New Jersey Law Blog

Ensuring the Benefit of the Bargain - Due Diligence for Business Acquisitions

Before purchasing a business, the proposed buyer of company should request and review extensive documents about the target company’s ownership, function, income, assets, obligations and liabilities.  That process, called “due diligence” affords the buyer the last real chance understand exactly what he or she is buying. 

The importance of conducting due diligence in an organized and exhaustive way cannot be overstated.  Failure to do so could lead the buyer to unknowingly purchase a company that is not viable under new ownership, or a company that is facing serious legal or financial issues. Therefore, to ensure the benefit of the bargain, the shrewd buyer should take full advantage of due diligence.

Having represented clients in both local business and multinational corporate acquisitions, I’ve realized that the due diligence process for each is surprisingly similar. That is because no matter the size of the target company, buyers have universal concerns about the target company remaining profitable under new ownership. 
 
Depending upon the nature of the transaction, such as in the case of a small business owner who does not want to upset the employees, the sale purchase agreement may require the buyer to conduct due diligence discreetly by, for example, visiting the business off-hours or by only contacting a designated individual for follow-up.  Due diligence may also require a personal visit to the target company, or even the seller opening all of its files for review in a designated place (usually a conference room or online on a secure website).

Ideally, a trusted professional should issue the due diligence requests, and then review all of the responsive documentation. An experienced attorney can be invaluable in that respect by knowing exactly what documents to seek, by helping the buyer to identify irregularities in the responses, and by drawing  the buyer’s attention to the important risks of the deal.  It may also be beneficial to have an accountant review the financial documents provided in due diligence to advise the buyer as to the target company’s financial health.

In order to capture the complete picture of target business for the buyer, the due diligence requests and documentary responses should at least address the following aspects:

Corporate Documents
The buyer should review and understand the implications of all of the governing documents for the target company along with minutes of the board of directors or shareholders, Certificates of Good Standing; stock certificates and stock ledgers.  That way, the buyer can understand how the company has operated and how it should continue to operate under new ownership.

Intellectual Property
Name recognition is always an issue.  Therefore, the buyer should review evidence of any trademarks, trade names, service marks, patents or copyrights that may be registered, pending, rejected, searched, or even contemplated by the target company.  The buyer should also seek a list of all know-how, trade secrets and technical information material to the target company’s business to make sure that the buyer will be able to continue to operate the business after the acquisition.

Furthermore, the buyer should analyze the way the target company has protected the intellectual property, and should review all contracts or documents relating to the protection of proprietary information such as agreements with independent contractors, confidential information policies and non-disclosure agreements.  Otherwise, the intellectual property may not be worth very much if it has been or may easily be disclosed to the public.

Material Contracts and Agreements

The buyer needs to know if the target company is contractually obligated or restricted from taking action after the acquisition, and whether or not the target company may assign all of its business contracts to the buyer as the new owner. For example, if most of the target company’s revenue stems from a service contract with a local government, the buyer should ensure that the target company will be able to continue providing services under that contract even after the buyer becomes the new owner.

It is therefore imperative for the buyer to review all of the contracts that affect the target company’s performance.  Some examples include the target company’s credit agreements, mortgage agreements, financial or performance guaranties, notes, indemnifications, sales & service agreements, non-solicitation agreements, non-compete and marketing agreements.

Litigation
Thorough due diligence includes a search to determine if the target company is subject to or even threatened by litigation that may be extremely expensive to defend.  While the claims facing the target company may be of little substance, the buyer should at least know what to expect, and to make sure that he or she is properly indemnified against the cost of pre-existing claims or litigation in the sale purchase agreement. 

Employees
The buyer should be able to identify at least the key employees to understand how each one contributes toward the target company’s daily operations, in addition to understanding how the employees are (and may continue to be) compensated. In that respect, the buyer should review all: employee lists, employment agreements, benefits policies, retirement plan policies and compensation schedules.

Financial Information
It is often advisable for the buyer to have an accountant review the target corporation’s income tax returns and financial statements to evaluate the target company’s financial health, to determine if there are any tax issues, and perhaps to advise if the purchase price is fair under those circumstances.

Property
Because the target company’s real and personal property may be the most expensive aspect of the deal, the buyer needs to know all of the details surrounding such property.  Buyers therefore often seek bills of sale, deeds, appraisals, depreciation schedules or restrictions on that property.

Insurance
The buyer or the buyer’s attorney should review all material insurance policies affecting the target company, and should ensure that the policies are appropriate and up-to-date.

Governmental Regulations
Finally, all target companies answer to a higher authority . . . the government.  Therefore, the buyer may request OSHA, EPA, IRS, EEO, or other governmental agency inquiries, as well as copies of all permits and licenses necessary to conduct the company's business.

After conducting due diligence, the buyer should have a full understanding of the target company and its relative value as a going concern.  If the buyer chooses not to conduct extensive due diligence, well, caveat emptor.
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