Due diligence, due diligence, due diligence - need we say more?

Saturday, June 1, 2002

In this era of corporate scandals it is hardly surprising that the term due diligence has become more relevant.

In general terms, due diligence refers to doing your homework properly when enacting any sort of business deal. Due diligence is understood by the legal, financial and business communities to mean the disclosure and assimilation of public and proprietary information related to the assets and liabilities of the business being purchased.

This information includes financial, human resources, tax, and environmental and legal matters. This review requires the buyer, or his underwriter or investment banker, to review all of the corporate documents of the company, the backgrounds of the management team, pending and threatened litigation, intellectual property issues etc. This review must be thorough, complete, and, with the new SEC standards, for public cases, in some instances go beyond the material provided by the company.

Due diligence provides the buyer an opportunity to confirm the accuracy of the information disclosed by the seller. It also helps the buyer determine whether there are any potential business concerns, including, for example, the assumption of noncompete obligations, questionable receivables, liens on title to the assets, changes of control or assignment restrictions, government approvals or other issues that need to be addressed in the definitive agreement. It also helps the buyer evaluate and plan for the integration of the seller's business.

Due diligence helps the seller ascertain rights that should be retained by the seller, determine any obstacles that could delay the closing, and aid in the preparation of the seller's disclosure schedules for the definitive agreement.

One of the advantages to a stock deal is that due diligence focused on a public company is generally a much easier process than due diligence focused on a private company. Data on public companies is simply easier to obtain. Due diligence for public companies often focuses on the carefully crafted mechanisms a deal professional will provide to protect the seller's price despite the shifts in stock value. There are also sometimes legal limitations on when stock acquired from the sale of a business can be sold.

Investment bankers sometimes say, "the deal dies three times." A likely point of mortality is the due diligence process. If a buyer suddenly feels misled or surprised by a business issue in due diligence, that buyer may simply walk away from the deal or substantially lower the offer.

The advantages to buying an existing business typically outweigh the disadvantages. Existing businesses can usually obtain financing from financial institutions because they have an established history, assets, and a proven idea. Or the seller of the business will provide a portion of the financing in the form of a loan. Established businesses are less risky because there is an existing customer base, relationships with suppliers, operating processes, a known location, and employees have already been hired and trained. In addition, existing cash flow often provides some immediate income to the buyer.

This extra value only accrues if the business is being accurately presented to the seller, who has a limited timeframe under which to conduct this review. A good investment banker in a decent market will have processed multiple offers before selecting this buyer to "go the distance."

A common tactic used by unscrupulous buyers with inexperienced sellers is to draw out the due diligence process to unreasonable lengths to increase the seller's anxiety and desperation. The end result of this charade will be a much lower offer being made, the other buyers having long since moved on to other deals. An experienced deal professional will be wary of this and a professional buyer will know it.

Most deals that fail don't do so because the price was too high or there was some hidden bombshell. The failures, for the most part, are due to a failure in the post acquisition integration. This is all the more reason for careful due diligence on the part of the buyer.

This problem is compounded by the behavior of some business owners. Every business has a certain number of skeletons in the closet, and one of the duties of a deal professional is to help with these issues before due diligence. Every deal professional has a story of an owner who was unwilling to bring a problem to the professional's attention until it was discovered by the buyer during the due diligence process.

At that point either the deal really is dead or the owner can expect a substantially lower offer.

John Mack is the president and chief executive officer of Santa Monica, Calif.-based USBX Advisory Services, a business advisory firm that provides mergers and acquisitions services to small and medium sized businesses.