Due diligence is the multi-step process of determining the fair market value of a business by examining its financial, legal, and regulatory health and to uncover potential risks or liabilities that impact a purchase or sale. When properly carried out, due diligence should assure lenders, stockholders, and partners that the price of a business represents a good investment and that foreseeable risks can be mitigated. Major pitfalls include rushing the process, skipping portions, or failing to research change-of-control clauses in contracts.
Attorneys who specialize in business deals are valuable partners when undertaking the due diligence process. They can identify patterns in recent business transactions that may raise red flags and pinpoint areas for investigation according to industry trends.
Due Diligence Roles for Buyers and Sellers
The Florida Bar Association has specific rules for attorneys involved as counsel in business purchases and sales. These specifically include observing regulations around fiduciary duties, effectively communicating with their clients, and preserving confidentiality. In addition, Florida attorneys have a duty of competence, meaning they must be knowledgeable about business transactions (such as whether the documentary stamp tax applies to a particular deal, how to handle a fictitious name, and/or the application of regulatory and licensing transfer laws). Ask for references and call past clients before engaging a business attorney. You may also check for the attorney’s certificate in business litigation by calling the state bar association.
Effective due diligence requires strategic preparation. To reduce delays, sellers take an active role in creating digital data rooms for buyer reviews while the buyer’s attorney examines finances, contracts, and compliance issues. To strengthen negotiating leverage and provide lenders with necessary documentation, both should memorialize their findings in writing.
Buyers’ due diligence must satisfy their lenders that the business is legitimate and a good risk for loans. To do so requires a deep dive into the operations, income, debts, and risks involved in the purchase. The resulting due diligence memorandum must be comprehensive and legally defensible. It should include:
- Financial records including 3-5 years of tax returns, financial statements, and understanding capital requirements for running the business. Scrutinize records for unusual transactions.
- Legal and corporate documents such as contracts, foundational documents, and litigation files.
- Regulatory documents and the applicable licenses and registrations. You might want to avoid buying a company if the records show shoddy compliance standards.
- Employee contracts and benefit plans.
- Licenses for intellectual property used in day-to-day business.
- Leases for buildings and equipment.
- Insurance policies and claims history.
Sellers should compile the following to make research easy for potential buyers and to outshine the competition:
- Put together your financial documents in an easily comprehended format and prepare a seller’s disclosure. Require non-disclosure agreements for those viewing the material, particularly sensitive information regarding employees.
- Compile all contracts with notations about the terms of transfer for each, including leases, intellectual property agreements, and partnership agreements.
- Make a plan for employees to transition to new ownership and management.
- List assets critical to successful operation of the company and provide a chain-of-title history for each as well as transition notes. These items can be intellectual property, assets, real estate, trademarks, patents, and more.
- Plan for negotiations, including opportunities for escrow, earnouts, and holdbacks to bridge valuation discrepancies. These tools can help to seal a purchase agreement. Discuss the pros and cons of your options with your business attorney.
Knowing Where to Look and What to Look For
Experienced and competent business litigation attorneys like the professionals at WKFK Law have performed due diligence for hundreds of business transactions. That experience in analyzing business documents goes far beyond knowing how to read a spreadsheet–it encompasses evaluating legal structures, operational weaknesses, and identifying potential regulatory pitfalls. This depth of experience can save both buyers and sellers time, money, and legal headaches.
