Anatomy of an M&A Transaction (III): 8 Line Items to Expect in Any Due Diligence Checklist
By Michael Mercurio Esq., Offit Kurman
For buyers and sellers alike, due diligence is often what makes or breaks a mergers and acquisitions (“M&A”) transaction. Now that you have agreed to the prospective buyer’s expectations, as outlined in a letter of intent (“LOI”) or term sheet, it is time for both parties to get serious about pursuing the deal. For your buyer, this means a rigorous investigation of your business. For you, this means accommodating your buyers’ requests, and preparing your records as thoroughly as possible (which hopefully are in good order, as you have ideally performed a self-audit of your business prior to going to market).
At this juncture in the transaction, all interested parties take on a role; you—the seller—are front and center, along with the buyer, legal counsel for both parties, accountants, and consultants. Communication between all parties is vital, so do not try to hide any sensitive information or remaining skeletons in your closet. Disclosure is your friend (this, of course, is dire opposite to running your business where confidence and discretion are key). Whether you have revealed it or not, every aspect of your business will be dug up during due diligence. So for the sake of moving the deal forward, it is best that your buyer learns the details from you first. You never want to be in a situation where the buyer experiences remorse after the transaction is struck and comes back to you to say, “If only I knew this detail about this business,—I would have valued the transaction differently.” This is a conversation you do not want to have subsequent to the transaction.
Consider what your buyer is looking for: proof of sound business practices, ways to save money, nasty surprises hiding under the rug, and any indications their investment will (or will not) pay off.
Due diligence generally falls into three (3) categories: Operations, Legal, and Financial. Communication of diligence also falls into multiple forms and tracks—it may take the form of in-person meetings with the buyer (interviews) but will also include the disclosure of written documents. The transfer of such documentation will also take different routes.
You, the seller, will facilitate some diligence directly to the buyer. Other diligence will funnel through legal counsel. Still other diligence may involve the financial teams exchanged details directly. Keep in mind, that when communicating diligence (and in negotiations in general), use of different communications forms can be a subtle (or not-so-subtle) means of sending an underlying message among the parties. For example, certain communications can be handled between the parties directly, while other communications may want to travel via legal counsel to legal counsel (a more serious route).
With the above in mind, below are several sample line items you can expect to find on your buyer’s due diligence checklist. This list is far from inclusive and exhaustive. Usually the diligence checklist is very long and overreaching. This is intentional: The buyer wants to cover every aspect. No buyer wants to be caught in the position of having a seller tell them that they did not disclose an aspect of the business because the buyer did not seek it.
1. Corporate Structure
- Incorporation documents, and/or corporate bylaws
- Minutes from board, shareholder, and/or executive committee meetings
- Organizational chart
- Financial information for the past 3–5 years, including income statements, balance sheets, cash flow, and audit reports
- Projections, budgets, and forecasts for the next 3–5 years
- Credit agreements, debts, and contingent liabilities
- Bank and safety deposit box information
- Customer agreements
- Schedule of accounts receivable
- Schedule of accounts payable
- List of key customers and vendors
- Insurance policies
- Loan agreements
- Contracts for service suppliers
- Federal and state returns
- Audit reports and other tax examination records
- Tax sharing/funding agreements
- List of employees and wages
- Employment agreements
- Standing of key employees
- Personnel handbooks
- Vacation and sick time schedules
- Employee benefit policies
6. Intellectual Property
- Domain names
- Records of claims or disputes made over intellectual property
- List of current stock, including cost, number, and acquisition date
- Inventory schedule
- Estimated valuation of inventory over time
8. Other Assets
- List of real estate property
- List of equipment, including computers and motor vehicles
- Titles for property
- Appraisal of property
9. Legal And Regulatory Matters
- Records of pending or threatened litigation
- Court orders and permits
- Regulatory investigation reports
- Notices of violation
- Contact information for legal counsel representing the company in each matter
The results of due diligence are contingent on the differences between the LOI—the buyer’s best estimate of how much your business is worth—and the actual worth as determined by the investigation. Your buyer may amend its LOI to adjust the purchase price and/or the payment terms. Due diligence sets the stage for the final phase of negotiation: not only what your buyer is willing to pay, but whether they are comfortable moving forward with the deal at all. As such, it is in your best interest to start negotiating contracts as soon as possible in order to close the deal and maximize your payout. And remember due diligence is not limited to the buyer seeking information from you. As the seller you should perform some limited diligence on the buyer. You need to make certain that the combination you are contemplating is best for you and that the promises the buyer is making can be fulfilled. My next article will address considerations for contract negotiations during the M&A process.
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Michael MercurioOffit Kurman, Baltimore, United States
Michael Mercurio is business law and transactions attorney. He serves as outside general counsel to clients on matters related to corporate and business law, commercial transactions, government contracting and real estate. As a strategic partner to firm clients, Mr. Mercurio regularly counsels entrepreneurial individuals and assorted entities on all aspects of business and commerce including formation and structure; ownership, management and control; financing and capital; expansion and acquisition; sale and transfer; and contraction and dissolution.
published: January 2016