Do Your Due Diligence Before You Acquire A Company!

Before you finalize an agreement to purchase a company, undertake a thorough due diligence process in order to verify that the information presented by the seller is accurate and that there are no hidden liabilities.  As a purchaser, you should structure the transaction as an acquisition of the assets of the company, rather than an acquisition of the stock or other equity interests in the company.  If you acquire assets you don‘t need to acquire any liabilities attached to the assets.  However, if you acquire the stock or other equity interests in the company, you will acquire all of the assets and the liabilities of the target company.

You should begin the due diligence process after all involved parties have signed a letter of intent (LOI).  The LOI should provide for a due diligence period of sixty (60) to ninety (90) days and have the target company agree to provide the purchaser with access to all of the target companys records.  Due diligence is a complex undertaking consisting of legal, financial, and operational components.  By doing it correctly, you will minimize the risk of wasting your money on an unprofitable business, acquiring unwanted liabilities and headaches or paying far more than the true value of the assets.

Legal

Your objective in carrying out legal due diligence is to make sure that the target company is on a sound legal footing.  First of all, you want to confirm that the business has been legitimately formed and that it exists.  You want to understand the companys ownership structure, the rights of different owners, how it is managed and who has the authority to approve the transaction.  You also should review agreements with key suppliers, key customers and key personnel.  Find out if there are any pending or threatened lawsuits, or if litigation is likely to arise in the future.  Check to see if the companys insurance is adequate.  Verify that the company is in compliance with all applicable laws and regulations.

Financial

Your aim in doing financial due diligence is to verify that the financial information on which you base your buying decision and purchase price is accurate.  You should gain a thorough understanding of the companys finances so that you can include potential contingencies in your projections and financial models.  Find out if there are customer collection or cash flow problems.  Check to see if there are unfunded liabilities such as pension benefits for current and future retirees and bonuses promised to employees. Depending on the size of the deal and your level of expertise, you may want to engage accountants or financial advisors to help you analyze the financial data.

Operational

Your goal in performing operational due diligence is to make sure that the target company will function as expected after you have purchased it.  The business may be profitable now, but it might not be able to generate the same level of earnings after it has been acquired for a variety of reasons.  The target company may be dependent upon key employees, key suppliers or a small customer base.  Leases and loan agreements are often non-transferable, or may require the consent of the lessor or of the lender, even in the context of an acquisition of the stock or equity interests in the target company (which you should avoid anyhow).  You should also verify that the company owns its intellectual property and trade names.

Why You Need to Consult an Attorney

Due diligence is a major project that involves scrutinizing an enormous quantity of information.  Your approach to due diligence should be thorough, organized, and strategic.  You should work closely with your attorney, accountants, and financial advisors to map out a strategy before you begin and get their advice at every step of the process. As you perform due diligence, you may uncover legal or financial liabilities or asset impairments in the target company that suggest it is worth far less than the sellers asking price or that make you think twice about acquiring the company.  The cost of doing due diligence inadequately could be far higher than the cost of carrying it out properly.

 

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Yes, the representation and warranties in a Purchase Agreement matter!

John Client was ready to sell his business.  He negotiated the price, agreed on the basic terms, and received a purchase agreement from the Buyer.  However, there were pages and pages of representations and warranties.  Rather than consulting with his attorney to ask about this, Mr. Client figured this was standard procedure and didn’t think twice about it or inform his attorney.

After John Client and the Buyer signed the agreement, the Buyer decided he paid too much for John Client’s business.  The Buyer used the language in the representations and warranties to threaten to sue Client unless Client agreed to reduce the purchase price, and, according to the language in the representations and warranties, the Buyer was within his rights to do so.

When selling a business, a smart owner will do everything necessary to limit risk.  This is especially true with representations, warranties and indemnities.  Sellers should get their attorney involved early in the process, when they are negotiating the basic terms of the transactions.  The Seller may not understand the implication of some of these terms. Sellers should not presume that the representations, warranties and indemnity provisions of the selling contract are just “standard boilerplate language.”  They are incredibly important and the language can be negotiated to reduce the Seller’s risk.  If the representations, warranties and indemnities aren’t crafted specifically to fit the Seller’s circumstances and minimize the Seller’s risk, the Buyer may be able to use these provisions to sue for damages or to re-negotiate (read: reduce) the purchase price when the Seller believed it was a done deal!

Representations and warranties.  Crafting accurate representations and warranties lay the foundation for a solid legal document. If the Buyer finds any misrepresentations or is not satisfied with the representations or the warranties provided by the Seller, the Buyer can walk away from the deal or, even worse, come back after the fact and sue for damages.  A good selling contract will have detailed and accurate representations about the formation of the company being sold, the company’s approval of the transaction, the authority of the officers who will sign the definitive agreement(s), intellectual property, existing contracts, previous or current litigation, employees, customers, and tax issues, among many other issues.

Disclose.  The representations and warranties can be the most tedious section of a purchase agreement.  The Seller can reduce its risk by disclosing any exceptions to the representations and warranties in a schedule (referred to in each subsection of the representations and warranties provisions and attached to the agreement).  The Seller should review each representation and each warranty with the Seller’s attorney to make sure (1) the Seller understand each representation and each warranty, (2) the Seller understand whether s/he can make each representation and each warranty, and (3) whether there are exceptions which need to be noted on the attached schedule.  This takes time and is not the place to cut corners.  A smart Seller will get involved in the disclosure process and fully understand what the disclosures say about their business. This section isn’t just legal language tinkering, but has the potential to make or break the deal.

Indemnities. An indemnity is  a promise to reimburse the Buyer if a specific set of circumstances are met.  If a Buyer finds that the Seller has misrepresented any aspect of their business in the selling contract, then the Buyer can sue for damages.   So, if a Seller over-reports revenue, misrepresents customer information or under-reports tax burdens, a Buyer can sue for a breach of warranty and demand payment equal to the Buyer’s losses due to the  misrepresentation.

Set Limits.  A smart Seller can reduce his or her risk by reducing the limits on indemnities as much as possible.  This would include keeping the term of the indemnity short to keep the Buyer from making claims years down the road and restricting the types of damages the Buyer may recover.  So, instead of a 4-year term on tax claims, the Seller and the Seller’s attorney might ask for a 2-year term on environmental claims and either completely remove tax claims or limit them to those arising within one or two years of the closing.  Setting good limits reduces the chance that the Buyer can bring legal action against the Seller.

Sellers can protect themselves from frivolous lawsuits and massive headaches by using an experienced attorney with the knowledge to negotiate and craft a better purchase agreement, as well as by being involved in the process and knowing (or asking) where the Seller can help to limit its risk.