05 Oct Due Diligence and the Stages of M&A Transactions
Drew EricksonSenior Associate
A business owner going through a M&A transaction as a seller (which can include a sale of assets, equity, or a merger of two or more companies) is often one of the most important decisions a business owner will ever make – a buildup of years of hard work, culminating in a transaction that is likely to be an experience foreign to most business owners. The M&A transaction itself can define the business for years to come, and the success (or lack thereof) of a M&A transaction depends largely on the due diligence conducted in the deal-making process. This article will focus on the perspective of a seller going through various stages of the deal, including what to expect in the due diligence process.
The Due Diligence Process Generally
Due diligence mainly involves a prospective buyer reviewing various aspects of a business to get comfortable with the potential purchase, which includes identifying any issues with the business that may affect the prospective buyer post-closing. The issues that can arise during due diligence can range from the negligible (corporate records needing updating, charter reinstatements, etc.) to the very important (e.g., lawsuits, IRS issues, encumbrances, title not being vested in the seller, etc.). The “comfort” level of a prospective buyer after due diligence will ultimately reflect the final deal points the prospective buyer is willing to accept. For example, the prospective buyer may have originally proposed a $5 million purchase price, but if certain issues uncovered during due diligence concern the prospective buyer, the purchase price might drop, or a portion may be held in escrow post-closing pending satisfaction of such issues. But the reverse can also be true – that the business is better than expected and requires a premium attached to the purchase price to ensure the seller remains exclusive to this buyer and does not shop around for other potential buyers.
The due diligence process itself and the negotiations of the definitive agreement of an M&A transaction usually is conducted simultaneously, but it is common for primary due diligence to start early to get a good feel for the target business before incurring additional expenses (e.g., reviewing financial statements). While the process can be expedited, due diligence can often last for months. This, combined with all of the moving parts leading to the closing of the deal, makes the process extremely complex and daunting for both the buyer and seller.
It is easy to think that the burden of due diligence is borne solely by the buyer, but the seller is also tasked with preparing and making certain information available for the prospective buyer, which depending on the business and the scope of requests, can be extensive. To relieve some of the pressure of voluminous document production, buyers usually assist the seller with the help of a Due Diligence Request List, summarizing everything the buyer desires to have from the seller, prioritizing which requests are most important and should require the most attention, and updating the list periodically to shift the focus of the seller upon completing certain requests.
While every M&A transaction is different, the process generally follows certain predictable stages: a Non-Disclosure Agreement (or NDA), Preliminary Due Diligence Review, a Letter of Intent (or LOI), Full Due Diligence Review, and Definitive Agreement Negotiations.
Stages of M&A Transactions
It is important for a seller to ensure the confidentiality of its proprietary information. However, it is also important for a prospective buyer to have as much information as is necessary for the buyer to be apprised of the business it is looking to acquire. In order to satisfy both party’s needs, it is common for the parties to enter into a NDA, where all information delivered by the seller or made available to the buyer cannot be used or disclosed by the buyer except for evaluating the potential M&A transaction.
Once an NDA is entered into, the seller will provide high-level information on the seller’s business in the form of preliminary due diligence in order for the buyer to appropriately evaluate the business and its potential offer of purchase. During this preliminary due diligence, business-level discussions are often held between the buyer and seller to determine whether a prospective buyer views the business, and the proposed acquisition, as worth pursuing at the price and payment terms expected by the seller. If the parties are satisfied with the business terms of the proposed acquisition, they will execute a LOI that sets forth initial deal terms and proposed timelines for the buyer to conduct its due diligence. The LOI also typically includes other agreements and restrictions, including restrictions on the seller engaging in discussions with other potential buyers during a defined exclusivity period, requirements that the seller continue operating in the ordinary course of business, and mutually agreed terms regarding access to the seller’s property and employees.
After a LOI is executed, the buyer’s due diligence team will begin the full due diligence review of the seller’s business. To start the review, buyers will typically send a Due Diligence Request List to the seller based on the LOI as well as any publicly available information about the seller. Buyers often organize the due diligence requests and resulting information in data rooms where the seller can upload information and the buyer will have a single source to access all the due diligence materials. As the seller begins to respond to the buyer’s requests and populate the data room, the buyer may learn important information on the business that would have not otherwise been known, which will require analyzing the materials and following up with the seller in order to resolve any potential issues. The buyer’s review of the due diligence materials should include not only the tangible and intangible assets of the business, but also a review of the corporate and ownership documents, commercial contracts, financing and debt, real estate, employment, intellectual property, and a thorough examination of the regulatory, tax, technology, litigation (pending and threatened), and related risks.
Either after due diligence is completed or contemporaneously, the M&A transaction must be memorialized in a definitive purchase agreement, which may be an equity sale, asset sale, merger, or other business transaction. However, the form, the M&A transaction will reflect the terms of the LOI (as may be modified after the buyer’s due diligence review), as well as ongoing negotiations between the parties. One of the most important aspects of the definitive agreement will be the representations and warranties of the seller reflecting the current state of the business, usually as of the closing date. These representations and warranties will be crafted, and be a result of, the due diligence review by the buyer, giving the buyer certain assurances that after closing it is protected with certain guarantees by the seller as to the business and the due diligence information delivered to the buyer. Upon an agreement of the definitive agreement between the buyer and seller, the parties can target an appropriate closing date and consummate the transaction they have worked so hard to achieve.
A final note – given the complex nature of many businesses, it is essential that buyers conduct thorough and tailored due diligence for the target business and the seller. Failing to identify and remedy a significant issue during the diligence process can be devastating for both parties. The right legal counsel and other professionals, including a CPA, in your corner during a business purchase can help guide you through the process and put you in the best position possible.
ABOUT THE AUTHOR: Drew Erickson is a Senior Associate at Rapp & Krock, PC in the Corporate Law and Business Transactions group.
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