In many transactions, due diligence is an important step to take before finalizing a contract. This post from the team at Lex Moderna explains what due diligence is, why parties may engage in the process of due diligence, when to undertake due diligence, and how to go about it.
What?
Due diligence is the process of learning more about a transaction and the other contracting party before committing to a binding agreement. It involves a detailed examination of a company so that the investigating party can be certain that it understands the assumptions, conditions, risks, and opportunities associated with the planned transaction. Typically, due diligence reflects the exercise of care that would be expected of a reasonable businessperson before entering into a particular agreement.
Due diligence may occur across a range of transactions but is especially crucial in guiding parties in a potential merger or acquisition. Buyers typically conduct due diligence on a target company to confirm the accuracy of the seller’s claims in an effort to mitigate risks and gain insight into the seller’s operations prior to committing the deal.
Why?
The process of due diligence helps firms decide whether a particular transaction makes sense from financial, legal, reputational, operational, and overall strategic perspectives. Failure to perform adequate due diligence may result in overvaluation, excessive legal and compliance risk, reputational downsides, and synergistic and integration difficulties.
When?
Due diligence should begin when there is an agreement in principle between the parties but before a binding contract is signed. The parties may execute a letter of intent outlining the basics of the agreement between the parties and rules—including a timeline—for the negotiation period. The letter of intent normally stipulates that negotiations will be conducted in good faith. Often, it will also include a provision that prevents parties from negotiating with others regarding the subject of the proposed agreement.
The duration of the due diligence period will vary depending on the deal. Frequently it will last 30 to 60 days but may be longer for more complex transactions.
How?
The basic elements of due diligence in a merger or acquisition are discussed below. Additional elements might be involved depending on the type and complexity of the transaction.
General Information—general information includes business records and the business plan to understand the corporate structure and standing of a company. Documents that fall into this category include the company’s articles of corporation; corporate bylaws (including any amendments); minute book; certificate of good standing; business plan; list of subsidiaries, partnerships, joint venture agreements, and any other equity interests held by the company; a list of jurisdictions in which the entity is authorized to do business; and any documents relating to reincorporation or restructuring.
Organization and Ownership—information disclosed in this category typically includes a list of officers and directors; an organizational chart; records regarding issuance of grants of stocks and stock options; a list of shareholders, indicating for each the number of shares, dates of issuance, and consideration received; and past and current shareholder agreements, rights, and other matters pertaining to ownership.
Administrative Information—administrative due diligence seeks information about the company’s business facilities and includes a list of all business locations, generally defined as any place where the company owns or leases property, maintains employees, or conducts business.
Regulation and Compliance—regulatory and compliance due diligence assesses any regulatory or compliance issues with the target company or the deal more broadly. This process will be particularly complex in heavily regulated industries or when large parties are involved. Materials to be reviewed in this process includes the firm’s compliance policy and written standards of conduct; copies of any governmental licenses or permits; any correspondence, citation, notice of documents related to proceedings before any regulatory agency; any documents filed with the SEC or any state or foreign securities regulatory agency; any material reports to governmental agencies or other entities; and an analysis of any potential antitrust issues.
Accounting and Financial Information—accounting and financial due diligence enables a realistic valuation by seeking to confirm the seller’s financial performance to identify any unreported liabilities, understand the seller’s current financial position, and determine the sustainability of its earnings.
Operational—operational due diligence looks at the company’s systems and processes with the goal of identifying any risks associated with execution of the business function. Information to be disclosed should reflect sales, marketing, technology, supply chain, and production in order to determine any gaps and areas in which investment or development may be needed. Ultimately, the goal is to determine if operations can support the target’s business plan.
Tax Data—tax due diligence involves an analysis of tax returns and the company’s tax structure. This is critically important because the acquiring company will be responsible for any tax liability it inherits.
Legal—legal due diligence identifies and analyzes legal matters facing the target and related risks around contracts or potential litigation. This, too, is an extremely impactful aspect of due diligence as the buyer will be liable for any obligations, contingencies, and restrictions once the deal is complete.
Technology—the technological aspect of due diligence processes examines the firm’s IT assets to assess their sustainability, value, costs, capabilities, and scalability, as well as the ease with which systems would integrate into the buyer’s assets. This aspect pf due diligence may also embrace data protection matters, such as how a company stores and processes data.
Physical Assets—physical asset due diligence verifies the tangible assets possessed by the target and seeks to confirm the existence, value, age, quality, and ownership of a company’s real estate, fixed assets, and inventory.
Intellectual Property—a target company’s IP portfolio is extremely important in certain kinds of transactions, particularly in technology-driven industries. IP due diligence evaluates the materiality of the IP portfolio and ascertains whether there are any ownership issues.
Human Resources—human resources due diligence looks at information about people such as the total number of employees, organizational structure, demographics, compensation and benefit plans, human resources policies, and contracts. Understanding HR issues helps identify key employees and enables the development of an integration plan that can be implemented after the transaction is complete.
Commercial—commercial due diligence evaluates the target’s market position by looking at market conditions and trends, consumers, competitors, opportunities, threats, and differentiators.
Environmental—environmental due diligence identifies environmental and health and safety issues that may affect the value and reputation of the business.
Cultural—cultural due diligence, more subjective than other forms of due diligence, seeks to understand the cultural dynamics of a firm in areas like values, perceptions, mission, culture, working style, and traditions.
Strategic—strategic due diligence integrates all other forms of due diligence to determine whether the transaction should be pursued employing a range of hard and soft metrics.
We Can Help
Contact the team at Lex Moderna if you would like advice as to whether due diligence is recommended for a particular transaction and, if so, how to create an effective due diligence checklist and analyze the information received to evaluate whether a proposed deal meets your business needs.
