Mergers and Acquisitions (M&A) in simple terms is the process by which one party buys — whether in whole or in part —someone else’s business. Although M&A can be simply defined, the process is anything but easy. There are dozens of legal implications, seemingly innocuous clauses that can sneak up on even the most careful entrepreneur, and potentially significant sums of money to be made or lost.
This field guide is a five part series and will discuss in detail the five phases of M&A:
- Part One – The Letter of Intent
- Part Two – Due Diligence
- Part Three – The Definitive Agreements
- Part Four – Closing
- Part Five – Post-Closing
Part Two – Due Diligence
Due diligence is a comprehensive investigation and appraisal of a business by a prospective buyer to ascertain the business’s structure, assets, liabilities, legal compliance, past and current operations, and evaluate the business’s commercial potential. There may be some due diligence done by the sell-side on the purchaser, but it’s typically at a much lower level than the buy-side. If the deal is a merger, however, both sides will likely perform the same or similar levels of due diligence on each other. In either case, each side has a vital role to play.
Typically, the seller will create a virtual “data room,” which will house all of the documents and related information that the buyer requests from the seller to conduct due diligence. In smaller deals, the data room can simply be several folders within a Dropbox account. In bigger deals, however, the data room is often run by a third party data room vendor.
Although due diligence is the most laborious and tedious aspect of M&A, it is also one of the most important and must be taken seriously by both parties for differing reasons. This is the stage where buyers can find leverage to renegotiate a deal, or if things are bad enough, to back out entirely. For sellers, this is the time to show the buyer that everything is in order and that the records support the numbers. The focal points for due diligence break down are as follow: (1) structural and company matters; (2) financial matters; (3) contractual matters; (4) employment matters; (5) litigation and claims; (6) assets; (7) real property; (8) environmental due diligence; (9) intellectual property; (10) regulatory compliance; and (11) affiliate transactions.
Structural and Company Matters
Whether you are buying the business entity itself or the entity’s assets, structural due diligence is an important aspect of due diligence and involve looking into the setup of legal entity or entities involved with the operation of the business. Of course, this is critical if you are buying the entity itself under an equity acquisitions for more intuitive reasons (you of course want to understand the business entity that you will own). But even in an asset purchase, you need to determine whether affiliated entities such as a parent, subsidiary, or sister entity, hold assets used for the business and therefore need to be involved as well.
The buyer also needs to verify that the selling entity(ies) or target entity(ies) under an equity sale are properly organized, validly existing and in good standing under the laws of the states of their formation and operation. Obtaining clarity on the structure enables the parties to determine if any modifications to the structure of the deal are needed or if any discrepancies need to be corrected prior to closing. This could include updating corporate documents or remedying any issues with a lack of good standing in the state of formation.
A buyer will also want to examine the financial matters of the business they wish to purchase. This, of course, includes financial statements such as the balance sheet, income statement, and cash flow statement, as well as supporting records and documents related to accounts receivables, accounts payables, short-term and long-term debt, and other financial matters.
Further, the buyer may engage its accounting or financial advisors to perform a quality of earnings (QoE) assessment on the business’s financial statements. QoE is the ability of reported earnings or income of the business to predict its future earnings, which is typically a substantial basis of the purchase price under a deal. It is an assessment of how repeatable, controllable, and reliable a business’s earnings are, as well as the degree to which the earnings reflect underlying economic effects, are conservative, or are predictable, thereby providing a better estimate of cash flows.
A buyer needs to evaluate this information and data to analyze the current performance of the business and predictions about its future performance to determine whether the purchase price accurately reflects the business’s value. In addition to verifying what liabilities must be paid off and encumbrances released at closing, financial due diligence will also aid the buyer in making strategic decisions and refinements that may be necessary post-closing to improve performance.
Often one of the biggest assets or liabilities of a target company are the material contracts it has signed. Accordingly, a buyer must review all contracts, leases, loan documents, and other agreements to ascertain their value, and the target company’s express obligations and liabilities, as well as uncover possible contractual issues and unforeseen liabilities.
If certain contracts are important to the acquisition, the buyer will need to confirm they can remain in effect when the deal closes and determine what any steps, if any, are needed to ensure they in fact remain in effect following the closing. Therefore, buyers will not only want to look into the rules governing assignment but also how long the contracts are set to last. If you are buying assets that are heavily reliant on contractual relationships with the target company’s clients, you will want to know whether these contracts can be terminated quickly and easily or if they are long-term contracts.
Regardless of whether a buyer is buying equity in a company with the expectation of continuing to employ its personnel or purchasing its assets with the intent of offering employment to the personnel, the importance of this aspect of due diligence is self-explanatory. The buyer will need to understand the compensation, bonus, and benefit plans of any written employment agreements, nondisclosure and proprietary information agreements, and any other consulting or personnel related agreements in place.
But there are many other considerations when investigating and understanding the target company’s employment matters. They include classification of personnel as employees or independent contractors, classification of employees as exempt or non-exempt for purposes of overtime, labor related litigation, impact on personnel by COVID-19 and legal compliance, the target company’s full and timely compliance with compensation, benefits, and payroll tax obligations, employee on-boarding and training, employee handbook and policy review, Family and Medical Leave Act, ADA, OSHA, and other regulatory compliance, as well as other matters. Each of these considerations can uncover significant liability and exposure if the target company failed to follow the appropriate rules.
Therefore, no different than looking into contractual matters, the buyer needs to investigate the target company for any potential labor related liabilities—regulatory or legal violations, potential disputes or claims, and other potholes that could arise following closing and significantly impact the business.
Litigation and Claims
Investigations into any potential litigation and claims are a critical aspect of the due diligence process (whether it’s an asset purchase, equity purchase, or other transaction) and should be ongoing throughout and until the deal closes. This is because litigation and claims can cripple or potential kill a business and potential litigation issues and claims can appear almost anywhere. Whether it’s a lien on a specific piece of property, a contractual issue, or a claim being made by a former or current employee, all of these can be serious red flags for the deal that may cause the buyer to pause and look to reevaluate the deal.
As a buyer, if the deal structure is an asset purchase, thoroughly investigating the asset will be one of your primary concerns. In an equity purchase, reviewing and analyzing the assets remains an essential part of evaluating the company and its operations as a whole.
Before anything else, the buyer will want to receive a fully itemized list of all assets to be included in the sale. This will be the starting point from which the buyer can examine all the crucial aspects regarding the assets. The buyer will want to investigate every asset for potential liens or claims placed against them. For physical assets, the buyer will need to conduct physical inspections to verify their serviceability, quantity, and quality.
Not all assets are physical given the category “assets” can be vast. Assets might also include intangible goods like intellectual property and related goodwill or software. These must also be evaluated and investigated during due diligence.
Real property simply corresponds to land, buildings, and any other improvements attached to the land. Associated with the property will be interests, benefits, and rights inherent to the property. When the deal does not include the transfer of any real property, it is still important to investigate the property under any leases instead.
No different than other physical assets, the buyer should investigate real property thoroughly. The buyer will inspect the property for any contracts, liens, or claims made against it. Land ownership often implies a different set of rights and liabilities than a piece of machinery or a non-tangible asset — buyers should tread carefully when doing due diligence on real property.
Closely related to examining real property and business operations are environmental matters. Although this tends to be contingent on the type of deal and the target business, it’s important to properly assess the target company’s history, compliance, and potential issues when it comes to environmental contamination as well as operations with respect to storage or disposal of hazardous materials in compliance with applicable laws. It will typically follow the standards and guidelines set out by the Environmental Protection Agency or related government bodies.
Intellectual property (IP) is a unique type of asset with its own inherent set of rights, risks, benefits, and liabilities. When conducting due diligence on intellectual property, a buyer should examine each of the following in depth with respect to use, licenses, applications and registrations at the state and federal level: trade name and trademark, copyright, trade secret, and patent ownership. A critical element to IP due diligence is an assessment of possible infringement in two different ways: (1) by the target company of third party rights; and (2) by third parties of the target company’s IP rights. Each of these is a crucial aspect of any IP asset a buyer may be acquiring.
Verifying and ensuring regulatory compliance is essential when purchasing a business. Regulatory compliance is especially important in healthcare as it is a highly regulated industry. The buyer must confirm whether everything is being run according to the applicable rules, laws, and regulations. If not, the buyer may be assuming risk post-closing. It therefore presents the buyer the opportunity to decide whether to terminate the deal altogether if the potential liabilities for non-compliance become too great. Additionally, it could also lead to renegotiating the terms of the final agreement to deal with and mitigate the compliance issues.
Another important aspect of due diligence is assessing affiliate transactions. If a founder of the target company has caused it to enter into arrangements with other entities with whom they share a certain relationship (i.e. the founder herself, siblings, friends, investment partners), the transactions may not be at “arm’s length” or fair market value to the detriment to the target company. An arm’s length transaction is simply a transaction where two or more unrelated parties agree to a business transaction, acting independently and in their self-interest.
Therefore, the buyer should be investigating and cleaning up any affiliate transactions that could have such consequences. For example, if the target company’s founder owns the real property being leased by the target company and charges rent substantially higher than fair market value with overly onerous terms under the lease agreement, the buyer will require the lease to be amended to be consistent with fair market value and will renegotiate the onerous terms of the lease to be more commercially reasonable.
A Long But Necessary Process
Although due diligence is a long and arduous process, it is necessary and incredibly important. The buyer has the opportunity to find out if they are buying what they initially wanted while the seller is presenting their business as a serious opportunity. If any discrepancies are found, the buyer will gain an opportunity to renegotiate some key terms — such as the valuation and purchase price —originally contemplated in the letter of intent. If everything is squared away, the seller will be in a better position to negotiate how strict the representations and warranties should be in the final agreement. The results of due diligence drive the creation of the sales agreement. For this reason, both parties have much to gain by preparing for and taking seriously the process.
In Part Three of this series we will discuss the next phase of M&A – the definitive agreements. If you have any questions or if you would like to learn more about the M&A process, email us at firstname.lastname@example.org.