The Due Diligence Phase: Why Compliance Matters in M&A

April 12, 2023

In this episode, we share the story of a med spa that was approached by a large private equity firm interested in purchasing the business. Tune in as Michael, Brad and series regular Jay Reyero breakdown the initial step of an M&A deal – the due diligence phase. We share what you should consider when identifying your risk tolerance, and how operating a compliant business can make or break a deal like this.

Listen to the full episode using the player below, or by visiting one of the links below. If you have any questions or would like to learn more, email us at


Intro: [00:00:00] Welcome to Legal 123s with ByrdAdatto. Legal issues simplified through real client stories and real world experiences, creating simplicity in 3, 2, 1.

Brad: Welcome back to another episode of the Legal 123s with ByrdAdatto. I’m your host Brad Adatto with my co-host Michael Byrd.

Michael: As a business and healthcare law firm, we meet many interesting people in various stages of their business. This season, we get to focus on the high stakes implications of selling a business. This season’s theme is The Hitchhiker’s Guide to M and A. We will be guest heavy and bring in different professionals to offer their experiences and perspective on M and A.

Brad: Yeah, and for those who don’t know the vocabulary word M and A, that stands for mergers and acquisitions. It’s legal jargon.

Michael: Yeah.

Brad: We are attorneys for buying and selling a business or buying and selling business assets. Michael, over the 12 seasons of our podcast, we have actually covered a lot of sports.

Michael: Yeah, we’re kind of competitive [00:01:00] here.

Brad: Yeah.

Michael: That means we end up talking about big sports like typing and tennis and some of the lesser sports out there like football and baseball, et cetera.

Brad: Okay. Well, speaking of football, that’s a sport that we actually haven’t covered. Of course, most Americans are thinking NFL or college football, but to the rest of the world, football is actually what we call soccer here in the states.

Michael: Well, to be fair, Brad, we did talk about Ted Lasso at one point, so at least we talked about a TV series that’s about soccer. I’m sorry, I can’t say football.

Brad: Yes, we did. It seems like many Americans like you think football only happens maybe every four years or maybe when you’re watching Ted Lasso, but when the World Cup is on…

Michael: Well, my kids played soccer almost year round until like fifth grade, and then of course they stopped when they grew up a little bit. Does that count?

Brad: Yeah, sure. I think between the audience members who are watching us on YouTube, they probably see a [00:02:00] third person sitting here. Maybe between the three of us, we could do an entire sports podcast on our kids’ sports, but we’re not going to do that today. Again, for those who don’t know, football is played every year with different clubs. Clubs is their version of teams all over the world, including the Premier Leagues, which are all over Europe. These clubs could be like Liverpool, or Rima Madrid, or even Manchester United and FC Barcelona. Now these clubs are valued anywhere from 4.2 billion all the way up to 5.1 billion, so these are some big time clubs.

Michael: Brad, are you trying to talk me into buying a football club again?

Brad: Yes.

Michael: Okay, well, we don’t have that kind of money.

Brad: Oh.

Michael: It’s just a dream. Where in the world are you going with the topic today?

Brad: All right. Since all these clubs are worth billions, even though we might buy one, to keep the fan base happy and attend the games, and watch the games, and by their merch, what do these clubs need to do?

Michael: It’s really poor to [00:03:00] ask me that question because I’m a Dallas Cowboys fan. Jerry Jones would tell you, branding and marketing.

Brad: Oh, okay.

Michael: Is how you successfully fill the seats and sell the stuff, but I’m guessing most people would say winning.

Brad: Right, that is correct. I’m glad you got past your cowboy blockers. Yeah, It turns out that’s pretty important, right? And what happens if one of the clubs is getting special treatment from the referees and prosecutors? In Spain, they have alleged that the soccer club, Barcelona, had been paying about 8.2 million over 20 years to the vice president of the country’s refereeing committee. The same committee would assign referees to games and actually international competitions. Now of course, Barcelona says these payments are actually done by the prior presidents and they’re paid for technical reports and other stuff that other companies pay for, but the prosecutor’s alleged that paying millions to people involved in managing the Spanish referees is not [00:04:00] normal.

Michael: Well, perception’s not great when you see those data points. I have no idea if any laws were broken, but I guess they say that perception’s reality. Again, Brad, what does this have to do with today’s guest?

Brad: Yeah, nothing that I know, unless our guest owns stock and a Spanish company and has been receiving millions of dollars that we’re not aware of, but let’s just bring on today’s guests, our podcast regular and partner, Jay Reyero.

Jay: Thanks for having me. It is good to be back.

Brad: Yeah. Well, Jay, I guess we got to start at the very beginning. Do you own stock in a Spanish company that happens to be managing referees?

Jay: I can neither confirm nor deny that. No, but fun fact, I have actually been to camp Nou, FC Barcelona’s soccer stadium. Not to watch them play, but to actually see a U2 concert that was pre-kids. It was their opening leg of their European tour. It was the 360 tour and my wife and I flew across the country and watched U2 play in the stadium. It was [00:05:00] magical. It was great.

Brad: I love the fact that you had to qualify that this was pre-kids, aka when I still had money.

Michael: Yeah, and I was about to say, did you really have to say pre-kids?

Jay: I traveled to Europe. That’s enough.

Brad: Well, all right. Well, thank you Jay. Michael, before we get into today’s story, maybe we can give a high level overview of the five phases of an M and A deal.

Michael: Well, as you and Jay know, I love context and typically during the selling season of a business, entering into an M and A transaction is the goal. It’s the big part of that season of your business. When we refer to the five phases of an M and A deal, we’re really just taking the deal timeline and breaking it down into pieces. So the beginning phase is the letter of intent phase. You get through all that, you have your signed letter of intent, you move over to the due diligence phase, [00:06:00]  everyone does that part, which we’ll talk more about today, and then you get into writing the documents, the definitive agreements phase, and then finally you are ready to close, you’re in the closing phase. Believe it or not, you’re not done there. There’s post-closing work, and that’s the last phase of an M and A deal. For today’s show, I kind of alluded to how we’re going to focus on due diligence, and really double click down into the importance of compliance in an M and A due diligence part of the deal.

Brad: All right, Michael, you’re skipping the first phase of an M and A deal, the LOI. Jay, Just again, for context, what is an LOI?

Jay: Yeah, so, LOI stands for letter of intent. People also sometimes call them term sheets or memorandum of understandings, confidentiality agreements. Basically when someone wants to sell their business, this is going to typically be the first thing that the parties are going to negotiate and sign the letter of intent. [00:07:00] It’s simply structured like a letter and it outlines the high level, very important kind of detailed terms of a particular deal.

Michael: Brad, if you remember, we talked about LOI’s in depth in season seven during our Red flags non-binding letter of intent episode. So those curious for some details, I encourage you to go back and listen to that episode.  We’re going to focus our attention on the second phase today.

Brad: Yeah, and that was during our red flag season so those who do listen to it will hear me, I think dinging a lot in that particular episode that happened for our poor client. Well, many people probably want us to skip discussing the due diligence phase to because that just sounds so exciting, but believe it or not, audience members this is actually very important to the overall five faces. Michael, we keep saying due diligence, what is the due diligence phase?

Michael: Yeah, I mean it at its simplest level, I know we’ll talk a little bit more in detail on this episode, but you have [00:08:00] this deal and the buyer wants to confirm that what they think they’re buying, and they’re actually buying.

Brad: Right.

Michael: That means digging into the details of the business, we call this the Proctology exam. We’ve had different terms, I know you have your own term, but it’s really a laborious phase where you’re digging deep.

Brad: Yeah, that’s for certain. Thanks for the Proctology exam. So that’s our basic understanding, but Jay, I think our audience members are ready. Can we jump into today’s story?

Jay: Yeah, let’s start our story. It revolves around a med spa. It’s been operating for over 10 years, and today we’re going to call the Med Spa, The Aesthetic FC.

Brad: Ah, good job, Jay. I like how you tied our opening banter into today’s stories. Again, for those who don’t know, FC stands for Football Club.

Jay: All right, so Aesthetic FC is a very successful med spa. It has multiple locations, it’s got a great brand and a [00:09:00] reputation, and so unsurprising this this day and age, private equity comes along and wants to buy it. For today’s story, we’re going to call them the Glazer Fund.

Brad: Ah, man. Jay, you are on a roll today. Again, audience members, since Michael loves context. We mentioned, Manchester United earlier as one of the most famous football clubs out there in Europe, and it is owned by the Glazer family. It probably would make sense that the Glazer Fund would want to get into another hot industry of aesthetics. All right, so Jay, Michael’s making a skip to LOI, so I’m assuming there was a sign LOI and the deal moved to the second phase of due diligence?

Jay: Yep.

Brad: Okay, good. As Michael was saying, due diligence really is that time that you need to, and I call it the underwear drawer moment, you’re going to open up that underwear drawer, you’re going to show the good, the bad, the ugly, and that’s really the time in which the buyer gets to see your underwear drawer and see if you, as Michael said, is it really worth what they say? So I’m assuming that that’s what happened next.

Jay: Yep, so in [00:10:00] any M and A deal, when you get to this due diligence phase, the first step is always going to be the buyer sending over the seller due diligence checklist. This is a list of all the categories of everything that the buyer wants to know exists, wants to see, wants to confirm, and so as a seller, you’re already expecting this in the process. If I ever talk with a client and they’re not really sure of what the process looks like, I’ll be sure to tell them what to expect because it can be a 4, 5, 6, 10 page document. This is really where, again, as Michael mentioned, the really tedious exercise kind of starts to be begin. 

Brad: Yeah, and I love the fact that we’re so sophisticated, we call it a due diligence checklist, like can we come up with anything else? All right, but Michael, for our audience, Let them know what are some of the general things they see in a due diligence checklist, and what will they be asking to prove up?

Michael: You know I don’t like getting into the details, right? I’m starting to sweat just thinking about all the specific [00:11:00] things that go into this, but I’ll give the general overview of what you would see in a checklist and the types of things that they’re wanting to explore. Corporate documents, they’re wanting to see kind of how the corporate structures set up and see all the backing behind the financials and the debt that the company has. Real estate, not just leases, but if they own any dirt. They’re going to want a bunch of information in that category. Material contracts, so they’re going to want to see all the contracts that the company’s entered into that are quote “material”. They’re going to want employee related information, is there any litigation and all the information behind that? Something that we face in the healthcare world, they’re going to have a ton of stuff about compliance and making sure the business is in order from a compliance perspective at both the state and federal level. [00:12:00] Intellectual property, trademarks, patents, etc. They are going to have a bunch on that. They’ll have tax categories, insurance, and in some businesses, even environmental related stuff.

Brad: Yeah, and for our audience members to understand these due diligence checklists can be anywhere from two to nine pages worth of questions. It’s so much material that there are actually companies out there that you can hire to help kind of process and pull information and drop it somewhere.

Jay: Yeah, and I mean even to the point of it may have things asking that don’t apply or you don’t have, and so I mean, they’re going to ask for everything just to see what’s out there.

Brad: Yep.

Jay: So it can sometimes be overwhelming because you’re like, this doesn’t apply or I don’t have any of these. That’s fine, they’re just asking.

Brad: Yeah. Good point.

Jay: All right, so in this case we get the checklist, Aesthetic FC gets it. We look at it, fairly standard checklist, and several pages. Aesthetic FC [00:13:00] was familiar with M and A, so we forwarded the checklist to them.

We gave them some general commentary, some general parameters, kind of some instructions to get started. We had them begin gathering all the documents and start uploading the documents so that everyone could start reviewing what they have, start asking questions, see what’s missing. Periodically we would go in and we’d just kind of get an update, see what’s in there, and make sure that the process was moving along.

Brad: Jay, when you’re going through this process, what are some of the comments like, you were talking about this earlier, but like, “I don’t know where to find that” or “I didn’t do that, Jay”. Going through this checklist of items, what are some of the comments you were getting back in this particular story?

Jay: Yeah, so in this particular story, what we’re getting back was just a mess. I’m going to go through some things that we identified and our audience, going back to our red flag days, are going to start hearing the dinging in the back of their minds. So strap up, and [00:14:00] here we go.  There were a lot of instances with third party contracts just not existing. We were basically told, “Oh, we just have some verbal contracts” or “oh, don’t worry, it’s a handshake type deal”. There were a few third party contracts that we did see and that did exist, but as we started kind of looking into them a little bit more, we found that they either required third party consents, which if you’ve ever done an M and A transaction, those can sometimes derail the deal by themselves or they contained right of first refusals. None of which at this point in time had ever been thought about, considered or planned for. That was a nice surprise we were going to have to start dealing with. They had a lot of different affiliated companies and subsidiaries, and there were transactions going back and forth between them, but there were no documentation to support that, no documentations to tie anything together. The form and substance for the flow of funds [00:15:00] wasn’t matching, so there were going to be a lot of questions that we knew were going to come from that. The biggest issues, going back to…

Brad: Wait, they’re bigger than everything else you’ve scratched so far?

Jay: I told you, ding, ding, ding.

Brad: Okay.

Jay: The biggest issues were the compliance issues. In healthcare compliance is obviously a very important consideration and when we started asking questions about some of the things that they were providing, we were uncovering that the good faith exam, on things such as cool sculpting, Microneedling, and IV therapy wasn’t happening. So we had estheticians, RNs, working to understand protocols and weren’t going through the proper good faith exam process. When they were doing good faith exams on certain things, they were being done by non-licensed individuals so there wasn’t an MD, NP, or PA involved.

Brad: Sorry, that sounds very counterintuitive. You’re doing a quote, “good faith exam by someone who can’t do a good faith exam”. Let’s keep going, Sorry.

Jay: They stayed at a Holiday Inn once.

Brad: Okay.

Jay: [00:16:00] finally, estheticians were performing a lot of the procedures outside their scope and which should have been done by RNs. There’s a lot of reasons behind that. We uncovered kind of the gist of their operations and it was just red flag after red flag after red flag that we were going to have to somehow deal with when we disclosed to the buyer.

Michael: Yeah, these are some big issues to discover at this point in time during the due diligence.

Jay: Yeah. I mean, to us they were massive issues. We didn’t know what to do or what to think. We started asking Aesthetic FC about them and about their compliance and what we were seeing and why there were issues and we were actually getting pushback from them on all the issues basically saying they weren’t that big of a deal. Their reasoning was they’ve been doing this for 10 plus years, never had an issue. That must have meant they were compliant or someone would’ve said something over the last 10 years if there was a problem.

Brad: Yeah.

Michael: I’m having some [00:17:00] flashbacks, by the way.

Brad: Yeah, and I’m about to say that the statement, “I’m compliant because it must be all good since no one has told us otherwise”, generally does not mean that you’re compliant.

Michael: You’re right, Brad. It is something we’ve heard too often. I assume, Jay, that you disclosed these issues to the Glazer Fund. I’m curious, how did the Glazer Fund receive these issues and did it derail the deal?

Jay: Yeah, so like Brad said earlier, this is an underwear drawer moment that you can’t get around because there’s nothing to hide. So we disclosed it and we just have to deal with the fallout. What does that mean?  Funny enough, in this case, the compliance issues actually weren’t a real roadblock to getting the deal done. Even though we were identifying all these compliance issues, at the end of the day, the Glazer Fund, all they cared about was getting the Aesthetic FC team underneath their umbrella and on their side. They just [00:18:00] wanted to get the deal done and they understood the compliance issues, but it was more about the people and because it was about that, we were able to go through the rest of the process in an uneventful manner and get the deal done. Of course we have to deal with the compliance issues post-closing, but at the end of the day it really didn’t interrupt or cause any massive issues.

Michael: Yeah, it’s really interesting and we see that sometimes and it’d be great to talk a little bit more about that. Let’s go to break and then unpack that a little bit more. We will talk about some of the lessons that we can learn from Aesthetic FC story.

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Brad: Welcome back to Legal 123s with ByrdAdatto. I’m your host, Brad Adatto with my co-host Michael Byrd. We are also still here with Series Regular and our partner Jay Reyero.

Michael: Yeah, and really interesting, our client in this story, Aesthetic fc, had an opportunity to sell to the Glazer Fund. We’re talking about M and A and a quick recap of kind of how it all went down, they get through the letter of intent, we get into due diligence, and Jay starts discovering a pretty big mess. I think we’re getting a little anxious just listening.

Brad: Definitely sweating.

Michael: Yes, and really double clicking even beyond that list was the big list of compliance related issues. [00:20:00] As the story was unfolding, we kept expecting to hear the deal derail or get delayed, and it was a little bit of a twist. What happened was that this was not a focal point for the Glacier Fund. They were really more focused on securing this team and the deal closed. Jay, you mentioned, at the start of the story, the biggest issue being compliance. You certainly listed a lot of things that were problematic. How important is compliance to a potential buyer in a healthcare M and A transaction?

Jay: Yeah, I would say it’s the one A to the one B being the financials. Over the last several years private equity has been coming into the aesthetic space, we’ve all heard, straight from them, how important compliance is to them when they’re looking at any deal in addition to the financials. [00:21:00] It becomes an even bigger deal outside the aesthetic space when we’re talking about commercial payers being involved, or particularly federal programs. If you have Medicare or TRICARE involved there are criminal and civil penalties that are triggered from a lack of compliance and can carry forward. We’ve seen private equity get wrapped up into those criminal issues when they identify compliance issues and don’t really take the proper steps to fix them. It’s the most important thing that anybody’s going to look at and it is going to be a lot of heavy conversations throughout the due diligence phase, particularly when those questions come up. As representing the seller on the Aesthetic FC side, you have to start having really good discussions on why you did things a certain way or why the compliance isn’t that big of a deal and it can really impact the discussions as you go forward, depending on the buyer [00:22:00] side.

Brad: Yeah, it’s all great points and I think we’ve talked about this before. A lot of people when they want to be compliant, they think compliance is black and white. Especially in the aesthetic industry, there’s a lot of gray in there and there’s something that we call the shades of gray, right? Except if you’re going to bring orange, which is illegal, which is more the federal side that Jay was referencing, but in the aesthetic industry, we’re really looking at shades of gray. Just because you approach it in one state one way doesn’t mean it’s legal in another state. As you dive deeper, as Michael likes to say, double click down through that, you really start figuring out from a compliance perspective, what is your risk tolerance. We’ve talked about this before, sometimes you have super high risk, you’re willing to jump out of an airplane, and other people have super low risk and they’re terrified about stepping out of the shower in the morning. No matter where your risk tolerance is, that’s going to drive a little bit of the compliance. Obviously, when you’re working with your counsel, they’re going to try to put you in the best position to actually protect your licenses and other things. Unfortunately, there’s a lot of [00:23:00] shades of gray, and that shows up in these M and A deals. Michael, we referenced this earlier, going back to our Red Flags non-binding letter of intent episode. That was a case where I believe we call him Benny in our story, had a similar compliance issue, but didn’t quite end up the same way in that particular show.

Michael: Yeah, and it’s kind of counterintuitive, I’m guessing for the audience right now because we’re telling a story where it all worked out fine, even though there was all this compliance mess. Yet we’re saying it’s one A and one b with the financials, and even in those circumstances where they’re cool with it and the deal closes, it can come back to bite you. That’s what actually ended up happening in our Benny story, although it wasn’t in the story, it was a later thing. After they get through to the conclusion at the very end of the day, that deal closed. They were somewhat [00:24:00] similar to the Glazer fund in the sense that they really were looking at the people and not really turning their cheek on the compliance. I mean, they don’t actually turn their cheek, they just, as Jay mentioned, they go “we’ll deal with the post-close and we’ll get it fixed”, Right? And they do, for the most part, try to get things cleaned up. In any of these deals structurally, there’s going to be a earn in type or earn out type situation or a look at how the company performs later, that can affect part of what you get as the seller. In this particular case, that’s what came back to bite Benny when it came time to look at the holdbacks and look at the other post-closing financial terms. They ended up holding this compliance [00:25:00] stuff against him, and he ended up a year later not getting near the return that he thought he was going to get. So the buyer in that particular circumstance, it was no big deal at the time until they realized what a big deal it was to try to fix things. Really they kind of hung their hat on that, but it was more financial performance related stuff that they were unhappy about. Then finally, we’ve just been through another transaction where compliance was the leading discussion point that almost caused the deal to fall apart multiple times, so you don’t know what the buyer’s temperament’s going to be going into it.

Brad: Jay, so what are some of the things that happen when compliance issues are identified?

Jay: Yeah, so like Michael said, you’re not just going to turn your cheek and say, oh, we can just keep on going. A lot of times it’s going to depend on the [00:26:00] buyer. Does the buyer want you to fix everything before they even proceed to closing the deal? So you have to start putting those things in or hey, we’ll just organically fix them as we go forward post-closing. Sometimes if the buyer’s going to overlay all their policies and procedures, that kind of fixes itself, but no matter what, compliance is going to be dealt with post-closing at some specific timeframe. I think more importantly, when you get to that third phase of the definitive documents, I think that’s where the buyers are really going to look at that compliance piece and try to either obtain maximum protection, some security, or like Michael’s story’s case, hanging their hat on the ability to hold that against some should it come up.

Brad: Well, I mean, those are all great points. Michael, I don’t know if you had any other thoughts before we close it out today?

Michael: Yeah, I mean when you [00:27:00] think about, as a seller, compliance, I think the thing you need to think about is how important it is and that it will come up and it probably is actually better if it comes up in the front phase rather than after you’ve closed a year later. I think the thing to understand is that buyers are humans, so their focal point is like all of us. I mean, some of us are very people focused people and some of us are very process focused people. So the buyer that’s excited and prioritizes team may let some things slide and it may give you a false sense of security if you’ve had a practice that’s got some compliance issues along the way. Again, if you are a process based buyer, that’s the way they’re wired. I mean, they’re going to meet these things head on. It’s going to cause a lot of pressure and [00:28:00] stress on the deal because they’re going to want things fixed before a deal’s done.

Brad: Yeah. Jay, what are your final thoughts today?

Jay: Yeah, I think in my experience with all the M and A deals, the ones in the due diligence phase that have the most headaches, roadblocks, and messes, are the ones that didn’t get their house in order first. A good strategy is to know what you have, get your house in order from a compliance perspective, it’ll make the entire process much smoother, and it’s good to be compliant anyway, so even if the deal doesn’t go through, you set yourself up on that end at least to start operating in a more compliant way so that in the future, all right, good. I have my house in order and that next unsolicited offer comes in, you’re ready to strike.

Brad: And when you’re saying get your house in order, Jay, we’re saying your underwear drawer because they’re going to open that drawer. You can’t throw all the junk in the closet so no one can see how messy that house is. I think there’s three [00:29:00] things I think our audience should understand and, y’all have all done a great job of explaining that there can be a compliance issue. We’ve seen it three different ways. Compliance issue number one is they walk because they can’t figure out what’s going on here and it makes them too nervous. They’ll close, but as Michael just referenced, they’re closing with a lot less money going into your pocket at the end. Or they’re going to close and hop on for the ride and figure out how it works later. That also references your story because Jay and I had a deal where they offered a lot of money, they saw the due diligence and before they even closed, they cut almost by half the actual purchase price. That was before they even had the earn outs that you were referencing. Michael, as we  close out today, what are your final thoughts?

Michael: Well, you don’t want to be like Barcelona trying to get compliant and pay off your medical board and all those sorts of things. So, yeah, do compliance the right way and not by gaming the system.

Brad: All right, well good points there. Of course he’s referencing as we know, Soccer or football? I don’t know.

Michael: Soccer. [00:30:00]

Brad: Okay. Well, audience members, that’s all the time we have today. Next Wednesday, we have Ben Hernandez with Sky Tail joining us as we continue on this journey of the Hitchhikers Guide to M and A, where we turn our attentions to the financials and discuss something called, QOE. We’ll have to learn out what that means.

Outro: Thanks again for joining us today. Remember, if you like this episode, please subscribe, make sure to give us a five star rating, and share with your friends. You can also sign up for the ByrdAdatto newsletter by going to our website at ByrdAdatto is providing this podcast as a public service. This podcast is for educational purposes only. This podcast does not constitute legal advice, nor does it establish an attorney-client relationship. Any specific product or entity does not constitute an endorsement or recommendation by ByrdAdatto. The views expressed by guests are their own and their appearance on the program does not imply an endorsement of them or any entity they represent. Please consult with an attorney on your legal issues. [00:31:00]

ByrdAdatto attorney Jay Reyero

Jay D. Reyero

Jay has mastered the art of communication, leaving clients with both an understanding of their business risk and the path to solution.