Friday, March 28, 2014

Due Diligence and the Business Transaction: Making the Examination Fit the Deal

Even fledgling entrepreneurs are aware of the importance of conducting due diligence in a business transaction, but possessing a true understanding of the process is another story.   A simple dictionary definition of the meaning will generally focus on analyzing a company in the context of corporate mergers or a stock purchase.  However, as with any simple definition, reducing an understanding of a due diligence investigation to a few words paints a woefully incomplete picture of its significance in a business transaction. If there is any one concept that should be emphasized before entering into any business transaction, it is this:  Do not engage in any important business transaction until a due diligence investigation that is tailored to the the nature, scope, and terms of the transaction has been completed. 

We conduct due diligence all of the time in our daily lives.  We make decisions about purchasing goods or engaging someone's services based on certain considerations with or without consciously realizing that what we are actually doing is a form of due diligence. It is common for us to conduct due diligence and make decisions about familiar and not-so-familiar transactions—such as trying a new restaurant, downloading a smartphone application, buying the latest high-definition television, hiring a lawyer, and so on— and although we might not realize it, we routinely engage in legal, financial, technology, personal, and other forms of due diligence depending on the product or service we are considering buying.  the legwork required to be a well-informed consumer and to ensure you are getting the right product or service at the right price is simply a less structured and less detailed form of the due diligence an entrepreneur should perform before entering into a business transaction.

Before purchasing a product or engaging a service, diligent consumers research the company/service provider, research the product or the services, try to determine the value of the product or services being offered, and, sometimes, conduct a background check or investigation of potential hires. Parties to a potential business transaction apply due diligence criteria similar to those precautions consumers perform before buying products or hiring professional services:  they will investigate the company and its business operations, research the products or services offered by the company, determine the appropriate valuation of the target business, examine management capabilities and perform background checks and investigations of founders and key personnel.  Due diligence therefore involves the process of examining and developing the necessary level of understanding of (i) the company and (ii) its business operations (in other words, its products, assets, and/or services and how the company functions); (iii) determining an appropriate valuation of a business and the transaction; and (iv) vetting personnel (management capabilities, key personnel and employment matters) before entering into a business transaction with, investing in, licensing assets or services of, or purchasing all or part of a business or its assets. I call these four aspects of any business the business cornerstones.

Whether you are buying or investing in a business, entering into a joint venture or partnership, considering making a business loan, or entering into a variety of other business transactions, you should focus on these business cornerstones before entering into any type of transaction.  While the amount of focus given to each of these areas varies greatly depending on the nature of the transaction and the goals of the parties, these four aspects of any business should comprise the basis for the due diligence investigation. What should you learn from your examination of the cornerstones? The goals of a due diligence examination corresponding to each of the four business cornerstones are shown in the Table below:

Table:  Due Diligence Goals
The Business Cornerstone
The Due Diligence Goal
The Company
To understand the legal and financial structure of the company and identify potential organizational or structural risks
The Business Operations

To understand the nature of the business and its products, assets, and services; the operational aspect of the business, and to identify potential legal, financial, and business risks

To determine an appropriate valuation of the company and/or the transaction and identify potential financial risks

To identify the key personnel and ascertain whether they are capable of operating the business, executing business plans, and/or fulfilling post-closing obligations

The common denominator of these four goals is that the due diligence process impart to you a level of understanding of the company, its business and operations that is sufficient to enable you to decide whether to engage in the contemplated transaction. To achieve this appreciation, the due diligence investigation necessarily involves, not only examining materials and data provided by the company or your potential business partner but also information obtained from various sources, including public and private information and the advice of professional consultants. 

Simply put, think of due diligence as a process of first hearing the company’s business story—as it may have been provided in an investment presentation or business plan—and then conducting an investigation to corroborate the story. A proper due diligence examination will focus on the four business cornerstones, and includes not only broad-based legal and financial questions, but also requires that you identify the critical areas of the business and thereby gear your inquiries to the specific business and the nature of the transaction involved. It is not enough rely on the standard due diligence set of questions; instead, tailoring the due diligence to the target company’s business operations and the underlying facts of the transaction is essential to conducting a productive due diligence examination. 

For a a comprehensive discussion of the role of due diligence in a wide variety of business transactions, please see Due Diligence and the Business Transaction:  Getting a Deal Done, by Jeffrey W. Berkman (Apress 2013) (available on Amazon and Barnes & Noble) 

Disclaimer:  The above is for informational purposes only and does not constitute legal advice.  You are advised to consult an experienced business lawyer before entering into any business transaction.

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