Business owners seeking to sell their companies are well advised to first consider undertaking a due diligence investigation of the company. A thoughtful evaluation of the business before the sale process starts will make the process more manageable, efficient, and cost effective for a seller.

What is Due Diligence?

Due diligence is the process by which business owners conduct a business, legal, and financial investigation of a company in preparation for a possible sale transaction. While company owners and management can adequately perform business due diligence, a company should consider engaging outside financial and legal advisers to conduct its financial and legal due diligence. Such investigations are time consuming, may be overwhelming, and vary greatly depending upon the nature and form of a potential transaction. Legal advisers can make available a variety of services to assist a client with selling its business.

For example, Ballard Spahr’s transaction teams routinely: (1) work with investment bankers to coordinate due diligence investigations with the mutual client, (2) assist clients with organizing due diligence information for prospective buyers through the use of data room services, shared drives, or FTP sites, (3) conduct formal litigation and Uniform Commercial Code and state and federal tax lien searches, (4) review contracts, licenses, approvals, and other corporate documents to assess how provisions affecting transfer may prolong the transaction process, and (5) render legal opinions.

Why is Due Diligence Important?

Legal due diligence is a critical part of the transaction process for several reasons. First, a selling company, along with its legal advisers, will identify potential and hidden liabilities during the due diligence process. Second, pre-transaction due diligence provides a company with the opportunity to prevent a buyer from discounting the value of a business due to the lack of proper respect for good corporate housekeeping. For example, a company may find that its key contracts are not fully executed, its corporate records are missing minutes or consent resolutions authorizing critical actions, or the company’s assets are encumbered by liens that have not been removed. In this case, the company with the aid of its legal advisers can remedy these matters before a buyer conducts its own due diligence and uses these deficiencies as a basis to discount the value of the business. Lastly, the information collected during due diligence will assist legal advisers in negotiating and drafting transaction documents and the company in preparing its disclosure schedules (exceptions to a seller’s representations and warranties in a purchase and sale agreement). Based on the liabilities and potential liabilities identified during the due diligence process, legal advisers can draft representations and warranties, covenants and indemnification provisions in the transaction documents, and disclosures to allocate risk at the seller’s direction. In some instances, a prospective buyer will request a legal opinion of seller’s counsel to be delivered at the closing, and such legal opinion requires that seller’s legal advisers conduct a detailed review of the selling company’s due diligence as a basis for the legal opinion. Therefore, the legal due diligence process is as important for legal advisers as it is for the selling party.

The Essentials of Due Diligence

A selling company will be asked to provide a prospective buyer with the information the buyer needs to satisfy its own due diligence inquiries and to evaluate the target business. There are a number of categories for which a seller should collect information early in the transaction process. As noted previously, the nature and form of the due diligence process will vary depending upon the transaction structure deployed by the parties, and, in some cases, the due diligence process may result in a revised transaction structure with greater benefits to the seller. Accordingly, the categories of legal due diligence will vary depending on whether the transaction involves an asset or stock sale. In general, the common categories of due diligence include the following:

  • Organizational information – formation or incorporation documents; bylaws or operating agreements; agreements between owners of the equity interests; up-to-date board minutes; notices for equity owner and board meetings; ledgers; equity certificates
  • Financial records – balance sheets; income statements; annual reports; audit reports; attorneys’ letters to auditors
  • Material contracts – customer contracts; supply agreements; loan and other financing agreements; insurance policies; employment contracts and consulting agreements; marketing and advertising agreements
  • Regulatory matters and litigation – permits and orders; copies of pleadings in pending litigation; copies of threatened litigation or notices of violation of any laws
  • Employment and labor matters – information regarding employees, wages, benefit plans, bonus compensation, vacation, sick time, and any benefits and policies
  • Intellectual property – documentation supporting any copyrights, trademarks, trade names, or patents owned by the selling company or any of its key employees related to the business

Investment bankers engaged to market a company’s business will likely have a supplemental due diligence checklist that will assist a seller in assembling relevant information. Further, prospective buyers will likely request numerous categories of operational due diligence.

The Benefits of Due Diligence

Because the due diligence process may be overwhelming and time consuming, engaging legal advisers to assist the seller in its pre-transaction organization of due diligence information and remedy any deficiencies or liabilities to the greatest extent possible will make a sale transaction process more manageable for a seller, minimize the likelihood that a buyer will devalue the business, aid in the negotiating and drafting of the transaction documents and disclosure schedules, and reduce transaction costs to both the seller and the prospective buyer in the long run.