By Jeff Wolfe
As business attorneys at the Forrest Firm, we often represent clients as they negotiate and enter into strategic transactions with other companies, such as mergers and acquisitions, strategic alliances, and joint ventures, and licensing. One of our most important jobs as attorneys is guiding our clients through the process of due diligence associated with these types of transactions, especially with regard to the mergers and acquisitions that occur between companies on a regular basis.
In this series, we’ll take a look at a few aspects of due diligence, from our legal perspective. First, let’s take a look at the big picture.
In the M&A context, due diligence is the term that generally describes an investigation by one party to a transaction of the other party, usually focused on analyzing the value of the target company, as well as the risks/liabilities involved with acquiring the target company. From a big picture perspective, however, it is not just the investigation that matters. Rather, due diligence encompasses the entire process of gathering, organizing, analyzing, reporting, and sharing information related to the target company.
In a traditional, negotiated M&A transaction (as opposed to a hostile unsolicited bid or an auction sale), the due diligence process typically begins with the target company providing due diligence information to the buyer and its representatives (lawyers, accountants, etc.), as requested by the buyer. Since the request list needs to be comprehensive, the buyer’s legal counsel usually prepares the due diligence request list (sometimes called a checklist) that provides a detailed list and description of the information it would like to review.
This information should only be disclosed by the target company after a confidentiality and non-disclosure agreement has been signed by the parties. It’s also common for one or more follow-up request lists to be sent to a target company since the review of the initial set of documents provided may trigger additional questions and inquiries. Although historically a buyer was granted access to diligence documents in a physical data room, electronic data rooms are now the norm.
Depending on the scope of the due diligence request list and the operations of the target company, the amount of information provided by a target company can be overwhelming. Accordingly, reviewing information requires a collaborative effort by the target company and its representatives. To ensure that this process is efficient (both from a cost and timing perspective), the scope of the legal counsel’s review should be clarified in advance. For instance, the target company may choose to handle review of financial records internally or pass along such review to its outside accountants or financial advisors.
There is typically a time crunch during the review period so ineffectiveness in coordination may delay the closing of the transaction, or worse, result in red flags being missed. Cost is also an important consideration, since the due diligence process can be very expensive due to the amount of information and the number of specialists involved.
Once the due diligence materials within its scope are reviewed, and assuming there is sufficient time, the buyer’s legal counsel usually drafts a legal due diligence memorandum that summarizes the material findings of its review. Although important matters should be brought to the attention of the appropriate individuals immediately, the due diligence memorandum provides an opportunity for a buyer to review a detailed summary of the documents reviewed on its behalf.
This summary not only provides an overview of the target company, but it also describes issues that arose from such review and recommended actions. Depending on the size and complexity of the target company, a due diligence summary can be lengthy so important issues should be appropriately highlighted in an executive summary or other manner for executives of the buyer to quickly identify.
Armed with this due diligence analysis, the buyer then decides whether to move forward with the transaction on the current terms, or pause to renegotiate. If the lawyers are communicating red flags properly and meeting regularly with the buyer to discuss the status of its review, hopefully there are not any surprises at this stage, but this may be the best time to ensure that all critical information has flowed up to the decision makers. There may be some additional questions the buyer has, or additional analysis it wants legal counsel to conduct, so delivery of a due diligence memorandum should not be treated as a last-minute delivery requirement just to provide liability protection for the legal counsel.
Even if a deal moves forward, red flags raised in the due diligence process can play an instrumental role in the transaction negotiation. For example, the buyer may insert closing conditions for loose ends that need to be resolved prior to closing, or a specific indemnification provision may be drafted around an issue identified in the due diligence process.
Also, comparing the disclosure schedules to the information in the diligence memorandum will help determine whether additional information should be requested (if information is mentioned on a schedule but related documentation has not been reviewed) or questions should be asked (if information was provided in the diligence process but not disclosed on a schedule).
In our next installment, we’ll look at assignment and change of control provisions that require careful analysis.