By Richard D. Harroch, David A. Lipkin, Richard V. Smith, and John Cook
Mergers and acquisitions typically involve a significant amount of due diligence by the buyer. Before committing to the transaction, the buyer will want to ensure that it knows what it is buying, what obligations it is assuming, the nature and extent of the seller’s contingent liabilities, problematic contracts, litigation risks, intellectual property issues, and much more. This is particularly true in private company acquisitions, in which the seller has not been subject to the scrutiny of the public markets.
Recent M&A activity and litigation have highlighted the need for a buyer to conduct careful due diligence as to potential risks, especially investigating financial statements, data breach and cybersecurity issues, intellectual property issues, and potential employment law and sexual harassment liability.
The following is a summary of the most significant legal and business due diligence activities the buyer will undertake in a typical M&A transaction involving a privately held company. A buyer will employ additional highly specialized due diligence activities, beyond those set forth below, when investigating companies in regulated industries, such as telecom, banking, insurance, or finance.
By planning for the buyer’s due diligence activities carefully and properly anticipating the related issues that may arise and risks that the buyer may identify, the seller will be better prepared to negotiate mitigation measures and successfully consummate a sale of the company.
1. Financial Matters
The buyer will be concerned with all of the seller’s historical financial statements and related financial metrics as well as the reasonableness of the target’s projections of its future performance. Topics of inquiry or concern will include the following:
- What do the seller’s annual, quarterly, and (if available) monthly financial statements for at least the last three years reveal about its financial performance and condition?
- Are the seller’s financial statements audited, and, if so, for how long? Does the audit report include a “going concern” qualification?
- Do the financial statements and related notes set forth all liabilities of the seller, both current and contingent?
- Are there internal controls over financial reporting issues?
- Are the revenues and margins for the business growing or deteriorating?
- Are the seller’s financial projections for the future and underlying assumptions reasonable and realistic?
- How do the seller’s projections for the current year compare to the board-approved budget for the same period?
- What normalized working capital will be necessary to continue running the business?
- How is “working capital” determined for purposes of the acquisition agreement? (Definitional differences can result in a large variance of the dollar number.)
- How much is the seller investing in research and development? Is this amount sufficient?
- What capital expenditures and other investments will need to be made to continue growing the business, and what are the seller’s current capital commitments?
- What is the condition of tangible assets and liens thereon?
- What indebtedness is outstanding or guaranteed by the seller, what are its terms, and when does it have to be repaid?
- Are there any unusual revenue recognition issues for the seller or the industry in which it operates?
- What is the aging of accounts receivable, reasonableness of reserve for doubtful accounts, and are there any other accounts receivable issues?
- Should a “quality of earnings” report be commissioned?
- Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
- Has EBITDA and any adjustments to EBITDA been appropriately calculated? (This is particularly important if the buyer is obtaining debt financing.)
- Does the seller have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?
- Do any of the letters from auditors cause concern?
- Do any of the letters from counsel to auditors cause concern?
- Does the seller have net operating losses? How much is available for use by the buyer post closing?
- What seasonality in revenue and working capital requirements does the company typically experience?
- Are there any restrictions on the seller’s cash or repatriation taxes due in connection with foreign subsidiaries?
2. Technology/Intellectual Property
The buyer will be very interested in the extent and quality of the seller’s technology and intellectual property. This due diligence will often focus on the following areas of inquiry, among others:
- What domestic and foreign patents (and patents pending) does the seller have?
- Has the seller taken appropriate steps to protect its intellectual property (including confidentiality and invention assignment agreements with current and former employees and consultants)? Are there any material exceptions from such assignments (rights preserved by employees and consultants)?
- What registered and common law trademarks and service marks does the seller have?
- What copyrighted products and materials are used, controlled, or owned by the seller?
- Does the seller’s business depend on the maintenance of any trade secrets, and, if so, what steps has the seller taken to preserve their secrecy?
- Is the seller infringing on (or has the seller infringed on) the intellectual property rights of any third party, and are any third parties infringing on (or have third parties infringed on) the seller’s intellectual property rights?
- Is the seller involved in any intellectual property litigation or other disputes (patent litigation can be very expensive), or received any offers to license or demand letters from third parties?
- What technology in-licenses does the seller have and how critical are they to the seller’s business? How might these licenses affect or restrict the business of the buyer or any of its affiliates? Are royalty obligations affected by the sale of the seller to the buyer?
- Has the seller granted any exclusive technology licenses to third parties?
- Has the seller historically incorporated open source software into its products, and, if so, does the seller have any open source software issues?
- What software is critical to the seller’s operations, and does the seller have appropriate licenses for that software (and does the seller’s usage of that software comply with use limitations or other restrictions)?
- Has the seller disclosed, or is it contractually required to disclose, any source or object code?
- Is the seller a party to any source or object code escrow arrangements, and has any such code been released from escrow?
- What indemnities has the seller provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
- Are there any other liens or encumbrances on the seller’s intellectual property?
- Has the seller received subsidies or support from governmental authorities or universities? Is there any obligation to return subsidies upon a change of control of the seller?
- Has the seller used any intellectual property owned or claimed to be owned by any university or other educational institute?
- Does the seller’s software include any disabling codes, bugs, viruses, or other material problems or defects, and does the seller use industry standard practices to detect any such problems or defects?
- Does the seller have sufficient IT systems, including computer, information technology, and data-processing systems and facilities, for existing and currently anticipated future needs?
The buyer will want to fully understand the seller’s customer base, including the level of concentration of the largest customers as well as the sales pipeline. Topics of inquiry or concern will include the following:
- Who are the top 20 customers and what revenues are generated from each of them?
- What customer concentration issues/risks are there?
- Will there be any issues in keeping customers after the acquisition (including issues relating to who the buyer is)?
- How satisfied are the customers with their relationship with the seller? (Customer calls will often be appropriate.)
- Are there any warranty issues or obligations with current or former customers?
- What repair, indemnification, and/or liquidated damages obligations does the seller owe to its customers?
- What is the customer backlog?
- What are the sales terms/policies, and have there been any unusual levels of returns/exchanges/refunds?
- How are salespeople compensated/motivated, and what effect will the transaction have on the financial incentives offered to employees?
4. Fit with Strategic Buyer
A strategic buyer is concerned not only with the likely future performance of the seller as a stand-alone business; it will also want to understand the extent to which the seller will fit strategically within the larger buyer organization. This can also be the case where the buyer is a private equity buyer that has one or more existing portfolio companies in businesses related to those of the seller. Related questions and areas of inquiry will include the following:
- Will there be a strategic fit between the seller and the buyer, and is the perception of that fit based on a historical business relationship or on future expectations?
- Does the seller provide products, services, or technology the buyer doesn’t have?
- Will the seller provide key people (is this an acqui-hire?) and, if so, what is the likelihood of their retention following the closing?
- What integration will be necessary, how long will the process take, and how much will it cost?
- Will the transaction be accretive to or dilutive of the buyer’s earnings?
- What cost savings and other synergies will be obtainable after the acquisition?
- What marginal costs (e.g., costs of obtaining third-party consents) might be generated by the acquisition?
- What revenue enhancements will occur after the acquisition?
5. Material Contracts
One of the most time-consuming (but critical) components of a due diligence inquiry is the buyer’s review of all material contracts and commitments of the seller. The categories of contracts that are important to review and understand include the following:
- Guaranties, loans, and credit agreements
- Customer, reseller, and supplier contracts
- Agreements of partnership or joint venture; limited liability company or operating agreements
- Contracts involving payments over a material dollar threshold
- Settlement agreements
- Past acquisition agreements
- Equipment leases
- Indemnification agreements
- Employment agreements
- Exclusivity agreements
- Agreements imposing any restriction on the business activity of the seller or the right or ability of the seller (or buyer after closing) to compete in any line of business or in any geographic region with any other person
- Agreements containing “most favored nation” provisions
- Real estate leases/purchase agreements
- License agreements
- Powers of attorney
- Franchise agreements
- Equity finance agreements
- Distribution, dealer, sales agency, or advertising agreements
- Union contracts and collective bargaining agreements
- Government contracts
- Contracts the termination of which would result in a material adverse effect on the seller (including, for example, acceleration of indebtedness upon a change of control or liquidated damages provisions)
- Any approvals required of other parties to material contracts due to a change in control or assignment
6. Employee/Management Issues
The buyer will want to review a number of matters in order to understand the quality of the seller’s management and employee base, including:
- Management organization chart and biographical information
- Sexual harassment or discrimination policies or allegations
- Sexual misconduct allegations or culture issues
- Summary of any labor disputes
- Information concerning any previous, pending, or threatened labor stoppage, slowdown, picketing, or other similar labor activity
- Employment and consulting agreements, loan agreements, and documents relating to other transactions with officers, directors, key employees, and related parties
- Schedule of compensation paid to officers, directors, and key employees for the three most recent fiscal years showing separately salary, bonuses, and non-cash compensation (e.g., use of cars, property, etc.)
- Summary of employee benefits and copies of any pension, profit sharing, deferred compensation, and retirement plans
- Evidence of compliance with IRS Section 409A in connection with incentive equity issuances
- Summary of management incentive or bonus plans not included above as well as other forms of non-cash compensation
- Likelihood of need for compliance with IRS Section 280G (“golden parachute”) rules in connection with any potential acquisition
- Employment manuals and policies
- Involvement of key employees and officers in criminal proceedings or significant civil litigation
- Plans relating to severance or termination pay, vacation, sick leave, loans, or other extensions of credit, loan guarantees, relocation assistance, educational assistance, tuition payments, employee benefits, workers’ compensation, executive compensation, or fringe benefits
- Appropriateness of the seller’s treatment of personnel as independent contractors vs. employees
- Carve-out plans in the event of a change in control of the seller
- Employee compliance with obligations to prior employers (such as non-compete and non-solicit provisions)
- Compliance with employment rules, including wage and hour, overtime, immigration, child labor, employment discrimination, and disability rules and regulations
- Whether there are agreements/incentive arrangements in place with key employees to be retained by the buyer, and whether they will be sufficient to retain key employees
- The extent to which layoffs and resultant severance costs will likely be incurred in connection with the acquisition, and whether the buyer or the seller bears these costs
- Accrued but unpaid bonuses or commissions
- Employees on medical, maternity, paternity, adoption, or other leave
- Deferred compensation arrangements
- Historical employee and consultant turnover
- Whether employees may be contractually and legally terminated at will without payment of severance or other payments
An overview of any litigation (pending, threatened, or settled) or arbitration involving the seller is typically undertaken. This review will include the following:
- Filed or pending litigation, together with all complaints and other pleadings
- Litigation settled and the terms of settlement
- Claims threatened against the seller
- Consent decrees, injunctions, judgments, or orders against the seller
- Attorneys’ letters to auditors
- Insurance covering any claims, together with notices to insurance carriers
- Matters in arbitration or mediation
8. Cybersecurity and Data Privacy
It has become increasingly imperative that a buyer considering an acquisition fully investigate and identify cybersecurity and data privacy risks and liabilities posed by the transaction. It is equally important that the seller anticipate cybersecurity and data privacy issues. Notably, because a seller may not even be aware of a prior or current compromise of the seller’s data that may be pertinent to the deal, it is also incumbent upon the buyer to engage expert third parties to conduct due diligence in this area. Appropriate cybersecurity or privacy counsel should be consulted in any particular M&A due diligence investigation.
At a minimum, the buyer’s due diligence investigation should focus on the following:
- Identifying the particular types of privacy and cybersecurity risks the seller faces given its industry sector, geographic reach, and the nature of the products and/or services that it manufactures, develops, or provides
- Understanding the network and system architecture and data flows, including the use of cloud providers and third-party applications
- Understanding the extent to which the seller gathers and uses personal information, especially customer personal information and highly sensitive proprietary information, including information provided by business partners and/or governmental agencies
- Reviewing commitments and representations made by the seller to its users and customers in connection with privacy and security issues, including contractual obligations
- Recognizing whether the buyer will need to obtain any consents to use personal or private information of the seller post-closing
- Asking whether the seller has experienced any prior cybersecurity incidents, including data breaches, and how it has responded to such incidents
- Determining whether the seller has a written security program that meets current regulatory and industry standards and best practices, including with respect to organizational (policies), operational (processes), and technical controls
- Assessing the buyer’s potential liability, compliance posture, and/or notification obligations that might exist after completion of the acquisition
In addition, there are several other types of due diligence inquiries and procedures that a buyer may wish to undertake in connection with its investigation of data privacy and cybersecurity issues set forth below.
Review of Selling Company Policies and Contracts
The buyer will often request and review copies of various policies, contracts, and other documents of the seller, including the following:
- Current and older versions of the seller’s privacy policies
- Whether and to what extent the seller has deviated from its privacy policies
- Telemarketing and email marketing policies
- Security policies, including but not limited to the seller’s Information Security Policy, Acceptable Use Policy, and Data Classification Policy
- Results of security audits and assessments, vulnerability scans, and penetration tests
- Privacy and security program maturity plans
- Privacy impact assessment processes and assessment reports
- Certifications (e.g., ISO 27001/2, PCI DSS, SOC) and audit records
- A list of business-to-business customer contracts, particularly with public companies in the financial, health, energy, telecommunications, and other highly regulated industries
- Contracts with the seller’s vendors, suppliers, and providers
- Incident response plans and playbooks
- Privacy and information security training materials, and a description of the training program
- Employee background investigation processes and policies, and onboarding processes
- Organization and reporting structure as it relates to the security function, and any information regarding executive management of cybersecurity and privacy risk
- GDPR-related compliance materials, as applicable
- Software development processes and documentation
- Insurance policies protecting the seller from cybersecurity or data breach losses (including claims history)
- Whether there are appropriate systems of internal accounting controls to guard against fraudulent requests for money
Review of Procedures to Protect Data
The buyer may also inquire of the procedures the seller has put in place to protect its and its employees’, customers’, and business partners’ data and information as well as its networks and systems. For example:
- Does the seller have a written cybersecurity program that establishes administrative, operational, and technical controls to mitigate security risks?
- Does the seller have appropriate policies, including at a minimum an Information Security Policy, an employee-facing Acceptable Use Policy, and a Data Classification and Handling Policy?
- Does the seller conduct regular risk assessments, and vulnerability and penetration testing of systems?
- Does the seller have dedicated security personnel?
- Does the seller perform an annual risk assessment relating to privacy and cybersecurity?
- Does the seller train its employees on privacy and security best practices?
- Does the seller have a comprehensive Incident Response Plan and is it tested?
- Does the seller appropriately manage vendor risk?
- Does the seller have a business continuity and disaster recovery plan, and back-up protocols?
- Does the seller appropriately protect the physical security of its facilities and assets?
- Does the seller implement “reasonable” technical security controls (or comply with mandatory standards), including, for example, antivirus software, encryption, access controls, network monitoring, authentication, and asset management?
- Does the seller have an insider threat program to detect the potential theft of proprietary information or intellectual property?
- Does the seller require privacy impact assessments when implementing new systems or processes?
Review of Past Data Breaches and Claims Against the Seller
The buyer may also inquire about possible past data breaches against the seller or intrusions into its computer network. For example:
- Is the seller aware of any prior cybersecurity incidents, including but not limited to the compromise of sensitive data? A description or report of all prior known incidents should be requested.
- How were any such incidents discovered or detected?
- Did the seller conduct an investigation and what was the methodology and scope? Was a third-party forensic consultant engaged to investigate the incident? Any investigative reports relating to cybersecurity incidents should be requested.
- What was the impact of the incident on the seller’s data or systems? What was the scope of the compromise or data impact?
- Has the seller experienced any theft or suspected theft of proprietary information or intellectual property? If so, when and what kind of information was stolen? Was the subject of the investigation an insider (employee, contractor, or ex-employee) or a third-party intruder?
- Has the seller experienced a potential breach of personal data? When? Were notifications made? Why or why not? Did the seller consult with external counsel on legal obligations?
- Has the seller been defrauded or extorted as a result of an email compromise?
- What remedial actions or patches were implemented to fix any vulnerabilities or other root causes that resulted in an incident or potential incident?
- How often are networks, systems, applications, and other digital assets scanned for vulnerabilities or subject to penetration testing?
- Has the seller received privacy or security complaints from its customers?
- Has the seller settled any claims or complaints? If so, on what terms?
Other Pre-Acquisition Due Diligence
Cybersecurity due diligence also may require the buyer to consider more “invasive” technical methodologies unfamiliar in the traditional M&A due diligence context. The following additional steps are particularly important to consider when the seller or the buyer are in highly regulated and/or critical infrastructure industries, for government contractors, or where post-acquisition notification of prior breaches may be required:
- Require the seller to engage a third-party security company to run vulnerability scans or penetration tests on critical assets (for example, those that store sensitive data or valuable intellectual property) and applications.
- Engage a third-party security company to scan systems for artifacts of current or past compromises (no one wants to acquire a Russian Advanced Persistent Threat (APT) along with their investment).
If such measures cannot be taken prior to acquisition, a buyer must consider such assessments prior to integration of networks and systems to ensure that any existing infections, malware, or compromises do not spread to the buyer’s environment or otherwise continue following the closing.
9. Tax Matters
Tax due diligence may or may not be critical, depending on the historical operations of the seller, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carryforwards and their potential benefit to the buyer may be important. Tax due diligence will often incorporate a review of the following:
- Federal, state, local, and foreign income, sales and other tax returns filed in at least the last five years
- Government audits
- Copies of any correspondence or notice from any foreign, federal, state, or local taxing authority regarding any filed tax return (or any failure to file)
- Tax sharing and transfer pricing agreements
- Net operating losses or credit carryforwards (including how a change in control might affect the availability thereof)
- IRS Form 5500 for 401(k) plans
- Review of potential liability for income and sales tax in any states where the seller has a place of business or permanent establishment
- Agreements waiving or extending the tax statute of limitations
- Allocation of acquisition purchase price issues
- Correspondence with taxing authorities regarding key tax items
- Settlement documents with the IRS or other government taxing authorities
- Withholding tax compliance
- Tax sharing or indemnity agreements or arrangements
10. Antitrust and Regulatory Issues
- Antitrust and regulatory scrutiny of acquisitions has been increasing in recent years. The buyer will want to undertake the following activities in order to assess the antitrust or regulatory implications of a potential deal:Considering Exon-Florio issues if the transaction involves national security or foreign investment issues, including application of the new CFIUS rules (see Merger, Acquisitions, and Investments Involving U.S. Companies With Chinese and Other Foreign Parties)
- If the buyer is a competitor of the seller, understanding and working around any limitations imposed by the seller on the scope or timing of diligence disclosures (including use of clean rooms to facilitate exchanges of sensitive information)
- Analyzing scope of any antitrust issues
- If the seller is in a regulated industry that requires approval of an acquisition from a regulator, understanding the issues involved in pursuing and obtaining approval
- Confirming if the seller has been involved in prior antitrust or regulatory inquiries or investigations
- Addressing issues that may be involved in preparing a Hart-Scott-Rodino filing (if thresholds are met) and effectively responding to any “second request” from the Department of Justice or Federal Trade Commission
- Non-U.S. merger control or competition law filings, including implications of Brexit
- Other Department of Commerce filings if the buyer is a foreign entity
- Understanding how consolidation trends in the seller’s industry might impact the likelihood and speed of antitrust or regulatory approval
- Considering Foreign Corrupt Practices Act, export control laws, and other anti-bribery and corruption laws where the seller has non-U.S. operations
- Considering U.S. sanctions laws and prohibitions on trade with embargoed countries
In any acquisition, the buyer will want to undertake a review of key insurance policies of the seller’s business and the seller’s compliance with, and claims history under, such policies, including:
- If applicable, the extent of self-insurance arrangements
- General liability insurance
- Cybersecurity insurance
- D&O insurance
- Intellectual property insurance
- Car insurance
- Health insurance
- E&O insurance
- Key man insurance
- Employee liability insurance
- Worker’s compensation insurance
- Umbrella policies
12. General Corporate Matters
Counsel for the buyer will invariably undertake a careful review of the organizational documents and general corporate records (including capitalization) of the seller, including:
- Charter documents (certificate of incorporation, bylaws, etc.)
- Good standing and (if applicable) tax authority certificates
- List of subsidiaries and their respective charter documents
- List of jurisdictions in which the seller and its subsidiaries are qualified to do business
- List of current officers and directors
- Evidence that securities were properly issued in compliance with applicable securities laws, including applicable federal and state blue sky laws
- Lists of all security holders (common, preferred, options, warrants)
- Stock option agreements and plans, including both standard documents and any deviations therefrom
- Warrant agreements
- Stock sale agreements
- Stock appreciation rights plans and related grants
- Stock redemption or repurchase rights
- Agreements granting restricted stock units
- Stockholder and voting agreements
- Stock-related preemptive rights, registration rights, redemption rights, or co-sale rights
- Agreements restricting the payment of cash dividends
- Recapitalization or restructuring documents
- Agreements related to any sales or purchases of businesses
- “No shop” or exclusivity obligations
- Rights of first refusal or first negotiation in connection with a sale of the seller or its business
- Minutes of meetings of board of directors, board committees and stockholders since inception, including written consents to action without a meeting
13. Environmental Issues
The buyer will want to analyze any potential environmental issues the seller may face, the scope of which will depend on the nature of its business. Where an environmental review is conducted, it will typically include a review of the following:
- Environmental audits, records, and reports for each owned or leased property, including results of tests or audits of the seller’s properties and possibly neighboring facilities
- Hazardous substances used in the seller’s operations
- Environmental permits and licenses
- Correspondence, notices, and files related to EPA, state, or local regulatory agencies
- Any environmental litigation, claims, or investigations
- Any known Superfund exposure
- Any contingent environmental liabilities or continuing indemnification obligations
- Any contractual obligations relating to environmental issues
- The use of any petroleum products on the seller’s properties other than by passenger vehicles
- Any asbestos contained in any improvements located on the seller’s properties
- Records from any public agency investigation of the seller’s properties or any neighboring properties with respect to any environmental laws
14. Related Party Transactions
The buyer will be interested in understanding the extent of any “related party” transactions, such as agreements or arrangements between the seller and any current or former officer, director, stockholder, or employee, including the following:
- Any direct or indirect interest of any officer, director, stockholder, or employee of the seller in any business that competes with or does business with the seller
- Any agreements with any officer, director, stockholder, or employee that is entitled to compensation
- Any agreements in which any officer, director, stockholder, or employee has an interest in any asset (real estate, intellectual property, personal property, etc.) of the seller
15. Governmental Regulations, Filings, and Compliance with Laws
The buyer will be interested in understanding the extent to which the seller is subject to and has complied with regulatory requirements, including by reviewing the following:
- Citations and notices received from government agencies since inception or with continuing effect from an earlier date
- Pending or threatened investigations or governmental proceedings
- Material reports to and correspondence with any government entity, municipality, or agency, including FDA, USDA, EPA, and OSHA
- Documents showing any certification of compliance with, or any deficiency with respect to, regulatory standards of the seller
- Reports on the burdens and costs of regulatory compliance (including ERISA, labor and other federal, state, and local regulation)
- Any problems with such regulatory compliance (including ERISA, labor and other federal, state, and local regulation)
- Material governmental permits and licenses required to carry out the business or operations of the seller or its subsidiaries currently in force
- Information regarding any of the seller’s permits or licenses that have been canceled or terminated
- Extent of evidence of the seller’s exemption from any permit or license requirement
A review of all property owned or leased by the seller, or otherwise used in the business, is an essential part of any due diligence investigation, with such review including:
- Deeds of trust and mortgages
- Title reports
- Other interests in real property
- Financing leases and sale and leaseback agreements
- Conditional sale agreements
- Operating leases
- Zoning requirements
- Condemnation risks
17. Production-Related Matters
Depending on the nature of the seller’s business, the buyer will often undertake a review of the seller’s production-related matters, including the following:
- List of the seller’s most significant subcontractors, including the dollar volume of business and the type of services or products supplied by each subcontractor
- List of the seller’s largest suppliers with the amount and type of products purchased from each during the most recent fiscal years and year-to-date, as well as whether or not the supplier is the sole source of such products
- Monthly manufacturing yield summaries, by product
- Schedule of backlog showing customers, products, and requested/scheduled shipping dates
- Copies of inventory reports
- Supplies or materials used by the seller to produce or develop products that are in short supply or subject to shortages
- Product service programs and copies of standard form of service contract and any contracts with service providers
- Information regarding backlogs and levels of plant operation
- All agreements and other arrangements related to the research, development, manufacturing, and testing of the seller’s products
18. Marketing Arrangements
As part of diligence, the buyer will want to understand the seller’s marketing strategies and arrangements, including through reviewing:
- Sales representative, distributor, agency, and franchise agreements of the seller
- Standard sales forms or literature, including price lists, catalogs, purchase orders, etc.
- All other agreements related to the marketing of the seller’s products
- Surveys of the markets the seller serves or plans to serve, whether or not compiled by or at the direction of the seller
- Press releases concerning the seller (or any partnership or joint venture involving the seller or any subsidiary)
19. Competitive Landscape
The buyer will want to understand the competitive environment in which the seller’s business operates, including by obtaining information on the following:
- The seller’s principal current and anticipated competitors and the level of competition and propensity for litigation by competitors
- Technologies that could make the seller’s current technology or manufacturing processes obsolete or less competitive
- Advantages/disadvantages of the seller’s products and technologies compared to those of competitors
- Financial strength and market penetration of principal competitors
20. Online Data Room
It is critically important to the success of a due diligence investigation that the seller establish, maintain, and update as appropriate a well-organized online data room to enable the buyer to conduct due diligence in an orderly fashion. Such electronic data sites are customary today. The following are the common attributes and characteristics of an effective data room:
- The seller makes it available to the buyer as early in the process as possible, at the latest immediately following the parties finalizing the letter of intent or term sheet.
- The data room has a logical table of contents or directory and full text search capabilities (which requires scanning of all documents with optical character recognition software).
- The data room permits bookmarking within the application.
- Subject to confidentiality concerns, the buyer is permitted to print documents for offline review.
- The data room is keyed to any due diligence checklist, including updates, provided by the buyer to facilitate cross-referencing and review.
- Ideally, access to the data room is accompanied by delivery by the seller to the buyer of a draft disclosure schedule and all materials referred to in the disclosure schedule are in the data room.
- Updates to the data room are clearly marked or trigger email notifications to the buyer’s counsel to help ensure that nothing is missed as supplemental materials are added during the process
See, for example, the online data rooms offered by Merrill Corp. See also The Importance of Online Data Rooms in Mergers and Acquisitions.
Buyers increasingly are using artificial intelligence software and resources to facilitate their review of data room documents. Where thousands—or even tens of thousands—of documents included in the online data room need to be reviewed, especially in a short period of time, use of such artificial intelligence software and resources can provide a buyer with a competitive advantage over other potential buyers by enabling the buyer to complete its due diligence review more quickly, efficiently, and thoroughly.
Artificial intelligence can also replace (or at a minimum accelerate and enhance) laborious tasks traditionally performed by humans, including locating (and analyzing) anti-assignment and change of control provisions, and other contractual clauses that are frequently implicated by M&A transactions.
21. Disclosure Schedule
As a customary part of any M&A transaction, the seller must prepare a comprehensive disclosure schedule that addresses many of the key diligence topics described above, and that identifies any exceptions to the seller’s representations and warranties in the acquisition agreement. Careful preparation of this disclosure schedule is extremely important and time-consuming for the seller.
The seller’s management needs to be deeply involved in the drafting of the disclosure schedule; this document is not simply a “legal” document to be left to the lawyers to prepare. The seller also must anticipate that the buyer and its legal and financial advisors will negotiate the wording of the disclosure schedule.
Accordingly, it is not unusual for the seller to have to revise and update its disclosure schedule a number of times before it is either ready for delivery to the buyer or it is finalized. That means that it is essential for the seller to begin preparing the disclosure schedule very early in the planning stages of an M&A transaction, and to devote sufficient resources to this document to ensure that it is accurate and complete when the acquisition agreement is signed, particularly since in most cases the seller has no right to update the disclosure schedule after signing and prior to closing.
The buyer and its counsel will be looking for the following in the disclosure schedule, among many other items:
- Does the disclosure schedule accurately tie to the representations and warranties set forth in the acquisition agreement?
- Does the disclosure only modify the relevant representations and warranties?
- Are all material contracts and amendments listed, with dates and counterparties?
- Are all contracts listed in the disclosure schedule contained in the target’s online data room, and have those contracts been reviewed?
- Have all patents issued and pending been summarized and listed?
- Are any important contracts affected by a change in control? Will consents be obtained from the counterparty before or after the change in control?
- If litigation is listed, has an analysis been done of the potential exposure?
- If there are liens on any assets, how will those liens be removed at closing? Has the buyer identified any liens not shown in the disclosure schedule?
- Are there any unusual employment agreements or severance arrangements?
- Is the outstanding capital stock, options, and warrants of the seller properly listed?
- Do the seller’s continuing contracts provide for any issues for the seller moving forward?
- Are there any material matters set forth in the disclosure schedule that are inconsistent with statements previously made on behalf of the seller, or with the valuation that the buyer has placed on the business being acquired?
- Does the disclosure schedule include any broad disclaimers or generalized disclosures that would prevent the buyer from raising legitimate claims following the closing if individual representations and warranties turned out to be untrue?
- Are there disclosures or statements in the disclosure schedule that are internally inconsistent with each other?
- Should the buyer demand indemnity for any specific liabilities disclosed in the disclosure schedule?
For more information, read The Importance of Disclosure Schedules in Mergers and Acquisitions.
See also www.BizBuySell.com for a comprehensive listing of businesses for sale.
An M&A transaction typically requires a buyer and its counsel, advisors, and accountants to undertake a significant amount of due diligence. Sellers, by being properly prepared for these due diligence activities, can better ensure that the process proceeds smoothly and quickly, serving the best interests of all parties to the transaction.
Copyright © Richard D. Harroch. All Rights Reserved. This is an updated version of articles previously published. Special thanks to Jennifer Martin for her input on data breach and cybersecurity issues.
About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
David A. Lipkin is an M&A partner in the Silicon Valley and San Francisco offices of the law firm of McDermott, Will and Emery. He represents public and private acquirers, target companies, and company founders in large, complex, and sophisticated M&A transactions, as well as working with startups and other emerging growth companies. David has been a leading M&A practitioner in the San Francisco Bay Area for 20 years, prior to that having served as Associate General Counsel (and Chief Information Officer) of a subsidiary of Xerox and practiced general corporate law in San Francisco. He has been recognized for his M&A work in the publication The Best Lawyers in America for several years, and is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He is a member of the Board of Directors of the Giffords Law Center to Prevent Gun Violence, and has served on additional educational and charitable boards. He has been involved in over 200 M&A transactions. He can be reached through LinkedIn.
Richard V. Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. He specializes in the areas of mergers and acquisitions, corporate governance, and activist defense. Richard has advised on more than 500 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, corporate governance, and activist defense. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He can be reached through LinkedIn.
John Cook is a partner in the San Francisco office of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. He specializes in the areas of mergers and acquisitions and startup company representation. John’s practice has particular focus on the renewable energy, cleantech, and technology industries. John has been a leading M&A lawyer for over 15 years and has led hundreds of M&A and financing transactions. He is the co-author of the book Mergers & Acquisitions, published by Global Insights. He can be reached through LinkedIn.
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