Due Diligence: What Is It and How You Do It

Occasionally a legal or accounting term of art will slip into the general language from the legal, technical or accounting world and become a phrase often utilized by both professionals and laypersons in a careless manner, sometimes to show sophistication where there is none, sometimes attempting to describe a process or concept that is unrelated to the actual original term.

Thus terms such as "venture capital, " "IP, " "IPO, " "VC's, " "WRAPS UPS, " " OPTIONS, " " GOLDEN PARACHUTES, " "GOLDEN HANDCUFFS, " , etc. became common parlance in the vibrant days of the Silicon Valley boom and became part of the vocabulary of those who, for better or worse, immersed themselves in that now evaporated boom economy. Long established among professionals in the field, the words were rapidly used in everyday language in ways far from their original meaning.

And part of that now lost world was a frenzy of buying, selling and merging companies in which the parties often stated they had to do "due diligence " which often meant nothing more than making a few telephone calls to check out an idea or person and which is far removed from the real meaning of the word in legal documentation.

"Due Diligence " actually means a complete and appropriatereview of documentation and facts by a potential buyer or its agents before purchasing an asset or engaging in business with a prospect. It was NOT the legal equivalent to kicking the tires on a car; it WAS the legal equivalent to taking the car to a garage, having it checked over completely, and personally checking out every part of the car that did not require the expertise of the garage mechanic. It was a full and complete review using lawyers and CPAs to assist so that when one is done, one knows all that one needs to know before engaging in business with or buying a company or other asset or piece of property.

As with so much in America, the courts extended that concept due to the growth of litigation surrounding it. Failure to exercise "due diligence " before purchasing an asset was used as a claim of negligence by stock holders against the officers of the corporation if a merger or acquisition went bad. It was also used as a defense by Sellers against Buyers who claimed misrepresentation of the Buyers as to the value of the assets- e.g. the Sellers stated that the Buyers should have known the true state of the company if the Buyers had performed appropriate due diligence.

And, more recently, interference with due diligence or negligent assistance in due diligence has been used to sue CPAs and lawyers who were assisting buyers or sellers in a transaction. Cases have blossomed with courts and juries determining what is negligence in performing due diligence and what is interference with efforts at due diligence

But, ultimately, the fact remains that due diligence is a business term and comes down to what a reasonable business or accounting person would investigate prior to buying or merging with a company or buying an asset and the facts as to what constitutes appropriate due diligence alter from transaction to transaction.

Nevertheless, certain basic forms and approaches can be adopted, though the particular circumstances of a transaction may require more or less. The remainder of this article will discuss the usual requirements to accomplish appropriate due diligence.

THE TYPICAL INVESTIGATION FOR A BUSINESS TRANSACTION

There is nothing magic about figuring out what you need to know to buy a business. While each business has unique qualities, a typical due diligence check list would constitute, at a minimum, the following:

• Current Ownership and Structure Documentation and Proof of Same.
• Current list of customers and accounts receivable.
• Current list of vendors and accounts payable.
• Financial statements for the prior five years.
• Tax returns from the inception of the company.
• All contracts between the company and third parties.
• All contracts between the company and owners.
• All employment records of the company.
• All maintenance records for equipment of the company.
• Proof of ownership of all assets of the company along with list of all assets.
• List of all liabilities and proof of same. Include contingent liabilities.
• All minutes of all meetings of owners and officers of the company.
• A list of all litigation outstanding with opinion letters of counsel.
• All obligations of company both to third parties and owners.
• All tax documents relating to sales, property, etc.
• All audits performed by either CPAS or taxing authorities.
• Sales and/or Production Figures for the Company since inception.
• Any and all financial internal reports of the Company since inception.
• Any analysis of cost of goods and services.
• Any internal analysis of competition or alterations in the market.
• Any citations or complaints against the company by any governmental agency.
• Environmental documentation if relevant, including any EPA communications.
• Any Union documentation including past failed attempts at unionization.
• Any documents internally created relating to sales trends, customer complaints, etc.
• Organization chart currently in effect. All past organization charts.
• Schedule of all salaries and all bonuses for the past five years.
• Job description of each person, including years in that job.
• Interviews with all key personnel.
• Interviews with all majority owners.
• Insurance records including current insurance and past claims.
• Records of any transfers of any assets or dividends or bonuses for the past five years.
• Pension plan information including obligated future benefits.
• Product oriented or production oriented investigation predicated on the actual business under investigation, e.g. if manufacturing, number of double shifts, repair records, wastage records, etc., if service oriented, number of forms created and their use, etc..
• A long discussion with the CEO as to why the business is being sold or why the proposed merger makes sense.
• Proof of payment of all accrued taxes to date.
• Opinion letter on accuracy of financial records from the appropriate accounting professional.

The above checklist would have to be supplemented in a significant way for each and every deal so as to direct itself to the particular business or transaction. Thus, if a real estate merger or joint venture was being considered, due diligence would require inquiry into zoning restrictions, soil reports, engineering reports, local political trends, etc, etc.

The point to be made is that due diligence is a truly major effort and the average transaction, even if dealing with relatively small businesses, requires hundreds of hours of due diligence with help from appropriate accounting and legal professionals. One venture capitalist represented by the writer estimated that the average due diligence costs between fifty thousand and one hundred thousand dollars...but those were in the heady days of Silicon Valley. Depending on the scope of the business or venture being acquired, and depending on the personnel selected to perform the task, out of pocket costs can be kept to five or ten thousand dollars but the hours to be expended will always remain substantial.

Let us emphasize that the list above is a basic one, perhaps half of what a standard business due diligence requires. Each business will require its own checklist of what is important to be added to the basic list above.

DANGERS OF FAILURE TO DO DUE DILIGENCE; SOLUTIONS:

Obviously one wants to know what one is buying and any person foolish enough to enter into a transaction without due diligence is buying blind. But the dangers go far beyond merely failing to understand what one is buying.

If one is a fiduciary to a company (such as an officer or director) one has an obligation to act in a reasonably prudent manner in all business activities and the courts have long held that failure to conduct a due diligence correctly in the commencement of any transaction of import can be a violation of the fiduciary duty to the shareholders and impose personal liability on the fiduciary.

Equally dangerous is the Buyer later claiming that it was misled by the Seller not revealing full information which, if revealed, would have prevented the sale or altered the sales price. This can lead to later efforts to rescind the transaction or to seek damages for negligent and/or intentional misrepresentation.

Both of those types of law suits (and variations on them) are now common in our courts and are particularly galling for business people who feel they are being "second guessed " by shareholders or buyers who simply are now sorry they concluded a deal that did not work out.

What is vital to understand is that correct due diligence is protection NOT just for the Seller but for the Buyer since once a Buyer is given adequate access to the documents, that can be recited in the agreements or other documents memorializing the sale and act as protection against later suits.

Both Parties to the transaction have an equally important interest in achieving a full and complete due diligence for their mutual protection. Neither party benefits from lack of adequate investigation...since litigation will often result from failure to achieve effective due diligence.

It is therefore important for the parties to keep a written record of what was reviewed, when, by whom, and for the Seller to be able to demonstrate precisely what was in the packet delivered. Before a Buyer concludes a due diligence, the Seller should get in writing from the Buyer that Buyer has had adequate access to all the documents requested...and does not require any more. If a Buyer, for some reason, does not want to perform a due diligence, a wise Seller will confirm in writing that decision by the Buyer and indicate that Buyer is therefore assuming all risk for lack of completing due diligence.

Both sides should sign off on a document indicating completion of due diligence and which recites what was given...and not given. That document should be carefully kept in a safe location by both parties for a minimum of five years after the transaction is culminated.

If a Seller discovers that inaccurate information was disclosed to Buyer or that there are alterations in the information previously disclosed due to a change in circumstances, the Seller is well advised to make full disclosure of such alteration or inaccuracies if escrow has not yet closed. If escrow has closed, such disclosure may still be called for, but the Seller should obtain legal advice at that time.

If a Buyer discovers facts in the due diligence which are unknown to Seller (not uncommon in any large organization) the Buyer is NOT under a duty to disclose such facts to the Seller but should keep careful records of the discovery so as to protect the Buyer from later claims of Buyer's own stockholders. (For instance, Buyer discovers a report from one of Seller's now fired salesmen indicating that a new customer is interested in receiving a bid and likely to accept it but the report was somehow filed without the Seller's owners reading it, perhaps due to some mistake. Suddenly the company is worth much more...but the Buyer need not disclose such additional asset to the Seller unless the Buyer wishes...but the Buyer may still want to be able to show his own owners why the price was justified later on if that possible customer does not materialize, etc. Note that the Seller IS probably under a duty to disclose equivalent bad news to the Buyer since it is Buyer who is possibly assuming that transaction.)

A good idea is to create a due diligence checklist with the parties jointly checking off the documents provided (or not provided) and initialing the checklist at the end of the due diligence.

DUE DILIGENCE AND FAILED DEALS: CONFIDENTIAL INFORMATION

It is apparent that due diligence is of such a nature that if the transaction is not culminated an outside party will now know just about everything about your business. It is therefore vital BEFORE due diligence occurs, for the Buyer to execute a NON DISCLOSURE AGREEMENT which is discussed elsewhere on this website. Indeed, it is negligent on the part of any Seller not to have such an agreement fully executed before due diligence occurs.

It must be recalled, however, that such contractual protection is of little use in many circumstances. For example, if the Buyer is from abroad or has tremendous resources so that suing the Buyer would be difficult, it may not be economically feasible to enforce the terms of the contract. Further, much confidential information disclosed is hard to describe and hard to prove as not deriving from some outside source. It is vital for the Seller to carefully craft the Non Disclosure Agreement with good legal counsel and if the proposed Buyer is from a locale effectively beyond the control of the American courts (Russia, China, Indonesia, most of the Middle East and Africa, etc.) then the disclosure may have to be artificially restricted to protect the Seller.

A possible Buyer should also be careful when executing such Non Disclosure Agreements since the terms may very well interfere with Buyer's own business activities or lead to later litigation when the now angry Seller claims that the "fishing expedition " was an attempt to steal confidential information. Often a Buyer will NOT want to obtain certain documents precisely to avoid that danger.

A possible method to avoid this is to make disclosure to a third party trusted by the parties who agrees not to reveal any trade secrets to the possible Buyer until the transaction is culminated...and who will simply advise the Buyer as to any problems discovered in the due diligence, if any.

It is noteworthy that it is common for many entities world wide to use due diligence inquires to actually investigate a market or competitors rather than to truly consider a purchase. This was particularly true for various Chinese companies in manufacturing in China during the last decade and was also a bane of Silicon Valley in California. It might be wise for any Seller, before allowing due diligence, to conduct its own investigation of the proposed Buyer to determine if the motivations are sincere.

CONCLUSION

An experienced business client once commented to the writer that he could always determine if it was worthwhile to even consider doing business with a potential joint venture by seeing what they asked for in due diligence. "If they don't ask for far more than I want to give, if they don't infuriate me by insisting on access to everything, including my grandmother's tax returns from 1890, then they aren't good enough to do business with me...for I sure as heck want to know everything about them. "

While that is extreme, the lesson is not. One can learn a great deal about the sophistication, professionalism, and skill of a prospective business associate or buyer by simply determining if they fully understand what an appropriate due diligence is. The most revealing indication that a deal may not be worthwhile may not be that they ask for too much-it may be that they do not ask for enough!