Due diligence in general
Since “due diligence” comes up so often in the discussion of acquiring an existing business, it begs the question: what should you be reviewing or looking for on a basic level when purchasing a new business?
Well, before we get to that, consider this: there are three aspects to due diligence:
First, is the legal aspect.
Second is the financial aspect.
Third, is the operational aspect of the business.
We’ll focus on legal due diligence with some insights into financial due diligence in the following sections.
When is due diligence conducted?
Due diligence can happen before or after the purchase agreement is signed. I’ve seen it happen both ways. It’s usually limited to some agreed upon period of 15 – 30 days and is dependent on the ability to quickly obtain relevant information from third parties and the seller.
Due diligence is your “out”. If something doesn’t add up for you in a material way, then get out. If you find that the seller is not disclosing critical information, then you may want to get out. If you find that you cannot locate or obtain critical information, then you may want to get out.
Legal due diligence
Legal due diligence starts with understanding that there are three key relationships in a business: the owners, the employees, and third parties such as customers, vendors, etc. Specifically, you are trying to determine if any of those relationships, or anything about those relationships, pose a risk (or added value) to the business you are purchasing regardless of whether it is through a stock or asset purchase.
You want to identify whether those business relationships impose any contractual obligations to or from the business you are purchasing. You want to identify whether those business relationships might be setting the stage for potential liability or risk such as a lawsuit. In the following three sections we look at these three basic relationships in greater detail, the type of documents to request, and some of the basic issues that may arise.
- Business owners – the business structure
Legal due diligence often entails understanding the structure of the business you are purchasing, especially if you are making a stock purchase. For example, you will want to make sure that the individuals authorizing the subject transaction are the only individuals whose authorization you need in order to get the deal done. This means you want to know who owns the business and whose signatures you’ll need in order to approve the anticipated transaction.
You will also want to ensure that once the business is purchased the prior business owners don’t have some continued stake in the revenue or assets of the business (unless for some reason that is your intention). Generally, however, once the business is sold it should be a clean slate – bye-bye prior owners (with some few exceptions we discuss later).
You will want to know if the company you are purchasing owns part or all of any other entity as that can effect your business operations, profitability, and risk exposure. For instance, are there any subsidiaries? Are there any other real estate holdings where the target company is an owner?
With respect to authorizations, you will also want to ensure that the contemplated transaction at hand is not something that requires anybody else’s written authorization such as a landlord or licensing authority. If the purchase agreement requires a third party’s approval on any level then the agreement should be subject to that party’s written approval.
As part of your legal due diligence you will want to review some or all of the following:
- Shareholder agreements, voting agreement, bylaws, LLC operating agreements, and joint venture agreements etc. – to confirm the ownership and structure of the business.
- Company resolutions and meeting minutes – to confirm that there are no decisions that run contrary to any of the representations the sellers have made that might effect your legal exposure.
- Lease – to confirm what if any restrictions there are from the landlord with respect to the transfer of the seller’s business. You will likely need the Landlord’s sign off, but you’ll also want to review the lease as part of any sound due diligence practice. Leases are discussed further in a later section but they can greatly effect your business plan so walking away from a deal because of a bad lease is certainly not unheard of.
- Employment relationships
Employment matters always scare me because if you get sued by an employee the burden of proof runs contrary to everything I know about the law: you’re basically guilty until proven innocent. Employment litigation is a touchy subject for me because I generally view most employment attorneys (those representing employees) as bottom-feeders looking to shake down an employer for an easy buck. I’m sure there are plenty of lawyers that might disagree with these statements, but in my experience having represented many businesses being sued by their employees (and independent contractors in some instances) dealing with overtime claims, unpaid wages, and discrimination claims is quite the challenge for a small business that does not have sufficient documentation, and in most instances I’ve found the claims to be rather frivolous and vindictive.
Putting aside my personal feelings about that, the general point is that you want to make sure you have all documentation relevant to understanding the employment relationships, hiring and firing process, compensating and retaining key employees, and the payroll process.
In an ideal acquisition I like to review each employee’s job description/role and talk to the sellers/owners to try to determine their assessment of the employee’s performance as well as any other issues they might disclose about that specific employer-employee relationship.
Since employment issues tend to be critical for the success or failure of many businesses why not put in the time to understanding as much as possible about the employees that may remain with your newly acquired business, to determine which ones are true assets and which ones are potential liabilities?
As part of your employment due diligence you will want to review some or all of the following documents, if available:
- Employment agreements or letters
- Termination agreements
- Employee handbooks
- Payroll records
- Disciplinary reports
- Employee pensions
- Employee benefits and retirement accounts
- Pending claims to the Seller’s HR department
Although employee issues might become less relevant in an asset purchase (because the employees will be signing all new employment agreements once you’ve acquired the business) you still want to pay special attention to the key employees in the business you are acquiring.
To quote my colleague Neil Greenbaum: “Key employees should be part of the sale. This means having employment agreements that tie up the key employees for a specific period of time. Yes, they will probably have to be paid a premium however if they are so essential to the operations of the business, then they deserve it.”
- Customers and other third parties
Clients/Customers: Understanding the relationship between the business you are purchasing and its customers, is essential. Whether you’re dealing with an asset purchase or a stock purchase, for most businesses you’ll want to understand the strengths and weaknesses in the business-client relationships. This is best ascertained, from a legal perspective by examining the client contracts and client marketing materials. Those documents, however sophisticated (or not so sophisticated) will tell you about your ability to collect money from those clients (once you assume the business), the value of your accounts receivables, the representations the target company is making to its clients, and the possible exposure to claims from your customers/clients.
Landlords: Most business acquisitions require the approval of a landlord or may require you to assume a lease. Therefore, you want to review the lease in great detail to ensure there aren’t any undue restrictions on your overall business plan. For instance, if the lease is very restrictive on one’s ability to sell their business, then that is something that you will want to negotiate. If the lease is overly specific on the type of use permitted at the leased premises, then you may want to negotiate a broader definition of “permitted uses”. Why? Well, what if you’re purchasing a deli, but have a long-term vision for turning that deli into a bar as well? And what if the lease only permits the operation of a deli? To avoid unnecessary pushback from the landlord, you may want to broaden the definition of “permitted uses” in the lease which will require you to negotiate that aspect of the lease before signing the purchase agreement. A few other things you’ll want to confirm as a matter of due diligence with leases are the following: (1) confirm the correct real estate taxes and common area maintenance charges (2) confirm the costs of heating and cooling the space you are considering leasing (3) confirm that there is a valid Certificate of Occupancy for the space you are potentially leasing, and (4) determine if there are any violations on the property or the leased premises. This is not an exhaustive list but a good starting point.
Others: As part of your legal due diligence you will want to review some or all of the following third-party agreements:
- Loan agreements are certainly more relevant in a stock purchase deals. You’ll need the advice of an attorney and a CPA to determine the impact of assuming any substantial debt obligation.
- Supplier/vendor contracts to understand whether you are getting the best deal from current suppliers, or to understand if the business you are acquiring is potentially locked into a long-term bad (expensive or unreliable) relationship.
- Intellectual property and proprietary information
In many business acquisitions, whether it be through a stock purchase or asset purchase, you are purchasing some intellectual property in the form of copyrights, trademarks, names and logos. If the intellectual property is being licensed from a third party, then you want to review those licensing agreements to ensure that the rights still exist, and to confirm that the rights are transferrable. If trademarks/logos have been registered with the USPTO, then you want to confirm those trademarks/logos are still valid and you may also want to conduct a basic search to ensure other businesses are not unlawfully using or infringing upon the seller’s trademark/logo. There will also be a need to register the transfer of any registered trademark with the USPTO.
- Equipment being purchased
In having represented many businesses in the purchase of a restaurant, I like to get a sense of the equipment being purchased. I always suggest to my clients to do several things when it comes to equipment acquisition:
First, take inventory of all the critical inventory you intend to include as part of the acquisition. Write it down. You want this included in the purchase agreement as specifically as possible.
Second, make sure it’s all in good shape. Test it out. Is the commercial refrigerator cold? Is it cold enough? Is there mold? Is there rust? Do the ovens and burners work? When is the last time the grease traps were cleaned?
Third, confirm the equipment warranties. Have they expired? Can the seller find them? This could be a bargaining point if push comes to shove.
- Determining the existence of other liabilities
No good due diligence comes without its share of paranoia. But don’t shy away from that paranoia, explore it! There are many tools you can use to get a better sense of who you are dealing with as individuals and entities:
- Title reports (if there is real property being purchased as part of the deal)
- Lien and UCC search (always good practice) to determine if there are any liens against the business or its assets
- Judgment search. Find out what judgments exist against the seller or the business your are acquiring.
- Litigation search. Any pending litigation or prior litigation may mean ongoing legal obligations that could effect you regardless of whether you are entering into a stock purchase agreement or asset purchase agreement.
- Uncover the existence of any notices from any administrative agencies such as
- IRS
- Department of Labor
- Department of Buildings
- Social media due diligence. Google, Yelp, Facebook, and Instagram are all powerful tools. Read the reviews on the business you are acquiring. It’s the most basic thing you can do and you don’t need to be a lawyer to do it!
Financial due diligence
Financial due diligence is obviously critical for any acquisition and instinctively most potential purchasers skip right to the financial due diligence above all else. But what are they looking for? Rather, what should they be looking for exactly?
Well, first of all they should be trying to confirm that the income is what the seller(s) stated. This means both the income actually received and income that will be received in the future. For any future income you will also want to analyze how concrete that assessment or prediction actually is.
For almost any business acquisition I like to see the seller’s financials including prior year tax returns, profit and loss statements, and accounts receivables ledgers if applicable. I’m looking for several things:
- Did the seller file tax returns in the prior years? Believe it or not, even as a purchaser through an asset purchase deal you can be subject to certain tax consequences if the seller did not pay their sales taxes in the prior years.
- The tax returns are usually set up to show less income because businesses like paying less in taxes. So, you need to better understand the items that are there to offset income such as depreciated assets, deductions, and credits.
- I like to review a profit and loss statement because it’s easy to review (if I’m being honest) and I want to see if any particular item stands out. What expenses seem out of the ordinary?
- Accounts receivables review is not something necessary for every deal, but when it is relevant, I like to find out what receivable exist, the steps taken to collect those receivables, and the expiration date on those receivables.
I believe it is always worth having a good CPA relationship to get some preliminary review of the financials to determine the true value of the business being purchased.
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