Due diligence is a standard phase of any corporate transaction, whether structured as an asset or stock sale or joint venture, and sellers are often surprised, and even overwhelmed, by the comprehensiveness of the diligence investigation. Preparing prior to soliciting bids or looking for a buyer can ease the burden of diligence and allow the seller to focus on other areas of the transaction, such as negotiating important terms and documents.
The Two Phases of Diligence
There are usually two phases of diligence—one after signing a letter of intent (the “LOI”) and one when populating the disclosure schedules. Disclosure schedules are generally a set of documents that summarize and set forth the diligence responses that the seller provides to the buyer in the course of the transaction. They are negotiated just like any other document and can play a large role in the transaction. The initial phase, after signing the LOI, is comprehensive and may overlap with the latter, disclosure schedule phase. During this period, the buyer usually provides the seller with an extensive due diligence request list asking seller various questions about business governance, history, operations, financials, employees, employment matters, and compliance. The seller will then provide all relevant responses and documentation to a virtual data room. The buyer will review all responses and tailor certain transaction terms accordingly. Sellers should respond to all diligence requests accurately and completely, and with the guidance of counsel. The seller’s corporate counsel should have an opportunity to review all responses prior to providing them to the buyer for certain sensitive information, such as competitively sensitive information, that should be redacted or withheld during the initial stages of the transaction.
The second phase, conducted while populating the disclosure schedules, is usually prompted by anything that must be disclosed that has not already been disclosed in the virtual data room. Typically, the seller’s corporate counsel will have reviewed the data room and compile a list of documents and questions to ask the seller in order to fully populate the disclosure schedules. Often, several of the required documents are provided in the virtual data room during the initial diligence phase, but not always. Sellers may often feel frustrated and dismayed that they need to provide more diligence after the initial phase and at a time when the seller would rather be focusing on negotiating major terms and transaction documents, and so it can be helpful to prepare for diligence before the transaction even begins.
Before ever receiving the initial due diligence request list from the buyer, there are a few things a seller can do, such as identify a few people with broad operational knowledge of the business. These are employees, directors, managers, and/or owners who could be instrumental in gathering the appropriate documentation and responses to the diligence request list. If there are confidentiality concerns, it may be necessary to ask each to sign a Non-Disclosure Agreement regarding the potential transaction prior to discussing the transaction and the due diligence request list.
Second, most due diligence request lists require the seller to provide copies of the seller’s charter, financial statements and tax statements, making it beneficial to locate these documents and store them in an easily accessible place. If these documents are not on site, but with an engaged consultant or advisor, such as an accountant, the seller may want to reach out and ask for any and all documents the consultant or advisor possesses concerning the seller.
Next, every due diligence request list asks for certain types of contracts, such as payor agreements, agreements with a dollar value over a certain threshold, employment agreements, and agreements with governmental authorities. It may be helpful to start identifying and locating various agreements, and if this proves to be difficult, then running an accounts payable report and accounts receivable report can help identify the various parties with whom the seller has a contracting relationship. Often times, there may not be a written agreement, so providing invoices or purchase orders can also be helpful, along with a written summary of the nature of the relationship, such as how long the seller has done business with that particular vendor or customer, the dollar value of the relationship, and the frequency with which the seller places orders or the customer places orders with the seller.
The seller should work closely with its corporate counsel at all times during the diligence phase. Corporate counsel can help seller produce documents, review documents for purposes of drafting the disclosure schedules, identify documents that contain information that should be redacted or only provided to a small, select group of people representing the buyer, and generally advise the seller as to how to draft any required written answers or summaries to due diligence request lists.
While entering into a transaction is exciting for many sellers, that are certain phases or aspects of a transaction that can feel or become overwhelming, including the production of diligence responses. Preparing ahead of time and engaging corporate counsel to help can ease that burden and allow the seller to concentrate on operating their business and negotiating other transaction terms.