Perhaps it is no more than a result of a very active, if not somewhat frothy, auction market, but people are commenting that repricing seems to be occurring more often than usual. To the extent this is even accurate, there are many factors that could be contributing to the cause, such as continuing economic uncertainty or unevenness of economic recovery. A possible factor that is rarely mentioned but is perhaps particularly relevant is the effect of a decline in sell-side due diligence.
Rather inadvertently, many sellers have gotten out of the practice of doing a proactive due diligence review of a company prior to its marketing. Such a review previously often happened as part of assembling the diligence materials for a company. The evolution of electronicdata rooms has obviated the need for physically gathering and reviewing diligence materials prior to granting access to the buyer. Many investment banks also offer, as part of their services for their fee, to gather diligence materials and prepare data rooms, and often must fit that effort piecemeal into moments of availability in the marketing process. The largely coincidental result is that sellers are engaging in less considered review of their diligence materials and issues prior to marketing.
The view that “the facts are what they are” has an undeniable tautological correctness. However, the extension of that perspective to “it therefore does not matter how the diligence is assembled or furnished” is not an equally immutable truth. Rather, experience shows the exact opposite to be true—avoidable missteps in diligence can affect auctions and negotiations.
Issues that can be detected through closer diligence review early in the process often include problems that are essentially cosmetic, i.e., issues that should not necessarily affect the value or attractiveness of a company. Examples include unexecuted customer or employment agreements, inaccurate accounts of owned intellectual property, board minutes that do not reflect current officer or director elections, inaccurate capitalization tables or missing stock certificates, failure to refresh title on owned property and failure to be in good standing.
Although these comparatively inconsequential issues can ordinarily be inexpensively and quickly remedied, when discovered during the buyer’s diligence, these problems can produce a general discomfort regarding the overall operations of a business, undermining the perception of a tightly run organization. Additionally, while the buyer’s lawyers may recognize the superficiality of such issues, their investigation and correction take time, and, by necessity or through buyer’s artifice, impede a deal’s momentum to the likely detriment of the process and pricing. These issues also can provide a smoke screen for a buyer in negotiating the coverage of reps and scopes of indemnities.
Substantive issues, on the other hand, can create legitimate concerns regarding value and undermine deal terms. These problems may not be easily resolved and may simply be a negative aspect of the company or its business. Existing environmental liabilities and active litigation are common examples of such issues that sellers usually recognize and deal with upfront so that they do not disrupt an auction.
Other similar problems are less obvious, such as agreements with unfavorable exclusivity provisions, agreements with most favored nations or other unfavorable pricing terms, underfunded pension plans and lack of proper employee I-9s. These often are not apparent to a seller but usually will be discovered by a comprehensive diligence review on behalf of the buyer or the seller. Early detection allows the seller to accurately position the company during the initial bidding process and to reduce buyers’ ability to raise concerns about the validity of bid prices late in negotiations.
Many significant issues nevertheless can be corrected or mitigated if discovered on behalf of the seller. For example, one common substantive obstacle arises when missing links in the chain of title for intellectual property are exposed; the problem can be investigated and usually resolved. Similarly, by running lien searches, outdated financing statements can be identified and removed. Analyses of downside exposure of contracts or relationships with adverse termination rights can be prepared. Certain health regulatory compliance issues can be addressed by implementing compliance programs. The cost to remedy or ameliorate the issue is invariably less if such correction is done internally than if it is later done with the buyer’s knowledge and involvement.
The causes behind the trend away from sell-side preparatory due diligence are easily identified; the consequences perhaps less so. However, those consequences are at least a contributor to or an excuse for some of the adverse developments in auctions. What might be appropriate sell-side diligence should be considered in each case, but given the cost of processes and prices of doing little or nothing, the money and time saved by not doing any preparatory diligence may be truly penny wise and pound foolish.