What is Due Diligence?
Most people would not buy a used car or a previously owned house without having an inspector look at it and give them a report of the potential problems with the car or with the house. Even though the potential buyer may still buy the car or the house even though they know about the problem areas, they still want to know about all of the potential problems when negotiating the purchase. The same thing applies to the negotiation for the sale and purchase of a business. No matter how well legal documents are drafted, there is no substitute for thorough due diligence. Understanding the business and “kicking the tires” is the surest way to bring problems to the surface, which in turn reduces the possibility for costly post-closing disputes.
Potential Problem Areas
Due diligence should be undertaken in every major area of a business to discover whether circumstances that could give rise to problems exist. These areas include:
- Leases
- Potential and pending litigation
- Employee agreements, pensions, and benefits
- Financial accounting, including accounts receivable and payable
- Indebtedness, lines of credit, and loans
- Title to assets
- Relationships with major customers and suppliers
- Intellectual property
- Insurance
- Transactions with related parties
- Competitive issues
Any person reviewing the documents and records in these areas will be exposed to the businesses’ confidential and proprietary information. Therefore, any prospective seller will want the prospective buyer, and anyone reviewing the documents and records for the prospective buyer, to sign a written assurance that they will not disclose the confidential information to third parties, unless required by law, or use the information to harm the seller’s business should the transaction fail. These confidentiality and non-disclosure agreements are among the most important first steps in negotiating component of any sale.
Review of Books, Records, And Contracts
The prospective buyer should review the Seller’s corporate books and records to determine whether the Seller’s stockholders have rights to approve or reject the proposed transaction. For example, an agreement among shareholders may be in place granting each stockholder a right of first refusal to match any offer to purchase stock made by a third party.
The prospective buyer should review major contracts for information about how long the contracts will remain in effect, whether a transfer will trigger a default, whether the parties to the contract must be notified of a change in the ownership of the prospective seller, and other key terms. Contracts with major suppliers and with major customers frequently provide that a change in ownership of the prospective seller will give rise to an opportunity for the supplier or the customer to re-negotiate or to terminate the contract.
