Avoid seller’s remorse by understanding due diligence before starting the deal process.

Getting offers can be exciting, and securing a letter of intent (LOI) can feel like you just hit a home run. But closing the sale of your company is not assured until you make it through due diligence.

The process leading up to the LOI should be flexible enough to give both the buyer and the seller enough germane information about the company and expectations that a both sides can confidently establish mutual intent. But the buyer’s formal due diligence process won’t begin until the buyer has secured exclusivity with an LOI. The buyer needs to undertake due diligence to verify its initial assumptions made about the target company on a number of business dimensions. It also forces disclosure of issues and risks material to the transaction, and it allows the parties to address these prior to closing.

What is a deal team?

It is important to understand at a high level that buyer due diligence is not something the buyer performs while the seller simply waits. It requires active, responsive performance on the part of the seller, and it shapes the contract negotiation process. Some aspects of it are expertise-intensive, and others represent a significant administrative burden. As leader of the company, you can’t afford to shoulder this on your own while maintaining oversight of the overall deal, developing key relationships with the buyer, and sustaining the performance of the business through the critical final stretch. Making it through this phase on your own is usually unworkable, and trying to do so will likely derail the deal. So, early in your sale process, you should confer with your transaction advisor about the roles that need to be handled (including taking into account legal considerations, considering tax consequences, and collecting, vetting, and disseminating information), and who will comprise your diligence team when you find the right buyer. Your diligence team will include some internal resources as well as outside professionals.

You’ll need an M&A attorney to handle the legal aspects of the deal. You may have a long-term relationship with a general business lawyer who you trust and who knows you well. They may even regularly practice contract law. But they will not have the same knowledge base and experience dealing with the definitions and language found in sale and purchase agreements (SPAs) as do M&A attorneys. M&A lawyers deal with these concepts every day, and they can better appreciate the nuances of how SPA language should be crafted, disclosures that need to be made, representations and warranties, and how indemnity language should be negotiated. If you try to task your general counsel with serving in this role, they will be starting from far behind their counterparts on the buyer’s side. An M&A attorney is better qualified to collaborate with the buyer’s counsel to draft language that fairly balances risk between the parties and reduces frictions in the process. They are also far better equipped to manage the iterative contract drafting process efficiently while avoiding expensive mistakes and oversights. As the deal process draws to a close, part of legal representation is making sure a final inventory of documents provided to the buyer for due diligence is listed and incorporated by reference in the SPA.

Early in the deal process, while you are preparing to accept an LOI, legal fees can be kept to a reasonable level. Other than tax considerations (if you are relying on your attorney for that), counsel will want to address basics such as the exclusivity period, confidentiality provisions, and choice of legal jurisdiction. But they will need to remain cognizant of the risk of allowing the process to become bogged down by getting too deep into the weeds at this stage. The level of disclosure you’ll be obliged to provide once you accept an LOI is substantially beyond anything provided during the marketing process, so your lawyer will recommend getting an enhanced non-disclosure agreement (NDA) from the buyer as part of this phase of discovery. Many NDAs are written to be binding for only one year; but since due diligence involves revealing so much confidential business information you never would have revealed if you knew the deal wouldn’t close, prudent counsel will recommend extending terms closer to your state’s statute of limitations on written contracts. Buyers have increasingly taken the lead in preparing the NDAs. They may be designed to be signed by only the buyer and the seller, who agree to bind their advisors to the same level of confidentiality, or the parties’ law firms may be expected to sign NDAs as well. Regardless of who originates the document, your lawyer can ensure the term “confidential information” is clearly defined, the protections are reciprocal, and that the language doesn’t saddle the seller with unwarranted non-compete or non-solicitation provisions. An experienced M&A attorney can also advise you on a no-shop period that is reasonable for your situation, and they will help you manage any extensions that may be needed as the exclusivity expiration date becomes imminent.

Another good reason to involve legal counsel when evaluating an LOI is to ensure you understand the risks in the offer the buyer is putting on the table. Price is only one consideration in striking a good deal. Deal terms are just as important, and a good M&A attorney will help you evaluate the implications of a deal being offered to you. Earnouts used to be a way of allowing the seller to capture additional value beyond the buyer’s assessment of the business’s current value, by meeting certain growth objectives. Increasingly (more so in periods when buyer demand for M&A transactions declines), earnouts are used as a means of keeping the seller invested in the near-term success of the business post close, along with other mechanisms like seller financing or buyer equity. If seller financing or other executory consideration is part of the deal, for instance, your attorney will help you understand the risks posed to you by third-party financing. A subordination agreement, which will be necessary for the buyer to obtain third-party financing, will subordinate the position of your seller carryback note relative to the senior debt. Your attorney should negotiate a security agreement and UCC financing statement to collateralize your position. But if an SBA loan is part of the deal financing, it will require a standby agreement that will, if the loan goes into default, prevent you from collecting or even going after any collateral on your seller note, or collecting amounts from other deal components, including consulting agreements, earnouts, or other contingent consideration. Your attorney can point out not only how proposed deal terms impact the desirability of the deal, they but can also identify potential tools for mitigation that can be negotiated, such as getting a personal guarantee from the buyer if feasible. Although LOI terms that frame the final agreement are not binding, you can avoid introducing friction from the sell side by ensuring you understand the LOI’s terms and you are prepared to follow through on them.

A Tax advisor should be an integral part not only of getting through the deal process, but of planning for it as well. You may be using a tax preparer that has minimal or moderate expertise to handle your tax compliance work, and that is often a perfectly workable and cost-efficient way to get your tax returns filed. But aside from that, you need more substantial tax guidance at certain stages of your exit journey, not just during due diligence. Qualified tax advice obtained five years in advance could help you establish the most tax-efficient structure to have in place at the time of your exit, and to have it in place long enough to qualify for the tax treatment you desire.

Prior to accepting an LOI, perhaps even before going to market, you should have your tax advisor or tax-savvy legal advisor prepare a tax minimization analysis. This allows you to understand the way to structure the deal that is most favorable to you, and it shows you what you will end up with in your pocket when the deal is over. The tax and legal objectives of buyers and sellers are often at odds, so this exercise certainly doesn’t allow you to set the deal terms in advance. But it can help you understand the stance from which you should negotiate. This pro forma waterfall is very instructive to sellers, and covers:

• Expected selling price.

• Deductions for estimated fees, commissions, and the net working capital (NWC) adjustment, to arrive at net sales proceeds.

• Deductions for federal, state, and local taxes. This involves specifying the proposed structure of the transaction (asset or stock sale) and laying out an asset allocation designed to minimize your tax liability. The result is net cash after tax subtotal.

• The payoff of liabilities.

• The expected value of earnout, non-compete, and employment/consulting agreements expected from the transaction, as well as any leases expected to be part of the transaction. While earnouts are taxed as ordinary income at the highest marginal rates, purchase price adjustments can be treated as capital gain if terms are structured properly, so a good tax advisor will identify opportunities to obtain favorable deal terms.

• Options for tax-efficient deployment of your net proceeds. Depending on your goals and liquidity needs at exit, there may be opportunities to further defer your tax obligations with the right investment choices.

After closing, the buyer and seller must each file Forms 8594 to report their allocations of fair market value to the deal components. While they don’t need to be identical, an audit will usually be triggered if they are not. So it is common for the parties to agree to a common allocation as part of the SPA. While there is no hard-and-fast requirement for the asset allocation to be specified in detail in the LOI, the asset allocation is yet another detail that can avoid friction down the road if the buyer is amendable to addressing it at this stage. If the target company is taxed as a C corporation and the intended deal involves both the assets of the company and the personal goodwill of a seller (for which the seller can obtain capital gains treatment), clarifying this in the LOI is helpful because it signals to the buyer the need for two separate SPAs—one with the target C corp and one with the seller. An experienced M&A lawyer will also understand that among the deal risks they need to help you manage is the risk introduced by slowdowns they—and their counterparts on the buyer’s side—can create that could strangle the deal in the cradle. Your counsel needs to know when and how to de-complicate the process of getting to an LOI if it becomes bogged down. But the tax implications of the deal the buyer proposes are worth clarifying. If the buyer’s offer includes some kind of tax-deferred rollover equity, for instance, you should be aware of any restrictions on the transferability of that stock, and you are well-served to have your tax advisor require the buyer to verify the deferral treatment before you commit to exclusivity.

Your transaction advisor plays an even broader role in your deal. After preparing the company to go to market, preparing marketing materials, making a market for the company, and qualifying bidders, the next major function of the transaction advisor is facilitating the diligence process. Even if you’ve come to the process with a buyer already identified, it is not the norm for sellers to have the capacity and expertise to run the diligence phase internally, and relying on your attorney to do manager it alone can get expensive. You should hire a transaction advisor that regards this function as integral to their role in the deal process, is qualified to navigate it, and will help shoulder and appropriately distribute the burden. This can ensure diligence goes smoothly instead of turning into a protracted, multi-round affair that degrades the deal’s momentum and puts its closing in jeopardy.

Your advisor selections are significant, trust-based decisions, and the more well considered they are, the smoother your deal will go. You’ll be doing yourself a favor by not waiting until game time to hire your coach and key players. To be sure, you can mobilize your team under time pressure if necessary. But thinking about the deal process two to three years in advance gives you time to meet and develop relationships with people in the legal and intermediary fields, and exploring your taxation alternatives with an experienced tax advisor at least five years out will help you put the optimal tax structure in place.

These are obviously big, trust-based decisions, and the more well considered they are, the smoother your deal will go. So you’ll be doing yourself a favor by not waiting until game time to hire your coach and key players. To be sure, you can mobilize your team under time pressure if necessary. But thinking about this 2 – 3 years in advance gives you time to meet and develop relationships with people in these fields.

What will the process look like?

All else equal, due diligence is more thorough in a stock transaction than an asset transaction because the buyer assumes all unknown liabilities when purchasing the legal entity’s stock. In contrast, due diligence can be more targeted in an asset purchase. Even when purchasing the target’s stock, the buyer will prioritize their efforts to make the process cost- and time-efficient, giving lighter attention to certain risk areas. No matter how small the transaction, some minimal degree of due diligence will save the buyer time and money down the road, and skipping it altogether is both rare and extremely unwise. The extent of buyer due diligence will depend on the size and complexity of the transaction, but it can involve some or all of the following work streams:

• Valuation
• Financial due diligence
• Tax due diligence
• Legal due diligence
• Commercial due diligence
• Operational due diligence
• Market due diligence
• Human resources due diligence
• Antitrust due diligence
• Information technology (IT) due diligence
• Real estate due diligence
• Intellectual property (IP) due diligence
• Cultural and ethics due diligence
• Environmental and health due diligence
• Compliance and integrity due diligence
• Risk and insurance due diligence

Managing due diligence is more than just the mechanics of maintaining data rooms and holding discussions with the buyer’s team. It also involves disclosing information at the right time. The seller has no guarantee the parties will be able to bridge any divides that emerge during due diligence, so particularly sensitive information, such as unredacted employee and customer information, need not be provided until financial due diligence (FDD) is substantially complete. In markets where specifically identifiable information is particularly valuable, or when selling to a competitor, the seller will wait almost until deal closing to release the unredacted information. Due diligence findings will impact the definitive sale and purchase agreement (SPA) as well as the buyer’s plans for post-merger integration (PMI). The legal teams of the buyer and seller repeatedly trade drafts of the SPA throughout the process, and the process gives rise to negotiation on representations and warranties that continues until closing. Each side continuously updates its negotiation stance throughout the process.

To understand what you are headed for with your buyer’s due diligence process, you should obtain an idea of the following things:

• What areas they will cover? Large M&A transactions will be subject to scrutiny in each of the areas listed above. It is instructive to know just how extensive this process can be as a foundation for understanding the buyer’s expectations in your case. But if you are the seller of a small or mid-sized business and some areas don’t apply, the list will be abbreviated. Your advisor should find out from the buyer the scope of the buyer’s intended due diligence.

• Who from the buyer’s side will be conducting each area of due diligence? Depending on the size and nature of the acquirer, the buyer may engage third-party providers to get through all appropriate diligence areas. And third-party financial review may be required by the bank if the buyer is using debt to finance the purchase. Permanent corporate development divisions of strategic buyers and larger private equity investors tend toward in-house performance for more aspects of due diligence. Your advisor can confer with the buyer to form a picture of the composition of the buyer’s diligence team.

• What they will be looking for? The aim of some buyers in conducting due diligence is to confirm information the buyer already has. The objective of others is to identify problems, either to try to re-trade the deal, or simply to avoid negative post-close revelations. In other cases, the most important thing to the buyer is to make sure they have all of the necessary documentation in their possession, with the intention of dealing with any issues on their own after closing. Remember, the buyer’s legal team will insert expertly prepared reps and warranties into the SPA, so there is little to be gained and much to lose by being cagey during due diligence, or by delaying disclosure of material issues until the 11th hour. Throughout the process, the buyer will be looking for candor. They will also be evaluating management behaviorally, forming an impression of what it will be like to work with them after closing (e.g., how cooperative they are, whether they follow through on what they say they are going to do, etc.).

The areas of focus and prioritization will differ from buyer to buyer and will depend on the buyer’s investment rationale for the acquisition. The buyer will establish working assumptions for its diligence team regarding what to look for, including synergies, value drivers, opportunities/issues/risks, and non-negotiables. When preparing to accept an LOI, your transaction advisor should ask the buyer what they seek to get out of the diligence process. You may also ask them for an example of what they may find in the diligence phase that may cause them to change their confidence in the deal, or to revisit price. Experienced buyers know there are no perfect acquisition targets, and revealing the warts is an uncomfortable thing for the seller to do, but that they are better served when the seller apprises them of problems so the buyer can best manage them post close. They should also understand the importance of rating issues that come up by their magnitude rather than looking for a pretext to place the seller on the back foot and demand price concessions. The trust you engender as you develop the relationship before the LOI should give you comfort about the buyer’s attitude toward due diligence in the context of the broader deal process.

Below is a deeper look at some of the work streams included in buyer due diligence.

Commercial Due Diligence

Prior to the collapse of the Dotcom bubble, commercial due diligence (CDD) was more of an afterthought in the buyer’s due diligence process. Focus was mostly on financial due diligence, which is mostly focused internally on the company’s performance history. This was done with broad access to internal documents, but limited reliance on external information.

Since the flurry of mis-investment that marked the turn of the millennium, it became apparent that due diligence needed to focus more attention on external forces in order to help investors make more informed assessments of target companies’ forecasted performance. What used to be called market due diligence evolved into modern CDD, with explicit focus not only on the market environment of target companies, but a greater focus on the current and potential customers that comprise it, as well as competitors and the nature and intensity of rivalry in the target company’s industry. CDD will naturally overlap with the financial due diligence work stream as the deal process unfolds.

If you are the seller of a small or mid-sized business, you may not hear the term “commercial due diligence” used by the buyer’s team. This is because the diligence process for small businesses often includes it as part of a broader definition of operational due diligence. But CDD, by any other name, is still a critical part of buyer due diligence for small businesses. Though it will be much less structured and rigorous than for larger M&A transactions, you can still expect it to play a central role in the buyer’s process. So be prepared for it, and don’t be thrown by the flexible use of terminology.

Click on the article at right to learn more about CDD.

Operational Due Diligence

The buyer will ask questions of the management team about how the company conducts business, how employees are incentivized and compensated, their thoughts on team leadership post sale, and what is important to them.

As this is the beginning of the buyer’s relationship with your management team, the buyer will also be looking for management’s perspectives on aspects of current operations they feel could be improved.

Smart buyers will involve their PMI leads in this process, since the findings here will help determine major synergy opportunities, value will be driven by synergies that can be achieved, and doing so depends on realistic planning and careful consideration of the roadblocks to integration.

This “nuts-and-bolts” review is referred to as operational due diligence (ODD). But if you are selling a small business, the buyer will use this term more broadly, to also cover the review of market, customer, competitor, and business model aspects that may fall under the rubric of CDD in the context of larger M&A transactions.

Financial Due Diligence

A staple of the buyer’s process will be financial due diligence (FDD).

Among the things you should be prepared for as part of FDD is a quality of earnings (QoE) review, which focuses on validating the earnings on which the buyer based their offer price.

The buyer may hire a third-party accounting firm to perform the QoE review, or they may have their own internal finance personnel do it, depending on how the buyer’s team is organized and other factors, such as if a bank is providing financing for the deal and wants third-party verification. It is often a technology-enabled process of digging beneath the surface of the financials and conducting a time-series analysis of the seller’s general ledger to ensure consistency with the bank statements and identify anomalies for further investigation.

The other critical components of FDD are identifying and measuring all debt and debt-like items that need to be adjusted out of the purchase price, as well as well as computing the net working capital adjustment. FDD is also an opportunity for the buyer’s financial team to understand the company’s financial processes and start to develop relationships with its finance personnel.

Click the link at right to read more about FDD.

Tax Due Diligence

For stock acquisitions, tax due diligence (TDD) is critical. TDD includes sales and use taxes, property taxes, franchise tax, transfer taxes—and, of course, income tax. Even in the case of asset transactions, the buyer risks winding up on the hook for various state and local tax obligations of the assets acquired unless a tax clearance letter is obtained from the applicable states.

The larger the target company, the more complicated TDD becomes. More multifaceted operations translate into a greater number of relevant tax considerations, and multinational companies have tax obligations in multiple jurisdictions. Uncertainty in tax positions gives the seller considerable leeway in the value at which tax positions are recorded on the balance sheet, even if the financial statements have been audited by an independent CPA. The buyer will need to understand the positions you have taken and decide whether they are in overall agreement with their carrying values if your tax positions figure heavily into the transaction price. There may be specific reps and warranties as well as holdbacks associated with tax uncertainties.

If you are the seller of a small or mid-sized company and have simple tax positions with little uncertainty, TDD will be a simpler affair. To learn more about the potential considerations in buyer TDD, click the article at right.

Environmental Due Diligence

Depending on the nature of the company’s business, environmental due diligence (EDD) may be a work stream unto itself, or may be part of legal due diligence (LDD). Even if the target’s business and assets are not industrial in nature, due diligence must ensure environmental problems are not a concern. For instance, the target may own an office complex built on a landfill that is now leaking radon gas. Lawyers are involved in EDD at both ends of the spectrum.

EDD can be the most time-consuming diligence work stream in some transactions, so the buyer’s team will need to start it early in the deal process. The diligence team will:

• determine if the company and its predecessors have complied with all environmental laws and regulations;

• look for contractual or regulator-imposed environmental remediation responsibilities;

• question whether environmental permits are required to operate the business, whether the company has all required permits, and whether these are transferable; and

• consider whether the target has in place adequate systems and procedures for compliance.

Factors that determine the scope of EDD include the nature of the business, the number and [previous and future intended] uses of properties, current and future expected legislation and regulation, the cost of EDD, the extent to which the buyer will rely on warranties and indemnities, the financial status of the buyer and seller, penalties and reputational damages from violations, and the extent to which knowledge of environmental factors could strengthen the buyer’s negotiating position.

Remedies that protect the seller from issues discovered in EDD include: price adjustment; insurance; the possible structuring of the deal as an asset sale rather than a stock sale, so that problematic assets can be excluded; warranties and indemnities; and the rectification of environmental issues at the seller’s expense.

Intellectual Property Due Diligence

IP is a category of intangible assets that is transferred to the buyer in the transaction. It can include patents and trademarks, as well as other rights, such as know-how, designs, inventions, recipes, formulae, software code, and trade secrets. IP may include domain names and other contractual rights to use IP that is not directly owned by the target. In cases where the purchase price contemplates the acquisition of the contractual rights to IP, the buyer’s due diligence team needs to ensure those rights will survive the transfer of control at closing.

IP rights may be a significant component of deal value. Diligence in this area includes:

• identifying and cataloging the target’s IP;

• verifying the ownership of IP (the owner of a particular IP asset the buyer expects to obtain may be the seller rather than the company);

• establishing the validity of IP assets, including whether the rights are registered or not; and

• confirming the uniqueness and quality of IP.

The objective of IP due diligence is usually not simply the summation of discrete dollar values placed on each IP asset in the target’s portfolio. Rather, it is to attempt to assess the role the target’s IP plays in generating future earnings and cash flows. The quality of IP—like the quality of the target’s workforce, capital assets, etc.—will drive the future earnings reflected in the forecast, which is, conceptually, how the target is valued by the buyer. So IP due diligence findings need to be translated into their likely impact on the future revenues and costs of the target in order to ascertain the impact of those findings on the buyer’s assessment of deal value.

Information Technology Due Diligence

Depending on the industry, the target’s IT can be an important part of running the company’s business, or of doing so efficiently. IT can represent a major cost center for some targets, and a key determinant of the company’s profitability.

In IT due diligence, the Buyer will consider the current level of investment, ownership of hardware and software, service level agreements (SLAs), system vulnerabilities, trust among responsible IT staff, and how to plan for PMI.

Potential risks include dependency on a small number of key people, the quality of systems documentation, an inadequate level of technology, or obsolete equipment. PMI considerations include compatibility of systems, cost synergies, the approach to integration, and the time and expense to complete it.

Cybercrime is another major concern that poses risk to all business models, and due diligence will determine if a cyber security policy is in place to ensure the target company’s controls make it insurable and also to cover damages in the event of a breach.

HR Due Diligence

The HR due diligence (HRDD) process is often given less emphasis than other diligence areas, but it is usually the most important determinant of whether a merger is successful. From a purely technical perspective, employment agreements and benefit programs are of primary relevance to transaction due diligence, but the intangible challenges of bringing the target’s personnel together with a new buyer can easily doom the business after the deal closes. Even in a fairly simple scenario where the seller is not involved in day-to-day operations, and the buyer intends to continue operating the business on a standalone basis, the change in control that top management must deal with could create frictions significant enough to threaten the success of the company after the transaction. At the other end of the spectrum, a transaction that contemplates the integration of the target’s and acquirer’s teams across the C-suite and multiple departments is fraught with risk.

Buyers that have a healthy respect for the importance of human resources will deploy a PMI program that begins with HRDD. To learn more about this important diligence work stream and what it might look like, click the article at right.

Whether the buyer’s deal quarterback has an M&A law background or not, the issues surfaced during the various due diligence efforts will be funneled to the buyer’s legal team to be addressed appropriately in the SPA drafting process being undertaken in parallel.

Insurance Due Diligence

The buyer will conduct insurance due diligence (IDD), often as a part of LDD. IDD cuts across many functional areas of the target company. Some noteworthy considerations are:

• Representations and Warranties Insurance (R&WI). To supplement the protections provided by the seller’s indemnities, buyers are increasingly obtaining R&WI policies. If your buyer is interested in getting this coverage, which party will bear the premium may become a point for negotiation.

• Cyber Security Insurance. Cybercrime is increasingly rampant. As the use of modern computing, storage, and financial products expands, even traditional non-tech businesses are increasingly susceptible to cybercrime, but cyber coverage is particularly critical for certain business models. Stronger cyber insurance policies can be obtained with higher quality of internal controls and third-party assurance over them. The presence of a cyber policy and its exclusions gives an indication of the company’s preventative controls, as well as providing another layer of protection in case of a breach.

• Employment Practices Liability Insurance (EPLI). EPLI covers a business against claims by workers who allege the company is liable for violations of their legal rights. Even small companies are increasingly susceptible to such legal claims, which include sexual harassment, discrimination, wrongful termination, breach of employment contract, negligent evaluation, failure to hire or promote, wrongful discipline, deprivation of career opportunity, wrongful infliction of emotional distress, and mismanagement of employee benefit plans. EPLI may be its own policy, or it may be offered by carriers as an endorsement to the company’s business owner policy. EPLI may cover judgments, settlements, and the cost of defending against claims. The cost of coverage varies depending on a variety of factors, including employee count. As with other insured exposures, buyers are interested in EPLI as a failsafe, but HRDD will address the target’s preventative measures. These include having policies and procedures in place, and having processes for disseminating them, training and educating managers and employees, and documenting all HR actions, including claims made, responsive measures taken, and final resolution.

Legal Due Diligence

In addition to understanding a company’s business model through the lenses of commercial viability, operating architecture, and financial performance, and gaining a firm understanding of its tax positions and attributes, it goes without saying that potential buyers must scrutinize the target from a legal perspective as well.

LDD is not a rubber stamp formality or the domain of legal clerks ensuring papers are in order. It plays a central role that extends through to final contract negotiations, and it ensures the findings of all other due diligence work streams are appropriately considered. Knowing the target’s contractual commitments is key to understanding the constraints under which the buyer must operate the business post-transaction. It is also important to discover any unintended legal exposure to which the target has subjected itself through past operations, or to which it is susceptible by the nature of its business.

LDD is the most central of all diligence work streams. Beyond topics of inquiry that fall squarely into the LDD, The buyer will rely on their lead legal advisor for intake and synthesis of risks surfaced from all due diligence work streams. This ensures the risks surfaced from all aspects of the diligence process are appropriately addressed in contract negotiation and drafting.

To delve deeper into LDD, click the article at right.

What causes deals to fall apart in due diligence?

If the buyer due diligence process kills the deal, it is likely the seeds of collapse were planted before that. Avoiding failure entails action you take well before it starts.

• Indications of post-close personnel problems. Members of management may prove uncooperative during diligence, or they may demonstrate they will be unpleasant to interact with after close. Successful leaders know that the cohesion of a team is a critical part of any business, and insightful buyers know that it is one of the biggest unknowns in the purchase of a company. A contemplated business acquisition is unlike any other capital budgeting decision. A cash flowing company’s business model and client market are not as uncertain as when starting a new business or division from scratch or deciding to develop a new market; but the uncertainty of how the company’s workforce will respond to a change in control or to the culture shock of being integrated into another organization is a pronounced risk. The deal can die in due diligence if the buyer detects significant problems in this area.

• Indications that the business is not ready to be sold. Due diligence can reveal the company has problems that were not clearly articulated during the marketing process. It’s better for the buyer to learn this before closing than after. But it is an expensive and avoidable lesson. A critical part of the value provided by the seller’s transaction advisor is surfacing this and/or helping the seller accept it before starting the deal process so that the seller can invest the extra time to prepare instead of causing the expense of a false start to multiple parties.

• Dodging questions or giving inconsistent information. If this happens because of the seller’s reluctance to reveal an Achilles’ heel that would lead the seller to cancel the deal, this also boils down to a preparation or marketing failure. When the seller attempts to disclose the bare minimum instead of providing comprehensive answers, it will only generate more inquiry on the buyer’s part and erode trust. This can even kill deals where the item in question isn’t necessarily a deal breaker, but may have only affected price.

• Performance questions leading into close. As covered earlier, poor deal planning can lead a seller to understaff the diligence team, distracting management from giving the proper attention to day-to-day operations. But the seller may also make poor management decisions leading into the close, such as running unusual promotions or allowing inventory levels to fall, that are indicative of attempts to manage earnings rather than maintain operations at a sustainable pace. These behaviors call into question the integrity of the counterparty. Since businesses routinely experience earnings volatility month to month, in many cases, the incentive for these behaviors can be eliminated by fixing a price in the LOI rather than making it contingent on a financial formula. But this is a matter on which the buyer and seller would need to see eye-to-eye when putting the LOI in place.

• Managing conflict in drafting the SPA. Contention will arise over contract terms in some deals. There may indeed be no way to resolve them to all parties’ satisfaction. However, the teams–especially legal counsel–need to be reachable, responsive, and respectful in making every attempt to find solutions both parties can live with.

Once you commit to the buyer with an LOI, seek to make buyer due diligence a process of useful discovery. If both parties see the bigger picture, they can avoid making the process combative. Use the diligence phase of the deal process to build trust, and as an opportunity to get the buyer to closing with good management relationships started, a comprehensive understanding of the company’s history and current operations, and the confidence they can pick up with management post closing to forge a productive path forward without unpleasant surprises.

Diligence is a two-way street

The buyer can pose risk of a deal not getting done as well. Basic questions your transaction advisor poses during marketing can prevent wasting time and resources in due diligence disclosing your private business information to a party that clearly is not a serious buyer. But your attorney can help ensure the buyer is active and in good standing in its state, who the owners and directors are, whether there are any minority shareholders, and whether you are dealing with personnel authorized to bind the buyer entity.

If you will be providing seller financing in the transaction, it is important to establish what the security is going to be, so it may be important to form a better understanding of the buyer’s balance sheet. While the parties are tailoring the legal documents, an experienced attorney on your deal team will keep abreast of the financing terms and spot attempts in the language to undermine your security position. Other red flags include attempts to delay providing the seller note until after closing or otherwise camouflage the presence of seller financing from third-party creditors from whom deal financing is being obtained.

The buyer can pose risks to the seller past closing as well. If you agree to contingent consideration as part of the deal terms, more than just ways to structure it for the best tax treatment needs to be considered. The further down the post-closing income statement the driver of the payout is, the more risk to you that it will be eroded by costs outside of your control and that the buyer will font-load costs to avoid the payout. Even if the earnout is based on sales, poor top-line performance of the business in the buyer’s hands due to their lack of competence and poor decisions puts your payout at risk too. Poor post-closing performance will likewise adversely affect the value of any stock of the buyer you receive as part of the deal. Consider the buyer’s track record of stock performance after exchanging its equity in past acquisitions. Stepped up scrutiny of the buyer is warranted if the nature of the deal introduces these risks.

Due diligence and contract negotiation go hand in hand, and both parties need to approach it with candor and reason to find workable solutions and get your deal over the finish line.

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