It is difficult to overemphasize the importance of due diligence during a company’s acquisition transaction. Since the investigation aims to uncover the risks associated with purchasing the target company, the outcome of due diligence may result in a significant decrease in the purchase price or even discourage the buyer from proceeding with the deal.
Different factors determine the scope and items of due diligence. These include the nature of the transaction, such as a stock versus asset purchase, industry-specific and business-related concerns, the size of the transaction, and the parties’ preferences regarding diligence limitations.
In the current technological era, due diligence usually starts with establishing a virtual data room (VDR). The seller and the seller’s attorney upload the documents, as agreed with the buyer, to the VDR. The buyer and the buyer’s attorney review all documents provided by the seller to assess the risks associated with the target, the seller, and the acquisition.
The parties typically agree on an approximate timeline for due diligence efforts; however, the buyer may reserve the right to request additional time if certain risks are identified during the diligence process. For example, the buyer can request that the seller initiate an audit if the seller does not have audited financial statements. The process naturally extends the timing of due diligence.
An illustrative list of diligence items can be grouped into the following categories:
Governing and Capitalization Documents
The review of these documents is required to determine the company’s owners’ authority to participate in the transaction, assess the need for shareholder consent to approve the transaction, and identify the required percentage of shareholders for the consent. Additionally, the buyer requests documentation confirming the target’s capitalization, including shareholder agreements, stock certificates and stock ledger, documents related to equity purchase, contributions, etc. These documents help understand the company’s ownership structure, its owners’ rights, and transfer restrictions.
Financial Information
Financial statements for the last several years are crucial in determining the actual value of the target company, including its liabilities, solvency, accounting practices, and overall financial condition. Financial statements include income statements, balance sheets, and cash flow statements of the target company.
Financing Documents
The analysis of bank loans, promissory notes, lines of credit, and other financing documents provides a clear picture of the target company’s solvency and its financial capacity, as well as the steps taken to meet its liabilities before third parties, which directly impact the company’s prospects for future growth and performance.
Material Contracts
A target’s customer and supplier contracts, for the most part, determine its value to the buyer. Therefore, a buyer reviews these agreements to confirm they are transferable and assignable, as any restrictions can significantly diminish the company’s worth.
Employment Documents
Employment due diligence may involve reviewing employment and severance agreements, collective bargaining agreements, medical and life insurance, pension plans, etc. The primary objective of this review is to identify the rights of target employees, compare them with the buyer’s employees’ rights, and determine the most effective ways to integrate them into the buyer’s business. Moreover, the employment due diligence helps discover the target’s employees’ grievances and potential employment lawsuits, which can be detrimental to the buyer’s business in the future.
Litigation
Identification of existing or potential litigation protects the buyer from reputational damage and overpayment in the transaction. Having evaluated the scope and impact of the litigation, the buyer may reconsider proceeding with the transaction altogether. Some information can be found through public records; however, information about ongoing or threatened litigation and disputes usually is not in the public domain. Therefore, the seller’s relevant representations in the definitive agreement are important.
Property Diligence
The purpose of real property diligence is to determine its true value, assess its condition, uncover environmental hazards, learn zoning requirements, and reveal any structural damage and potential liabilities. In order to complete it, the buyer should request deeds, leases, title documents, zoning approvals, and preferably visit the premises. Additionally, property diligence is performed to verify that the seller holds a clear and transferable title and can convey it to the buyer. Similar diligence can be performed regarding personal property if it is a part of the transaction.
Environmental Diligence
A visual inspection of the premises is always recommended to identify hazardous materials on site, their improper disposal, and the seller’s compliance with existing environmental regulations. If agreed by the parties, the environmental diligence can be even more detailed and include laboratory testing, such as soil testing. Furthermore, the site inspection and review of the target environmental policies help determine their alignment with the buyer’s environmental policy.
Intellectual Property
Intellectual property rights are especially important for companies that build their businesses on innovation, such as technology, cosmetics, and pharmaceutical companies. If patents, copyrights, and trademarks are essential to the acquired business, the buyer is advised to verify the relevant registration records to determine if the target company still owns the intellectual property rights and if they can be transferred to the buyer upon acquisition of the company. For intellectual property that does not require registration, the buyer should request and review the original agreements through which it was acquired and verify the target’s ownership.
Tax Documents
In addition to identifying the target company’s tax liabilities and evaluating the risk of penalties for non-compliance, reviewing tax documents helps structure transactions in a tax-savvy manner.
Insurance Documents
Analyzing insurance documents, including property, product liability, workers’ compensation, and other insurance policies, helps assess the target’s risk management approach, evaluate existing coverage and the need for future coverage, assess the possibility of transferring existing coverage to the buyer, review the claim history, if any, and more.
In conclusion, due diligence is a highly tailored process, with its scope shaped by the transaction’s specific size, industry, and nature, as well as the particular priorities of the parties. There is no universal checklist, and a truly comprehensive review must extend beyond documentary analysis to include physical and operational diligence. The goal of the process is to identify risks inherent in the acquisition and build a clear path for successful post-acquisition integration.