M&A Due Diligence: Let the Buyer Be Sure

The suspicious thinking behind the expression caveat emptor – let the buyer beware – shouldn’t sow doubt between a buyer of a printing company and its seller if both parties are being open and above board with one another. However, “let the buyer be sure” (which doesn’t translate as neatly into Latin) is always good advice, and it’s what the exercise known as due diligence is all about guaranteeing.

Due diligence begins after negotiations are concluded and the parties have signed a letter of intent (LOI) declaring their willingness to proceed toward closing the deal. As we remind our clients, this is no time for surprises or last-minute attempts to finesse selling price up or down. Because due diligence aims at reconfirming everything that has been established up to this point, transparency isn’t just the best policy: it’s the only sure way to carry the deal across the finish line.

Responsibility for due diligence rests with the buyer, whose first step probably will be to engage a consultant or direct a qualified team member to perform a quality of earnings (QOE) audit of the seller’s financials. Its purpose is to validate the income statement that the deal is based on.

In a financially driven acquisition where the company is being purchased primarily as an investment, a QOE is almost certain to be required by senior lenders to the deal. In a tuck-in, on the other hand, the buyer’s main interest is in acquiring the seller’s customer base along with the sales staff and CSR personnel who support it. The buyer may thus decide to bypass the QOE, making due diligence faster and less intrusive for the seller.

Another part of the process consists of identifying and removing administrative obstacles that might stand in the way of closing the deal. Two types that we see arising frequently are issues of landlord consent and undischarged Uniform Commercial Code (UCC) filings related to debt.

The seller’s landlord must agree, for example, to reassign the lease to the buyer. There also could be covenants or zoning restrictions that could get in the way of the buyer’s plans to expand facilities on the property or add parking space. Full transfer of operational control can’t take place until these permissions have been obtained.

UCC filings cover a wide range of business transactions, but the ones that typically come up in M&As are filings made to create liens against property offered as collateral for loans. The thing to remember about them is that once the debt is settled, the lender must agree to delete the filing from the record – removal isn’t automatic upon repayment.

Here, the onus is on the seller, who shouldn’t expect the buyer to take his word that an undischarged filing still sitting on the books doesn’t have an unpaid debt attached to it. Tracking down the history of an old loan can be time-consuming, so it’s in the seller’s interest to get UCC complications out of the way as soon as circumstances permit. Again, the seller should not assume that their lenders did this when the loan was paid off.

Apart from the financial review, due diligence consists mostly of filling in details of the big picture that was drawn during the negotiation stage, and correcting errors and omissions that cloud it. Carried out thoroughly, the process touches almost every aspect of the business being acquired.

The buyer will want full information, for example, about any ongoing legal or human resources issues that need to be addressed prior to closing. Workers compensation claims, health/safety requirements, and environmental compliance should get the same degree of scrutiny. Buyers also appraise equipment, assess inventory, and examine accounts payable and receivable for clues to the true status of these components of the business.

Successfully integrating the seller’s sales team with the buyer’s is another objective of due diligence, achieved by asking the right questions about how the two groups will align post-closing. Compensation plans may have to reconciled; salespeople not working under non-compete agreements, which buyers frequently insist that they have, may be required to accept them.

It’s in delicate matters like these that the need for confidentiality in due diligence becomes apparent. Due diligence can’t be performed in a vacuum: at some point, key people on both sides will have to be brought into the loop so that the buyer can obtain all information needed to fill in the blanks. There’s also the risk of provoking negative reactions in those who feel they’re being blindsided by bad news at the last minute.

Once it’s out, however, news always travels fast, which is why we counsel our clients to delay sharing information for as long as reasonably possible. How long will vary from case to case, but a general piece of advice for timing might be expressed as, “Once you tell your salespeople, you’d better be sure to inform your customers.”

Although buyers take most of the initiative in due diligence, sellers have their work cut out for them in the process as well. A seller undergoing the examination for the first time may be surprised at the sheer volume of detail the buyer wants to see. But, executing due diligence the right way means drilling down into every layer of the business being acquired – a no-guesswork investigation that the seller should be prepared to fully cooperate with.

It’s well worth the effort, and not only because it’s crucial to closing the deal. At the end of it all, our selling clients often tell us that they’re grateful to have had the opportunity to learn as much as they did about the inner workings of their businesses – and about their effectiveness in managing them.

At the completion of a successful due diligence, everyone should be experiencing the same kind of positive satisfaction. The mark of its success is the fact that the deal is proceeding to closure on the same terms outlined in the LOI – only now, the merits of the deal and its advantages to both the buyer and the seller are clearer than ever.