This post is part five of our five part series exploring various aspects of due diligence in the context of a merger and acquisition (M&A) transaction. Our prior posts discussed M&A due diligence generally and its objectives, described the due diligence process, outlined considerations when assembling your due diligence team of experts and the due diligence request list, and explained how to respond to a due diligence request list. This post will focus on the scope and process of a due diligence review and how the results of such review will impact the proposed M&A transaction.
Scope and Process of Review
Once documents have been delivered, the reviewing party may wish to consider imposing some sort of control on the reviewing team as to the allocation and distribution of the documents. As discussed in our prior post, a full-scale due diligence review – particularly when the provider is a large company – will involve experts in many disciplines (e.g., tax, accounting, intellectual property, employee benefits, environmental and regulatory areas). Within each discipline, more than one reviewer will probably be necessary. For instance, different people may be needed to review federal and state tax issues, or patents and copyrights. In order to control this process and track the documents that are being reviewed by various team members (in case the documents must be returned or destroyed), a single individual responsible for each category of requested information should be established. This procedure helps ensure that there is a “closed loop” of identified individuals who know about the transaction and receive the documents for review.
Once an NDA has been signed, the due diligence request has been submitted, coordination procedures have been put in place on both sides, and the information has begun to flow, the real due diligence work can begin: evaluating the information and its relevance to the potential transaction. In this part of the process, the due diligence team will begin to review all the documents and materials provided to date, paying particular attention to those issues that may impact the proposed terms in the definitive transaction documents or the likelihood of consummation of the deal.
Much of the diligence review during this process is often performed by relatively junior team members. As such, it is important for junior team members to raise potential problems to the more senior members of the team as quickly as possible. Experience is the key to effectively analyzing and evaluating the results of a due diligence review. For example, an issue that may be deemed to be “interesting, but immaterial” to a junior member of the due diligence team may be extremely material to a more senior person who has firsthand knowledge of the problems associated with these situations. In fact, such information may ultimately be linked to another issue that, together, may be one of the most important issues to the buyer. Thus, coordination among reviewing team members is critical to success.
An equally important mechanism in the due diligence process is the exchange of information orally through site visits, interviews with management, formal presentations, and informal discussions. This part of the due diligence review is often performed by the acquisition team and other principal employees or consultants of the reviewing party. Generally, attorneys are not significantly involved in this process. In this step, members of management of the disclosing party may prepare and deliver detailed presentations that give an overview of the operations, prospects and finances of the subject company. The acquisition team will then have the opportunity to talk to these individuals to “drill down” on the assumptions and statements made in the presentations. An important fact to remember in these situations is that presentation materials, statements made in these meetings, handouts and other materials will directly affect the scope and substance of the representations and warranties and the extent of indemnification obligations (if any) in the definitive acquisition agreement. The buyer’s team will note any inconsistencies and inaccuracies in these statements and use these facts to shift any risks relating to the statements to the seller and its stockholders under the representations, warranties, and covenants contained in the definitive agreement.
Hot Issues in Due Diligence
Following is a list of “hot” issues that may arise during the course of the diligence investigation, and which may impact the definitive transaction documents:
- capitalization issues
- nonassignability clauses
- termination/default provisions
- change of control provisions
- employment/severance agreements
- discovery of “hidden” liabilities (e.g., litigation, environmental, intellectual property infringement)
- discovery of provisions that conflict with the transaction or require consent/waiver
- non-competition or non-solicitation restrictions on the seller
- open source software issues
- privacy or data security issues
- import / export control violations
- source code escrow arrangements
- acceleration of employee equity or severance
- 280G parachute payments or 409A issues
Results of the Review
The results of the due diligence review will ripple through all aspects of a proposed M&A transaction. A detailed summary of the due diligence review, often called a due diligence memo, is usually prepared by counsel as a way to organize, track, and manage which documents have been reviewed, who reviewed them, and what issues or action items were identified. The due diligence memo may also become an important tool for both the business and legal aspects of negotiating the final deal terms.
Once the parties have digested the results of their respective due diligence investigations, the last step in the due diligence process is making certain determinations:
- Can or should we do the deal?
- Do we still want to do the deal?
- Is the seller worth the valuation as originally proposed or should there be a reduction in the purchase price?
- Should an alternative form of consideration or payment be considered, such as an earn-out?
- To what extent should the scope of the representations and warranties be expanded to cover any areas of risk, issues or uncertainties identified?
- Is an adjustment to the indemnification and escrow term or amount necessary?
- Should additional covenants or conditions to closing be added (e.g., third-party consents, employee retention targets, or required terminations of contracts, customers, or personnel)?
Assuming the parties wish to move forward with the deal, the due diligence memo and related documents are invaluable to the buyer in confirming the contents of the disclosure schedules to the definitive agreement. They are also potentially invaluable for understanding and operating the acquired company post-transaction. Moreover, by maintaining an accurate record of all documents disclosed pursuant to a due diligence request list, the seller may use this list in the preparation of the disclosure schedules.
The due diligence process continues until the transaction is closed. The parties will continue to request, deliver, and review information throughout this period. As such, the parties should recognize that due diligence is an evolving process that will require a significant time commitment on each of their parts.