It is crucial to ensure that you “do your homework,” right off the starting block, in contemplating any deal. On the other side of that equation, it is equally critical to know your options as a vendor – the largest “top line” offer may not be the most money (or the most secure money) in your jeans. The process should not be taken lightly. It can significantly impact on the value of the deal and thus is best undertaken with experienced professional assistance to avoid missing important areas of risk.
Very recently, I heard the story of a gentleman and his fellow shareholders who had a falling out and the matter had gone to court. While the court undoubtedly felt that the right thing was done in securing a long-term payout for the shareholder, the result was immediate taxation of all proceeds, without the cash to make the tax payment. Ouch! Should a negotiated settlement have been reached with a sage tax practitioner to indicate options, things would likely have turned out differently.
Due diligence is a catch-all term to describe the process undertaken by a potential buyer to understand the nature of the transaction: what is being purchased, what risks may exist, the key drivers of the business, verification of the information provided by the seller and assuring that the buyer has all the information required to proceed with the transaction. The extent of due diligence depends on whether the buyer is buying assets or shares of a company. Sometimes it isn’t clear what is included with the business. There may be items used in a business that are owned by another company or loaned by “Uncle John.” You need to ensure you have access to all of the assets used in the business and not just those owned by the company. The process generally proceeds quickly as it will be essential to complete prior to closing the deal.
For a vendor, the process can seem invasive, as a significant amount of information may need to be disclosed. It may be prudent in certain circumstances to ask the buyer to sign a non-disclosure agreement (NDA) – legal advice should be sought to determine the necessity.
The results of due diligence can sometimes change the pricing set out in the letter of intent (LOI). For instance, take a situation where a buyer is buying business assets and as part of the due diligence, inspects the inventory of the business only to find that it contains a number of obsolete items which may not be saleable. If the price set out in the LOI had been based on the premise that all inventory would be saleable at a certain profit margin, this discovery may lead the buyer to adjust the initially proposed price downwards to reflect the new information.
As noted above, the extent of due diligence will vary depending on whether assets or shares are being purchased.
Where a buyer is acquiring the shares of a company, by default all the assets are being acquired and all the liabilities are being assumed – except those expressly excluded by the terms of the deal. This includes any liabilities which may not be disclosed on the financial statements of the target company. A significant part of the due diligence for a share deal will be for the buyer to gain comfort that they are aware of the actual and potential liabilities being acquired.
For example, a buyer may determine during due diligence that a vendor has offered a lifetime warranty on its products and hasn’t quantified what that potential liability may be on its financial statements. If the buyer did not undertake sufficient due diligence to find out about this potential liability, it may encounter some surprising costs in the future which will reduce the return on the investment in the business.
Sometimes, it is possible for a buyer and a vendor to agree that there might be a risk of a liability arising post-close, but quantifying that risk is difficult. In that case, additional representations and warranties and indemnifications may be required by the buyer from the vendor in the acquisition agreement.
For asset deals, the due diligence can be much easier provided the buyer and seller have clearly articulated which assets are being purchased and which liabilities are being assumed. It will be important for a buyer to verify how those assets drive profitability of the business and ensure the value being attributed to them is appropriate (as per the example above regarding inventory).
Due diligence is a necessary part of the anatomy of every deal and it is vitally important that both the buyer and vendor are prepared for and understand the dissection process.