By: Robert C. Hackney
The process of the due diligence investigation is one that can take as few as a week or as long as a year. It can run from a fairly inexpensive process to an extremely expensive process depending upon how much cost the buyer is willing to incur. There are two main thrusts of the due diligence process. The first one focuses on the financial condition of the target, its prospects for the future, and the intricacies of its operations, primarily with a view towards evaluating the company from a buyer’s pricing standpoint. The purpose here is obviously for the buyer to come to some conclusion as to what he would be willing to pay for the company.
The second purpose, or focus, of the due diligence process is to uncover or ferret out any problem areas that will either kill the deal or will at least make the buyer think twice about what he is buying. The due diligence information that the buyer will accumulate will come from two generic sources. The first being the target itself and the second being outside sources, such as the state agency that regulates corporations, the local property appraiser’s office, the local governmental offices where deeds and uniform commercial code lien documents are filed and the other applicable federal, state and local regulatory authorities.
A buyer should always work from a due diligence checklist. In a separate post I’m going to give you an outline of what I typically use as a due diligence checklist, but keep in mind that the checklist has to be tailored for the specific target. The checklist I use is usually broken down between a checklist for reviewing and evaluation the target’s financial condition, and a checklist for reviewing and evaluating the target’s operations.
Operations of the Target
Let’s talk about operations first before we get into the financial component of the target’s business. I always start at the target’s beginning. By that, I mean that I want to know about the target’s organizational structure. First you should obtain the company’s certificate of incorporation or articles of incorporation as filed with the state agency that granted the company its original charter to begin business. One of the most important basic things that you can glean immediately from the articles of incorporation or certificate of incorporation is the exact specific name of the target, because some targets you will see referred to as having their name ending in “Inc.”, or “Corp.” and their name might really end in the full word “Corporation” as opposed to “Corp.” or “Incorporated” as opposed to “Inc.” and there are variations on names that create problems when you start doing your checking on property and liens as filed with the governmental agencies.
Be sure that you obtain not only the original incorporating documents of the target, but all of the amendments that have been made over the years. There could have been a name change of the company or more typically there may have been a rearrangement of its capital structure. You want to know how many classes of stock there are outstanding and if the different classes carry different voting rights or preferences with regard to dividend or distribution. You need to also look in the certificate and the amendments for items such as preemptive rights and control provisions and/or any anti-takeover provisions that may be contained in those documents.
Along with the incorporating documents from the state agency you will need to also obtain the corporations bylaws and corporate minutes. These documents will tell you information such as the terms of office of your directors, whether or not you have a staggered term for the board of directors, who the officers and directors of the corporation are and whether or not any poison pill type anti-takeover provisions have been adopted by the company.
You are also going to want to obtain the stock record book showing what transfers of shares have taken place and analyze whether or not those transfers were done properly. This is fairly easy in a small closely held company, but if your target is a public company, you are obviously going to have to get a stockholder list and other information from the company’s transfer agent. You want to also ask the target if there are any stockholder’s agreements among the majority stockholders because they may contain buy-sell agreements or restrictions on voting or there may even be a voting trust agreement among some of the more substantial stockholders.
Obtain any reports that the company has issued to stockholders. Obviously, if they are a public company they will have annual reports of some type, but also many privately held companies prepare some form of an annual report so you want to see if they have any documents like that. When you are reviewing the corporate minutes, they should reflect whether or not a pension, profit sharing, or stock option plan of any type has been adopted. If such is the case, you need to obtain a copy of any such plans that would currently be in effect. You should also ask for all employment contracts to review their substance.
The next section on the operational side after you look at all of the organizational type documents, is usually the contracts or agreements that the company has in place and these would include the following: any and all loan agreements, which includes security agreements, agreements regarding lines of credit, promissory notes, corporate bonds, corporate debentures, or other debt instruments including any guarantees that may have been made by some of the target’s management or stockholders. Underneath the loan agreements you want to look at and ask for any correspondence with the lenders to see if there are any defaults or there were any defaults or if there has been any acceleration of any loan agreement, or if any loan agreements have previously been terminated or are on the verge of being terminated.
Second, you want to know whether or not there are any collective bargaining agreements or other negations regarding union or any unionization attempts that are being made.
Third, you want to review any real estate leases that the company has or leases that they have on equipment, such as computers, heavy machinery or other items that are material to the operation of the business.
Fourth, you want to ask if there are any royalty or license agreements and you want to review those agreements if they exist.
Fifth, you want to determine if there are any marketing or distribution contracts and if the company uses some independent distributors, you want to determine the depth of those relationships.
Sixth, you want to find out if the company is a participant in any joint venture or partnership and get copies of those agreements if they exist.
Seventh, you want to find out if there are any patents or trade secrets or any confidentiality agreements that relate to those patents or trade secrets.
Eighth, you want to obtain all of the information about the company’s computer systems, their websites, their network, their firewalls, their anti-virus software, their encryption technology and all computer security systems to avoid hacking.
One of the most important groups of contracts that you need copies of will be the company’s insurance contracts. You are looking to determine if you have got enough coverage for the risks that the company incurs. You want to review the liability limits and the amounts of deductible. You need to know whether or not these policies are on a “claims made” basis or on an “occurrence” basis, do the policies have reservations of rights clauses, and what are the exclusions under the policies. Next, are there any product warranty agreements and what are the terms of those agreements, if they exist?
Moving out of the contracts and agreements area, you want to go to the asset identification area and here you are going to be looking for deeds for the company’s real estate, bills of sale for the company’s major assets, and encumbrances on company assets. Undoubtedly this will go back to some of your loan agreements, if there is any kind of a revolving credit facility, but there may be some mortgages on the real property, for example, or UCC liens on some of the assets that aren’t covered in other documents that you will need to review.
Moving out of the asset area of operations, you should next go to the labor relations area. Are relations with the labor or labor unions satisfactory at this time? Are there any labor agreements binding on the buyer? Do those agreements restrict the buyer? Is the target presently in violation of any of the terms of such agreement? Has there ever been a strike? Is it likely that a strike will occur in the future? Are existing employment contracts with management binding on the buyer or will they terminate at sale? What kind of benefits and severance agreements are in place with both management and other employees.
Under operation, there are two other areas of concern that will require you to ask a number of questions. Those are the areas of sales and the product information questions. When looking at the company’s sales, you should ask the following questions.
1. What is the target’s competitive position with regard to its sales?
2. Do the target’s sales personnel perform to the goals met by the target’s competitors?
3. Are the commissions and incentives paid to the target’s personnel competitive in the marketplace?
4. Is advertising used by the target current and timely?
5. Where are the target’s principal customers geographically located?
6. What are the percentage of sales attributable to each of the target’s principal customers?
7. Does the target use market research in connection with its sales and marketing strategy?
With regard to the target’s products, the buyer must obtain a description of all of the target’s products, the volume sold of each product, and the backlog of orders of products. The buyer needs to evaluate the markups on each product and whether or not there are any patents and licenses and what kind of exclusivity and terms are connected to the licenses. Are the target’s products competitive in the marketplace with regard to price, quality, and style? Is the target meeting present demand for its products and is there the potential to expand if production could be increased? What new markets are there for the company’s products? What is the obsolescence factor with regard to the target’s products? Does the target have an ongoing research and development strategy? What projects are being worked on and what is the size of the R & D budget? Is there much turnover in the research department? Is the target’s R & D long term oriented or short term oriented? How does the target’s budget for R & D compare with its competition? How does the target’s budget over the last few years relate to its earnings then as compared to its earnings presently?
Assuming that the target is involved somehow in the manufacturing process, the buyer needs to evaluate the condition of the plant, machinery and other facilities. What is the market for raw materials? How have raw materials costs changed over the last five years and what is anticipated for raw materials expenses in the future? Does production per employee compare favorably with other companies in the same industry? Will the target have to relocate its facilities to increase efficiency? Are the target’s manufacturing controls adequate? In the event that sales and business generally increase, can existing facilities accommodate such increases?
I’m going to tell you where to look when you are searching outside sources for information on your target, but before I do that, let me mention two operational areas of great concern, and I can’t over emphasize their importance. The first area is the one of pending or threatened litigation against a target. When you are reviewing your insurance policies, they need to be reviewed with regard to what they cover and what they exclude, and if there is pending or threatened litigation, there must be an analysis done to determine exactly what kind and how much coverage you will have under your existing policies. As a buyer, if you are buying assets, and not stock, you generally would not have any liability for the debts or the torts of the seller. The word “general” is misleading, because in specific situations the buyer can be liable and those situations are where there has been an agreement to assume that liability in the acquisition agreement or if the buyer is deemed to be involved in a mere continuation of the predecessor, or if the transaction was created solely to avoid liability and could be set aside as fraudulent conveyance.
As a buyer, if you purchase assets but you keep all of the seller’s employees, you will almost definitely be required to continue to recognize and bargain with the unions that are in place, if any. If you are continuing to manufacture the same products, there is a good chance that you will be liable for product liability claims brought by individuals who are injured by a product manufactured by your predecessor. When you look at your insurance policies, you also need to determine if they are for claims made or occurrence. An occurrence type policy is one that continues after the cancellation or termination of the policy and is for claims that arose during the period of insurance coverage. So for example, if you have a policy with one company and it is in effect December 31, 2018, and a person is injured during that time period, but they don’t report it until sometime in 2020 or 2021, and by then you have changed insurance companies, if that is an occurrence type policy, then the insurance that was in effect at the that time would cover the calm.
Recently, there have been a lot more of the claims made type policies issued and those are policies that cover only the claims actually made to the company during the term of the policy. If you have insurance of a claims made type in effect in 2019, and the claim is brought that year, that policy should cover that claim. You also need to see if the policies had what is commonly referred to as a tail, and that is a special policy that continues coverage that would otherwise be terminated. Policies and or state law may not permit coverage for putative or treble damages so the policies and the state law have to be reviewed with regard to those issues.
Litigation Analysis
Any litigation that is ongoing should be reviewed by an experienced litigator or someone who is trained to analyze litigation. The target should provide you with a summary of all pending litigation which is not a status report of the litigation, but an outline of what relief is being sought by the plaintiffs, what insurance coverage is involved, an estimate as to the cost of the litigation, and a copy of any legal opinions that have been rendered concerning the actions involved in the litigation.
There are two specific areas in litigation analysis that are extremely important to your review of your target. First is in the area of severance plans. Severance plans have become important topics, because some recent court cases have held that they are in essence employee welfare benefit plans and that as such they are subject to the disclosure, reporting, and fiduciary requirements imposed by ERISA (the Employee Retirement Income Security Act).
The second area of major concern in litigation analysis in connection with mergers and acquisitions is the area of environmental law. Even if the business you are acquiring is not one that is traditionally thought of as having environmental problems, you should keep in mind that there are some non-traditional problem areas. These include fuel tanks that the target may use to fuel its vehicles or onsite generators or asbestos, which could be contained in the company structures, such as its warehouses or even its retail operations. Many facilities have electric transformers and PCBs are an environmental troublemaker. Because federal environmental law is so stringent, a buyer can be devastated by an environmental problem that is discovered after he closes on the target. If a target is only one of the companies that have contributed to pollution of a common site, they are still going to be held liable jointly and severally for cleanup cost. A buyer can even become liable if he purchases assets as opposed to stock, so an asset purchase won’t protect you. Under the theory that you are continuing the same business as your predecessor, a buyer will typically be liable even though he didn’t expressly assume the liability in his acquisition agreement. The major problems of environmental liability are that officers and directors and sometimes even shareholders can be held personally liable. Clean up costs are astronomical and with joint and several liability, can be far in access of the value of the target that has been purchased. Finally, it can take years before there is a final determination of the liability and that generally means years of litigation costs which in and of themselves can put you out of business.
My best advice to a buyer where there is a potential environmental problem is to first obtain an audit report from a qualified environmental analyst and then make sure that if you go through the transaction that the seller’s warranties in his acquisition agreement are going to cover environmental liabilities and even liabilities that result in offsite pollution. You have to make sure that these warranties survive as long as possible because problems can come up long after your closing. That should tie into either some escrow provisions or some offset provisions if there is seller financing involved in the transaction. You should also try to have a provision in the acquisition agreement warranting against all actions which caused pollution whether or not those actions were illegal when they were taken. The reason for this is that federal environmental liability can be imposed for actions taken before the adoption of modern environmental protection laws. Many companies shipped environmental waste by unlicensed carriers and had waste delivered to unlicensed sites at a time when that activity in and of itself was not illegal. If such activity caused pollution, and the environmental regulators come after the target now, liability can be imposed for those prior actions.
Now before I go to the financial due diligence side, let me give you some tips on to where to look for information outside the target source. First of all, each state has its own agency where the state’s corporations are incorporated. In Delaware and in most states it is usually the office of the Secretary of State, so you can obtain from them the certificate of incorporation or the articles of incorporation, whichever they call it in their state. There are also companies that will perform searches of public records for you and it is important that you use them to see if there are any uniform commercial code filings which would reflect any liens. Typically those liens are recorded at both the state and the local levels. You should also check with the U.S. Patent and Trademark office to see if there is the possibility of any products or names that the seller is using that may be infringing upon existing patents or trademarks.
Financial Due Diligence
Let’s go now to the financial due diligence side. If the target is a public company, the first thing you will do will be to obtain copies of recent 10-K, 10-Q and 8-K filings, as well as any registration statements that have been filed by the target. When public companies are involved in mergers, and the filing of a registration statement is required, they use Form S-4 and in that form you will find historical financial information as well as pro forma financial information. So, if your target has been through a merger in recent years, you can and should look at that information. You will need to receive a copy of the most recent audited financial statement as well as the most recent un-audited financial statement.
Management usually creates projections and that information should be obtained from management. Financial statements for the preceding five year period should be obtained and reviewed as well as schedules of bank balances reflecting both current and average balances over the preceding five year period should also be obtained. Usually lenders will require that a minimum cash balance be maintained by a debtor and any information regarding that kind of requirement should also be obtained. A credit report from credit reporting agencies such as Dun & Bradstreet should also be obtained. The tax status of the target: federal, state and local, should be reviewed. Are there any loss carry forwards? Are there any claims for refunds from taxing entities? Has the company been audited in recent years?
You need to obtain a specific breakdown of accounts receivable. I would review closely a detailed description of the general and administrative overhead expenses over the last five years. Review provisions that have been made in the financial statements for employee benefit plan obligations and whether or not those reserves are adequate. You should obtain a description of the company’s intangible assets as well as descriptions of all of the companies long and short term debt. If any investments are reflected in the financial statements, the specific details of those investments must be obtained.
Read closely the notes to financial statements and make sure that you understand them fully. Any unique or unusual items are usually reflected and explained in these notes to the financial statements, so if the company is giving you a balance sheet and a statement of operations that just contains the numbers, make sure that you get the rest of the details.
The following questions are ones that you typically would need to ask with regard to the company’s financial condition and financial statements. What is the condition of the company’s inventory? How much of it is obsolete? What effect will the value of the inventory have on the balance sheet if it is written down to its liquidation value? Is the seller willing to maintain ownership of the inventory, if you will buy it from him on a consignment basis, and agree to try to sell existing inventory first. What are the differences between the tax and the book basis for the fixed assets that are shown on the balance sheet? Are there any assets not recorded on the target’s books? Have any items of previous tax returns been disallowed? Are any items subject to possible disallowance and if so, what effect would that have on the company’s future financial position? Are the reserves for bad debts adequate? Are the target’s credit lines sufficient if expansion is anticipated? How does the target record and determine cost of inventory?
Because of the variations contained in generally accepted accounting principles, the buyer must ascertain the method that the seller has used and the assumptions that have been made in accounting for each of the components on the target’s income statement. The buyer’s analysis will probably involve recasting the target’s income statement so that it can be measured in different ways, or if the buyer seeks to marry the target to his existing operations, he’ll need to recast the income statement, so that it is consistent with the method that the buyer is presently using.
The target’s balance sheet would then be examined to determine the effect of the adjustment in earnings that would result from the recasting of the income statement and to determine the accuracy with which items such as taxes, contingent liabilities, fixed assets, inventory, receivables or expenses are reported. Again, this type of an analysis should be done by qualified accounting personnel who have substantial experience with the intricacies and variations contained in generally accepted accounting principles.
Let’s summarize this post on the due diligence process.
Remember that the two initial purposes of the due diligence process are:
1) to find any problems that may kill the deal or affect the price and
2) to verify information to assist you in setting the price.
Don’t’ forget to check the outside sources of information as well as the information you get from the target itself. Remember to break the process down to operational due diligence and financial due diligence. In your litigation analysis, don’t overlook or be blindsided by either the severance plan issues or the environmental issues. And last, have your accountants recast the target’s financials using different accounting methods for the inventory, depreciation, and the like.
Good luck and happy hunting!