Legal Due Diligence of a Small M&A Deal

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1 Legal Due Diligence of a Small M&A Deal What is M&A due diligence? Put simply, M&A due diligence is fact checking and elaboration. M&A is a particular kind of transaction where meaningful due diligence is a baseline without which no purchaser should go forward. M&A due diligence is deal-specific and contract-specific, meaning that if you re doing it right, you never do quite the same thing. Both the factual circumstances of the deal (e.g. the commercial domain or domains of the target s activities), and the legal structure and terms (e.g. asset or share purchase) need to be taken into account in pursuing your due diligence. More extensive due diligence goes into large M&D deals and deals which must be filed under the securities laws. It can take months. But that is beyond the scope of this Memo., designed to guide inhouse counsel or independent lawyers with regard to smaller deals. What is the commercial purpose of due diligence? An M&A purchaser s legal due diligence serves to clarify and elaborate on what is being purchased. When a target company is sold, its financial statements give the buyer a picture of what the company looks like from an accounting point of view. Legal due diligence should give the buyer a corresponding picture of what the company looks like from the point of view of legal assets and liabilities, many of which may not appear in the financial statements. Such legal assets may include, for example, trade secrets of the target, and such legal liabilities may include, for example, guarantees that it made. In an asset sale, the same need applies for clarification and elaboration. It is common for asset sales to be described as including only specified liabilities, giving the impression that here the due diligence role of identifying legal liabilities is reduced. Not so. Due diligence here needs to focus on the liabilities linked to the purchased target assets. For example, the legal assets may include sales contracts which have great value for the buyer because of the customer relations that they bring over. But these same contracts may also bring over serious liabilities, such as a risk of cancellation upon assignment of the contract to the buyer or even built-in unsustainable pricing. Another example involves employees in certain foreign countries where employees have extensive rights. A company I knew (not a client, I hasten to add!) was delighted to purchase for a song manufacturing facilities in Europe, including all the needed up-to-date equipment and well-trained employees, with only a few specified liabilities. But unknown to that acquirer, those same employees brought with them substantial liabilities whenever the inevitable rationalization or reorganization of the business occurred. What is the utility (or otherwise) of a Due Diligence Checklist? When you first bring your lawyer into a proposed M&A deal, she will likely send you a Due Diligence

2 Checklist for you to send to the target s lawyer. Typically encyclopedic in content, such a checklist is a useful roadmap of potential issues as well as of the basic material to review. It is important to remember that a Due Diligence Checklist, however well prepared (and they typically are very well prepared), is no more than a preliminary roadmap. It is also asks for way too much in a small deal, because the law firm which prepared it is covering itself against a claim that it neglected something. In a smaller deal, you don t need to cover all the material underlying the deal, all of the headings on the Due Diligence Checklist. Rather you need to focus your due diligence based on the circumstances of the deal. Portions of the Due Diligence Checklist will likely turn out to be irrelevant or warrant very little of your time, and other portions will turn out to need a significantly more detailed review than they suggest. This is not a failing of the Checklist: if due diligence was a mechanical and purely repetitive process, there would be no need for lawyers to perform it! How do I initially orient a due diligence review? By far the most important step is to obtain from your own clients their goals and expectations for the proposed deal. It is a step frequently neglected, and more often accorded too little time and energy on the lawyer s part. This step is elaborated under the heading What should I ask my client? A small deal may involve a more substantial target, for example if it is selling a peripheral division. If the target is a public corporation or a division of a public corporation, review its most recent securities filings on EDGAR ( Not only will these filings discuss in some depth the business or corporation that you are acquiring (in the Management s Discussion & Analysis portion of the Form 10-K, for example), they will also highlight certain recent material events (in Forms 8-K) and commercial and financial risk factors (in the Risk Factors portion of the Form 10-K). In any event, review the target s website, in particular any press releases to be found there, and perform searches on the company and the names of the people and products identified on its web site. This may not be a very fruitful path, but is often a good orientation in the absence of securities laws filings. Last but not least comes what is classically referred to as legal due diligence, reviewing from a legal perspective the various documents and contracts of the business to be acquired. The Due Diligence Checklist is the basis of this review, subject to the modifications learned as you move forward working with your clients and from the documentation. What should I ask my client? You need ready access to the various individuals who comprise and lead your client. Clients who have been burned by big firm billing in an M&A context may resist your overtures to obtain this access! If you re in-house, point out that it costs client very little, if anything, more. If you re an independent, you

3 are already accustomed to explaining how your time cannot be inflated by a team of junior lawyers and complementary specialists. It is a good idea to meet with three or four different individuals or groups within a corporate buyer to get a feel for their respective issues in the deal BEFORE doing due diligence of the target. If time constraints preclude such meetings before you are on a plane to visit the target, catch up with them as the deal progresses. Meet with: (1) the VP of business development (or CEO: whoever is driving the deal), in order to understand what is really going on here and what the corporation is really looking to buy. You may need to remind the Officer concerned of your duty of confidentiality, because there are at times more or less hidden goals underlying the deal which the Officer does not yet want to share widely, even within the corporation. Yet if the lawyer on the deal does not know these hidden goals, she cannot help assure that it is accomplished in the deal as consummated; (2) the head of the product group, operating division or subsidiary which will digest or operate jointly with the target business, in order to understand how she sees the acquisition, and where she has concerns. Do the acquired product lines complement or overlap each other? What are her priorities within the various product lines, technologies and employees being acquired? Will integrating the acquired business s IT systems pose problems? Will the product lines be integrated or run as a separate subsidiary? Are there technological aspects of the target that warrant special attention? How do the target s customers complement each other? The list goes on. (3) the Controller or Finance VP who will be handling the accounting due diligence, in order to get a feel for the potential hotspots in the target s financial statements. As he goes through the financial statements line by line with his opposite numbers on the target s side, you will need to be parallel processing on the legal side. The target being (hopefully) in a business that both of you have some familiarity with will facilitate your joint effort to identify issues in advance; and (4) depending on the nature of the target, the Officer responsible for a domain particularly impacted by the acquisition, so as to orient yourself in that domain. This is more difficult to identify in advance. If the acquisition involves patents, work with your client s Officer responsible for IP. The HR Officer often fits under this heading, as does the GM of any local sales office or other facility in a location near a key location of the target. As you discuss the deal with each of these individuals, issues will inevitably arise, and they need to shape the focus of your legal due diligence going forward. What do the seller s organizational documents tell me? The starting point for a thorough legal due diligence review of the documents and contracts of a corporation or other going business is the various corporate records. This applies even in a smaller deal,

4 and this part of the Due Diligence Checklist is ignored at your peril. Here is a sample section of a Due Diligence Checklist covering these documents. It is phrased as a request of the target: Organizational Documents. Provide a copy of the following with respect to Company and each of its Subsidiaries: certificate of incorporation and bylaws (or their equivalents, and other constitutional documents for non-corporate entities), and all amendments and restatements thereto a list of jurisdictions in which Company and each of its Subsidiaries is qualified to do business or is otherwise doing business,... ; minutes of all meetings and materials presented (including financial projections) at such meetings (and all actions taken by written consent without a meeting) of the stockholders and the Board of Directors of the Company and its Subsidiaries; all stock books, stock ledgers and forms of stock certificates of Company and each of its Subsidiaries. These documents are to be reviewed first for what is included in them. They comprise the broad lines of a corporate history of the target. The minute books (of Shareholders, Board and Committee meetings) can be long, and do not need to be read word for word, but if they have been prepared correctly they will give you a roadmap of the significant deals in the target s life. The most significant transactions involving any company will likely be authorized by Board action. The Board minutes should show you the most significant deals that you may need to review as part of your due diligence. Of course, if your client is buying a division, transactions involving other divisions in the corporation may not need to be reviewed. Prior acquisitions made by the target are particularly significant, as are other M&A deals in its history. Much of the capital structure of the target should be visible in the minute books and shareholder registers. Even if the deal is an asset purchase, certain information about the capital structure remains important. For example, the terms of the options granted to employees who will be transferred with the assets is normally crucial information for the buyer, and that should be in Board minutes. Based on information that you have received from your own client, as well your review of available sources concerning the target (e.g. its filings under the securities laws or the results of your web searches), you may find significant matters not dealt with in the minute books. This could be a sign of incomplete minute books. How should due diligence be organized? Very carefully. However well you review what you find, its utility to your client depends more on how well you organize it and present it to them.

5 As soon as materials that you review (not just the legal materials: see How do you orient your due diligence review?) give insight into what your client is buying, organize them around the Due Diligence Checklist. Most Checklists nowadays incorporate columns for noting the status of review of each line of the Checklist. Use them! Your filing system for due diligence materials should initially track the Checklist, by headings or line depending on how much material you have accumulated. There will ultimately be lots of material, even in a smaller deal. In M&A, smaller rarely means less complicated. What is a Virtual Data Room? A virtual data room is a great improvement in the due diligence process, but a trap for the unwary. It brings the internet into service for the due diligence practitioner. When the target begins to respond to your due diligence request (the Checklist), you begin to get into the meat of your due diligence. In the not-so-distant past, this meant trip after trip to the target s offices or its lawyers or banker s offices to review materials that had been pulled together in a Data Room in response to your due diligence request. I remember days that accumulated into weeks shut in a windowless Data Room somewhere in Idaho with a group of lawyers painfully reading through file cabinets full of documents conscientiously provided by the seller. Nothing against Idaho, but a windowless room full of documents anywhere leaves much to be desired! The Virtual Data Room improves the Data Room process tremendously. The seller s banker or its lawyers prepare the seller s responses to your due diligence request and upload them online. You will be given a password, and can access the Virtual Data Room wherever you have internet access. Hopefully, the online documents will be organized congruently (or close to it) with your Due Diligence Checklist. The principal downside is the absence of a human interlocutor. In an old-fashioned Data Room, the seller s representatives were normally down the hall or even in the Data Room with you. As questions came up, they could be addressed in real time. Looking through a Virtual Data Room, you need to write down all questions arising out of your review and them to the appropriate Seller s representative. Then you have to follow up until you receive answers. That can be a time-consuming process. In addition, Virtual Data Room contracts and documents are regularly incomplete in some manner. Exhibits and Schedules are omitted, or amendments missing. Again, follow up is the key. No review of a contract is complete until the complete contract has been reviewed. The Virtual Data Room can trap the unwary by lulling you into a false sense of completion. When you have finished reviewing the broad selection of documents in the Virtual Data Room, you can be excused for feeling that you are done. Not so. There is almost always a lot more to do.

6 How do I communicate the results of my due diligence? The classic answer to that question is the Due Diligence Memorandum, a detailed summary of the results of your review. Normally tracking the Due Diligence Checklist, this Memorandum can grow into a monster, especially if you are asked to include certain key information for each reviewed contract, like its assignability in an asset sale. A thorough Due Diligence Memorandum is a requirement of complete reporting to the client in a large deal, but its highlights should have been reported already. In a smaller deal, the highlights may be sufficient for the client. For her, the benefits obtained from complete responses to the Checklist in all but the most significant target domains far outweigh their cost. In a smaller deal, a Highlights Memorandum is the most efficient way to communicate the results of your due diligence to your client. But the highlights referenced need to be those selected by the client to guide your work. This again requires close contact with those responsible for the deal within your client. As things progress and you identify issues that will be of interest to particular people within the corporation, tell them promptly. These people will principally be those whom you have already met to learn their itineraries in the deal (see What should I ask my client?), but should include whoever is responsible for key issues as they are uncovered. Even if your client ultimately wants a full due diligence memo, Highlight Memos remain of particular value because they obviate for many individuals a review of all the detail of the complete Due Diligence Memorandum. Clients typically have a strong preference for highlights! Here [insert hyperlink] is a sample Highlight memorandum prepared after an initial visit to the target company. It focuses on the areas of particular concern to the Bus. Dev. VP in charge of the deal. How are the results of due diligence incorporated in the contracts for the deal? The reps and warranties in the (Stock or Asset) Purchase Agreement are intimately linked with the Disclosure Schedule or Exhibits, which are based on the results of due diligence. This is the key interaction between the contracts and the results of due diligence, and others may exist in related or complementary agreements. Reps and warranties are the portion of the Purchase Agreement which delineate and confirm what the target is selling. Often long-winded, they are the meat of any M&A deal. Although not as sexy as the earn-out, indemnification or break-up fees, for example, they remain fundamental. There are essentially two types of Disclosure Schedule or Exhibits: (1) detail of assets, for example lists of contracts or of patents and applications; and (2) exceptions to the reps and warranties. The first type of Schedule is a simple compilation. If the contract calls for an all-inclusive list of patents and applications worldwide, the target s patent counsel will typically supply a print-out to be inserted.

7 One issue here is whether to include the list as a part of the contract or refer to is as an outside document. The latter is useful for reducing the length of a contract. In Paris, I once worked on a page Stock Purchase Agreement, as signed, when for various reasons several lists of assets were required to be included. That s a lot of pages! The second type of Schedule interacts more sensitively with the Purchase Agreement. To illustrate, an Asset Purchase Agreement will usually rep. that all the contracts of the business to be acquired are assignable to the purchaser, except as set forth in the Disclosure Schedule. What is then disclosed in that portion of the Schedule is a not a list of all the contracts assigned to the purchaser, but only those whose assignability is in question. (All of certain types of contract will likely be listed pursuant to other reps.) Identifying which contracts fit that description is a part of your due diligence. What should the final results of legal due diligence look like? Ultimately, you will share responsibility for being the guardian of this acquisition for your client. It is a responsibility that you will share with finance and probably HR, IP and other functional departments, as well as the operating division or product group that made the acquisition. You may not be given the resources needed to enable to adequately fulfill this guardianship role: the modern corporation tends to rush through its acquisitions with an emphasis on the speed of income accretion. But this haste is one of the principal reasons that so many acquisitions do not fulfill the hopes of their proponents within your client. There is nothing like insufficient attention to detail and to cultural blending to ruin the logic of an acquisition. Synergies need more than a good idea: they need careful execution. Your client will be best served by thorough and complete documentation organized around the Due Diligence Checklist or your Highlights Memorandum. The organization needs to be transparent to others in your corporation, both those there now and those who will come later. Your guiding principles are: all documents, including indices and memoranda, need to be numbered; the numbering system should bear some relation with the organization that has been applied; and complete copies of all documents should be carefully collated and included.