, patents, and any groups or individuals with control rights.
• Product, services, and customer information.
• Physical assets.
• Operations, such as information on supply chains.
• Technology, such as a review of processes to ensure compliance with data protection measures.
• Environmental, like whether facilities meet relevant environmental regulations, among other scenarios.
• Human resources information, such as employment agreements, list of employees, benefit plans.

Assemble and share documents

Following submission of the document request list, the seller and/or its counsel then assemble documents and make them available to the buyer. In parallel, sellers can remedy any issues through internal review of relevant documentation, such as corporate governance contracts, financial statements, management and employee contracts, and real estate and commercial contracts. Note that during the process, certain steps may be repeated if new information comes to light.

Draft an issues report

After reviewing the documents and information furnished by the seller, the buyer’s counsel will create a due diligence issues report to highlight legal matters identified during the due diligence process. This “red flag” report, as it is known, summarizes legal issues, next steps, and supplemental diligence requests.

Equally important, any recommendation to proceed with the transaction should be backed by clear documentation.

The seller side may also furnish its own report and detail the results of its due diligence review for potential acquirers. With consideration paid to issues such as current or potential litigation, regulatory disputes, and unsettled intellectual property claims, sellers can demonstrate proactive management of myriad internal and external issues.

Making the due diligence process more efficient

While due diligence is complex and time-consuming, buyers and sellers typically pay their own way in the process. Due to costs, it’s helpful to identify work efficiencies.

Bidders may choose a staggered approach, with more in-depth due diligence to occur in later bidding rounds when a deal is more likely to occur. Sellers should periodically conduct a due diligence review even if they are not actively seeking to sell their business. As a form of self-assessment, sellers may identify factors that could impact future deals regarding the value, delay the deal (with contracts requiring consent), and what can be done before a sale to fix them. Bidders and sellers may also first review the highest-risk areas most likely to impact the target’s value.

To further streamline the process, it’s often wise to convert documents produced for due diligence into electronic form and share them in a secured virtual data room (VDR). Due to the confidential nature of the information, the target should control data room access, and leverage analytics to glean insights into items most reviewed by bidders.