Even if you have very little experience purchasing a business or its assets, you are likely aware of the importance of doing due diligence on the target's business. In fact, in a prior posting I discussed the importance of due diligence, and the essential legal and business issues that require careful investigation before purchasing a company, its assets or the stock of a company from an existing shareholder. Now, let's say you are the selling company: have you ever considered the importance of conducting due diligence of your business before seeking potential purchasers? It is important for a company contemplating a sale of its business to do a meaningful evaluation and due diligence of its legal, financial and business operations before putting the company on the market to avoid issues arising after a potential suitor has been found. In the sale of a home, a buyer will use the inspection report and appraisal to try to knock down the negotiated price, and in the sale of a company the buyer will try to do the same with information learned in the due diligence investigation. Therefore, a thorough review of your company's business, legal and financial operations prior to seeking to sell your business will allow you to both address potential obstacles to a sale and reduce the chances the buyer will try to renegotiate the purchase price for the business.
1. Is the Company's Legal House in Order? Legal due diligence is a significant aspect of the investigation that any potential buyer will perform. There are numerous legal areas the buyer will review, and the scope and of the due diligence will vary greatly depending on a number of factors, including the nature of the business, its location and markets. Obviously, there are some common questions relating to organizational structure, material contracts, existing or threatened litigation, ownership of assets, intellectual property, labor/employment, and environmental questions. But, there are also some less obvious issues that should be carefully vetted.
While not an exhaustive list, consider the following:
(a) Corporate Structure: Of course, you will want to make sure the company's organizational documents and records are in order, but also that there are no potential obstacles to the transaction. For example, do any of the shareholders/members or any other third parties have a right of first refusal, or other rights, that could interfere with the transaction? Is there anything in the By Laws/Operating Agreement mandating a super majority or even unanimous approval of a sale? These kinds of rights are often freely granted when emerging companies are desperate to obtain financing, and may come back to haunt the company when trying to sell.
(b) Permits/Compliance with Laws: The company will need to show it has the necessary permits or licenses as may be required for the business, but it also that it is in compliance with the laws of any jurisdiction where it operates. If you have an Internet presence, is the company in compliance with properly drafted terms and conditions and privacy policies?
(c) Assets/Intellectual Property: Can ownership/title to assets be demonstrated? Does the company own or properly license necessary intellectual property? If your business is licensing any key intellectual property or other assets, make sure the license is assignable/assumable in a sale or rights do not revert to licensor upon a "change of control" of the business. Another major concern is that the company has Invention Assignment Agreements or can otherwise establish its rights to intellectual property developed by third parties or even by partners, employees or consultants.
(d) Material Contracts: All material contracts should be reviewed to ensure they are assignable/assumable and that they don't terminate in the event of a sale of the business or change of control.
(e) Employment/Labor Matters: Make sure all the company's records are in order detailing information as to employees, including salary, sick/vacation time, and benefits. Is there an employee manual? Are there open employment or labor issues?
(f) Litigation: If there are pending litigation matters, be prepared to summarize the claims, and procedural status for a potential buyer. Also, consider, how you will propose to address these claims in the Purchase Agreement (i.e., who will assume responsibility for these claims and related costs). Has the company been threatened with any lawsuits or other claims?
(g) Loans/Liens/Encumbrances: Are any of the assets subject to any liens, are there company loans, and what are the obligations of the conmpany in event of a sale of the business.
2. Are the Financial Records Properly Maintained? Work with your company's accountant and internal finance department (if you have one) to make sure all of the financial records are organized and financial events properly recorded. The buyer will ask to see balance sheets, tax returns and audits, profit and loss statements, accounts, ledgers and all the back up information.
3. Keep Company Books and Records Well Organized. Make it part of good corporate procedures to maintain orderly books and records from the start. Do not wait until there is possible exit opportunity to then run around trying to gather the due diligence materials the buyer will certainly request -- for example, the company does not want to have to chase down an employee for a copy of an Invention Assignment Agreement or a release from a litigation that settled many years ago.
4. Back Up Files, Processes and Key Software. Maintain copies of key documents and files. Prepare a road map of important business processes as a buyer will appreciate anything that makes for a smooth transition. Keep back up copies of computer code. The point: for all important aspects of the business have in place a disaster recovery plan.
In sum, a company does not want to learn from a potential buyer that a major issue has been discovered -- especially if it could have been addressed by the company prior to the buyer's due diligence. Inevitably, due diligence issues will result in a reduction of the purchase price or create obstacles to closing the transaction. At the very least, due diligence issues discovered by a buyer will raise transaction costs as the parties, accountants and lawyers try to resolve and then document any agreed solution. Additionally, it is generally less expensive for a lawyer to draft the Purchase Agreement and accompanying disclosures and schedules if company records are well maintained and the Seller's attorney is aware of the issues, if any, at the outset of the transaction. Lastly, retain professionals (an accountant, a lawyer, a business consultant/coach, payroll company, etc.) who understand your business and work with you from the start of your company. By doing so, you are reducing the chance that the buyer's due diligence will uncover legal, financial or business issues that either dramatically undermine the value of the company or result in a termination of the sale.
Disclaimer: The discussions in this blog do not constitute legal advise nor create any attorney-client relationship. You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.