Businesses Looking to Buy, Sell Must Prepare for Due Diligence

by Best Best & Krieger LLP

The Press-Enterprise - June 13, 2014

Are you ready? That’s what BB&K attorney Margaret Hosking asks in this week’s Best in Law column of business owners before they buy or sell.

Your business survived the economic downturn, economists are projecting growth and recovery and you are thinking of selling your business, or perhaps making a strategic acquisition. Are you ready?

We conduct diligence to assess the merit of the transaction or any challenges or impediments to it, and to allocate risk among the parties.

However, we must also remember that the results of our diligence investigation will be used following the closing in the successful integration of the two companies. Integration of corporate cultures, information technology, machinery, equipment, supply chains, and sales and distribution networks begins when a target is identified is honed throughout the diligence process.

In the past, diligence might have been more of a perfunctory inquiry because markets were ever increasing, and it seemed one could not make a bad acquisition.

As the market turned, strategic acquisitions were made quickly before valuable assets were lost, and often with cursory diligence. Next came the acquisitions through bankruptcy in an effort to cleanse assets from successor liability.

Finally, a new buyer has begun to emerge. This new buyer has carefully protected its cash reserves over several years and is poised to make strategic acquisitions – but this buyer is very risk-averse and cautious. The new buyer has a renewed focus on due diligence to identify and eliminate risk; is no longer willing to accept “baggage” to acquire specific assets or accounts – or wants a substantial discount for any flaws; and is also more keenly focused on “life after the closing.”

At a minimum, due diligence focuses on a review and audit of financial statements, financing or debt; accounting adjustments, policies and procedures; historical results and accuracy or reliability of forecasts, quality of assets, sufficiency of working capital, anticipated capital expenditures, taxes, key customer, supplier and employee contracts; and actual or potential litigation.

A buyer should also examine any employee or other liabilities that may be assumed through the acquisition, vulnerability to losses of key accounts or key employees, adequacy of insurance coverage and allocation of risk.

Few transactions focus on “just the assets.” Buyers want good corporate policies and consistent implementation, committed and well-qualified key personnel, good banking and supplier relationships, long-term customer relationships, strong earnings and fantastic projections.

Buyers are also increasingly concerned with intellectual property issues – from adequate licenses for software to copyright and trademark protections and, now, to network security.

“Network security” has become a household phrase due to recent retailer hacks that have focused attention on the substantial potential liability for improper disclosure of consumer financial information, system vulnerability and loss of data. Information technology is assuming a prominent role in due diligence both for assessment of the transaction and the successful integration of systems and cultures post-closing.

Buyers want well-qualified chief information officers, consistent staffing, and adequate policies in place to address physical theft/loss as well as data theft/loss. Buyers will audit and review the target’s audits of its own policies and procedures much in the same way they expect financial statements to have been audited and tested.

They will go beyond a review of firewalls, encryption technology, off-site data storage and policies concerning Internet and network access. They want to know if the target has run any penetration tests or have such tests been run by independent third parties? If so, what were the results and what did the target change following such tests? How is data secured and backed up? What is the disaster recovery plan – and has it been tested? What are the retention and protection procedures? And so on.

Clearly, this can be a daunting process for both buyer and seller. However, a knowledgeable team of accountants and attorneys can help you either prepare your company to be reviewed or review and properly structure any potential acquisition.

* This article first appeared in The Press-Enterprise on June 13, 2014. Republished with permission.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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