Due Diligence Best Practices and Pitfalls


Published on

Watch full webinar here: http://www.firmex.com/Due-Diligence-Best-Practices-and-Pitfalls-sign-up/

LOIs and NDAs signed. Now art meets science with the legal, financial and strategic review of the business. How do you test the value proposition and identify potential risks? Select the best tools to streamline the process? And prepare for regulatory and legal compliance issues arising from legislation like FCPA? Learn what it takes to avoid pitfalls that plague even the most experienced due diligence experts.

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Due Diligence Best Practices and Pitfalls

  1. 1. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 1Firmex Webinar SeriesM&A Master ClassNovember 17, 20111:00 p.m. to 2:00 p.m.Andrew J. Sherman, Esq.Jones Day51 Louisiana Avenue, N.W.Washington, D.C. 20001-2113202-879-3686ajsherman@jonesday.comArt or Science?Due Diligence Best Practices and Pitfalls#firmexmc
  2. 2. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 2About FirmexFirmex is focused on providing the best virtual data roomsolution for managing corporate transactions and financialcomplianceWho uses Firmex?•Firmex community includesover 125,000 users worldwide•Conducted over 10,000 dealsin the last 18 monthsWhy offer an M&A Master Class?•As part of our value-added service, we believe it is importantto offer educational resources to our expanding communityJoelLessemCEOFirmex
  3. 3. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 3Andrew J. ShermanMr. Sherman is a partner in the Washington, D.C. office of Jones Day with over 2,500lawyers worldwide.He is the author of 23 books on business growth, capital formation and the leveraging ofintellectual property. His eighteenth (18th) book, Road Rules Be the Truck. Not theSquirrel. (http://www.bethetruck.com) is an inspirational book which was published inthe Fall of 2008. He has appeared as a guest and a commentator on all of the majortelevision networks as well as CNBC’s “Power Lunch,” CNN’s “Day Watch,” CNNfn’s“For Entrepreneurs Only,” USA Network’s “First Business,” and Bloomberg’s “SmallBusiness Weekly.” He has appeared on numerous regional and local televisionbroadcasts as well as national and local radio interviews for National Public Radio(NPR), Business News Network (BNN), Bloomberg Radio, AP Radio Network, Voice ofAmerica, Talk America Radio Network and the USA Radio Network, as a resource oncapital formation, entrepreneurship and technology development.He has served as a top-rated Adjunct Professor in the Masters of BusinessAdministration (MBA) programs at the University of Maryland for 23 years and atGeorgetown University for 15 years where he teaches courses on business growthstrategy.He has served as General Counsel to the Young Entrepreneurs’ Organization (YEO)since 1987. In 2003, Fortune magazine named him one of the Top Ten Minds inEntrepreneurship and in February of 2006, Inc. magazine named him one of the all-timechampions and supporters of entrepreneurship.
  4. 4. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 4What Is “Due Diligence”?• Due diligence is both an art and a science• Proper due diligence involves:– Knowing where to look– Knowing what to ask– Knowing what tools to use– Knowing who to ask– Knowing how to test premises/answers– Knowing who should ask– Knowing how to verify
  5. 5. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 5What Is “Due Diligence”? (Cont’d)• The “Art” of Due Diligence:– Understanding how to extract key informationfrom a person or situation– Understanding the objectives of the partiesand the underlying transaction– Identifying key hurdles and risks– Identifying why information might be falsifiedor omitted– Targeting the proper sources for disclosure ofinformation
  6. 6. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 6What Is “Due Diligence”? (Cont’d)• The “Science” of Due Diligence:– Do your homework– Be prepared and well-organized– Be precise in your requests– Be persistent in your quest for the truth– Don’t accept the first answer as the finalanswer– Trust your gut – “if it’s too good to be true …”
  8. 8. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 8Due Diligence and Current Events• Impact of 9/11/01 Attacks• Impact of Dot.com failures and Enron• The era of Sarbanes-Oxley• Subprime Crisis• The Madoff and Stanford scandals• Overall global recession and financial system woesBottom Line:We are in an era where everything and everyone mustbe questioned and answers verified
  9. 9. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 9Dealing With Due Diligence SurprisesWalk/Run AwayWalk/Run AwayPurchase AgreementAmendmentsand Protections(Hold backs, R+W’s,Indemnifications,Escrows, etc.)Purchase AgreementAmendmentsand Protections(Hold backs, R+W’s,Indemnifications,Escrows, etc.)Purchase PriceAdjustments(or Terms)Purchase PriceAdjustments(or Terms)IgnoreIgnoreCostRisk
  10. 10. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 10Due Diligence Best Practices• Work as a team, but have a clear quarterback/captain• Designate a primary point of contact for each party to the transaction• Conduct regular team meetings to compare notes and coordinatecarefully• The more you know, the better questions you can ask• Be organized – set timetables and deadlines for deliverables• Use industry experts early and often• Use technological tools available to you (search engines, data rooms,etc.)• Develop penalties/consequences/remedies for non-compliance• Understand why a party may be trying to hide key facts orcircumstances• Question everything – BE INQUISITIVE!
  11. 11. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 11Overview of Analysis ofM&A Targets
  12. 12. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 12Overview of theDue Diligence Process
  13. 13. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 13Overview of the Due Diligence Process• Goal: Objectively prove or disprove the investment thesis:– Can it be operated better? Synergies?– Why own this business?• Intrinsic value: Determine the intrinsic value based on cash flows– Validate/negate assumptions• Levels: 3 levels of Due Diligence– Strategic and operational– Legal and regulatory– Financial
  14. 14. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 14Importance of Due Diligence• Ability to determine whether or not to complete thetransaction• Ability to successfully negotiate the deal terms• Assess in advance the ability to successfullyachieve the desired post-closing businessobjectives• A necessary prerequisite to a well-plannedacquisition though the process can be tedious,frustrating, time-consuming and expensiveAvoid Surprises!
  15. 15. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 15Purpose of Due Diligence• Provide information to assess risks andtransaction requirements• Understand the target business completely• Surface issues early on to identify deal breakers• Create a platform for a successful transaction• Note that while buyer should resist the temptationto conduct a hasty "once over" (either to savecosts or to appease the seller), at the same time itshould avoid "due diligence overkill," keeping inmind that due diligence is not a perfect process
  16. 16. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 16Key Objectives of theDue Diligence Process• Allocate discovered risks between the parties• Address particular issues in representations, warranties andindemnification• Restructure original terms of the transaction based upon duediligence• Adjust the purchase price• Adjust the payment terms• Include escrows and holdbacks• Change the legal structure of the deal• Terminate the transaction• Risk Allocation Options– Indemnifications– Escrows/Holdbacks
  17. 17. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 17Due Diligence Teams• Due Diligence Team: The purpose is to assemble a multi-disciplinary team– Attorneys– Accountants• Accountants can help give the team ammo to re-negotiatethe deal– Investment bankers and advisors– Operational personnel, including technology personnel– Lenders– Don’t forget specialty consultants (tax, intellectualproperty etc.)
  18. 18. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 18Common Due Diligence MistakesMade By The Buyer• Mismatch between the documents provided by the seller and the skills of thebuyers review team. It may be the case that the seller has particularlycomplex financial statements or highly technical reports which must be trulyunderstood by the buyers due diligence team. Make sure there is a capabilityfit.• Poor communication and misunderstandings. The communications should beopen and clear between the teams of the buyer and the seller. The processmust be well orchestrated.• Lack of planning and focus in the preparation of the due diligencequestionnaires and in the interviews with the sellers team. The focus must beon asking the right questions, not just a lot of questions.• Inadequate time devoted to tax and financial matters. The buyers (andsellers) CFO and CPA must play an integral part in the due diligence processin order to gather data on past financial performance and tax reporting,unusual financial events or disturbing trends or inefficiencies.• The buyer must insist that its team will be treated like welcome guests,not enemies from the IRS!
  19. 19. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 19Business Issues In Due Diligence• Industry - Macro Factors– Growth rates– Cyclicality– Adoption rates– Elasticity• Business Model - specific to company– Understanding its products, services, niche, "reason forbeing"• Growth factors– Barriers to entry– Competitors
  20. 20. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 20Business Issues In Due Diligence (Cont’d)• Customers• Suppliers– Distribution/how, and who controls?– Pricing– Regulations– Strategic relationships– Brand recognition• Are there areas where investors/buyerscan add value beyond?
  21. 21. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 21Business Issues In Due Diligence (Cont’d)• Management/Human Resources– Appropriateness of background– Track record of success– Honesty (Background check?)– Strengths/Weaknesses/Holes– Sense of teamwork– Compensation/employment contracts– Incentives (monetary and/or equity)– Entrepreneurial v. large co. culture– Operational v. strategic– Arrangements (related party)
  22. 22. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 22Business Issues In Due Diligence (Cont’d)• Other shareholders– Who are they?– Can you work with them?– Incentives?– Are their goals aligned with yours?• Special rights?– Financial
  23. 23. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 23Business Issues In Due Diligence (Cont’d)• Historic review• Recasts• Projections (reliability)– Information systems• Physical Plant, Property and Equipment– Appropriateness– Leased versus owned a Replacement value– Projected capital expenditure requirements
  24. 24. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 24Analyzing the Business IssuesIn Due Diligence• In conducting due diligence from a business perspective, you arelikely to encounter a variety of financial problems and risk areas whenanalyzing the target company. These typically include:– undervaluation of inventories or weakness ofbacklog/customer orders or lack of loyalty– overdue tax liabilities– market trends unfavorable (margin on demandshrinkages/erosion, highly competitive, lack of growth indemand, etc.)– inadequate management information systems
  25. 25. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 25Analyzing the Business IssuesIn Due Diligence (Contd)– incomplete financial documentation or customer information– related-party transactions (especially in small, closely heldcompanies)– an unhealthy reliance on a few key customers or suppliers(concentration issues)– aging accounts receivable– incomplete financial documentation or customer information– unrecorded liabilities (for example, warranty claims, vacation pay,claims, sales returns and allowances)– an immediate need for significant expenditures as a result ofobsolete equipment, inventory or computer systems
  26. 26. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 26Industry/Market Review• Key problems facing the industry• Market Characteristics• Financial results of comparable companies• Importance of technology, trademarks,licenses and other intellectual property• Impact on the industry of governmentalregulation• Competition
  27. 27. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 27Financial Review• Activities that would disallow contemplated accounting treatment• Accounting Policies and Procedures• Revenue Recognition• Profit Margins/trends• Interim Operating Results• Backlog• Related Party Transactions• Debt, Cash flow and Banking Relationships• Budgets and Projections
  28. 28. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 28Operational Review• Management: Strengths and Weaknesses• Internal Control Structure• Facilities• Compensation and employee benefits• Information systems
  29. 29. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 29Mechanics of Due Diligence
  31. 31. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 31Logistics of Due Diligence• Before we understand the sources of data for theprocess of due diligence, it is important to understandcertain logistics• The buyers lawyer should coordinate the due diligenceprocess so that target receives only one set of diligencerequests, rather than repetitive requests from the variousadvisors (e.g., accountants and bankers).• Even if accountants or other specialists are alsoperforming due diligence, the buyers lawyers should beresponsible for at least reviewing and cataloguing allitems in a data room unless explicitly told to not reviewcertain items.
  32. 32. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 32Logistics of Due Diligence (Cont’d)• The targets lawyers should control the duediligence process at least to the extent that theyreceive copies of all materials that are forwarded tothe buyer. Also, the targets lawyers shouldconduct their own due diligence review of thetarget, particularly if they have not historicallyrepresented the company, to ensure the accuracyof the representations and warranties andschedules.
  33. 33. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 33Logistics of Due Diligence (Cont’d)• When distributing a due diligence request list, the buyerslawyer may wish to also distribute the draftrepresentations and warranties so that the target cancompile information which is responsive to the diligencerequest and is necessary to prepare schedules to theacquisition agreement.
  34. 34. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 34Sources Of Information• Review Public Information• Due Diligence Request Lists• Site visits/Management Meetings• Industry specific professionals• Experienced peers• Interviews: clients, vendors, competitors• Investigators• Abandoned and Failed Deals34
  35. 35. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 35Virtual Data Rooms
  37. 37. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 37Virtual Data Room• Print and Access Features– Enable to disable printing of documents– Enable or disable the ability to view a document– “Confidential” Options• Audit– Customized reports show date, document, time and print activity• Maximum Reach– All users are more productive and efficient – office, road or home– 24/7 availability• User Friendly– No orientation necessary
  38. 38. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 38Virtual Data Room – Sell Side Advantages• Reduced Transaction Time– Serious bidders identified early in process– Deal closes sooner– No scheduling conflicts– No travel delays• Detail Audit Reports– Follow footsteps of each user– Easily identify documents that have not been viewed• Confidentiality– Users never bump into one another– Security protocols insure confidentiality
  39. 39. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 39Virtual Data Room – Buy Side Advantages• Target Risk Assessment– Easy access to target information for due diligence review ofcompany and industry• Negotiations– Centralized catalogue of documents for negotiation key issues• Post-Closing Document Integration– Documents are easily accessible to various department for reviewand integration
  40. 40. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 40Legal Due Diligence
  41. 41. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 41Due Diligence Checklists – Key IssuesThe buyers acquisition team and its legal counsel gather data to answerthe following a variety of key legal questions during the legal phase ofdue diligence:1. What legal steps will need to be taken to effectuate the transaction(e.g., director and stockholder approval, share transferrestrictions, restrictive covenants in loan documentation)? Has theappropriate corporate authority been obtained to proceed with theagreement? What key (e.g., FCC, DOJ) third-party consents (e.g.,lenders, venture capitalists, landlords, key customers) arerequired?2. What antitrust problems, if any, are raised by the transaction? Willfiling with the FTC be necessary under the pre-merger notificationprovisions of the Hart-Scott-Rodino Act?
  42. 42. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 42Due Diligence Checklists – Key Issues3. Will the transaction be exempt from registration underapplicable federal and state securities loans under the "saleof business" doctrine?4. What are the significant legal problems or issues nowaffecting the seller or that are likely to affect the seller in theforeseeable future? Are there any FCPA, DCAA, or otherregulatory investigations pending or threatened? Whatpotential adverse tax consequences to the buyer, seller, andtheir respective shareholders may be triggered by thetransaction?
  43. 43. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 43Due Diligence Checklists –Key Issues (Cont’d)5. What are the potential post-closing risks and obligations of thebuyer? To what extent should the seller be held liable for suchpotential liability? What steps, if any, can be taken to reducethese potential risks or liabilities? What will it cost to implementthese steps?6. What are the impediments to the assignability of key tangibleand intangible assets of the seller company that are desired bythe buyer, such as real estate, intellectual property, favorablecontracts or leases, human resources, or plant and equipment?7. What are the obligations and responsibilities of the buyer andseller under applicable environmental and hazardous wastelaws, such as the Comprehensive Environmental ResponseCompensation and Liability Act (CERCLA)?
  44. 44. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 44Due Diligence Checklists –Key Issues (Cont’d)8. What are the obligations and responsibilities of the buyer and sellerto the creditors of the seller (e.g., bulk transfer laws under Article 6of the applicable states commercial code)?9. What are the obligations and responsibilities of the buyer and sellerunder applicable federal and state labor and employment laws (e.g.,will the buyer be subject to successor liability under federal laborlaws and as a result be obligated to recognize the presence oforganized labor and therefore be obligated to negotiate existingcollective bargaining agreements)?10. To what extent will employment, consulting, confidentiality, ornoncompetition agreements need to be created or modified inconnection with the proposed transaction?In other words, legal due diligence will focus on the potentiallegal issues and problems that may serve as impediments tothe transaction as well as shed light on how the documentsshould be structured.
  45. 45. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 45Critical Success FactorsDo:• Involve an experienced, dedicated team with clearly defined roles• Discuss potential deal breakers early and often• Insist on full access to target• Be persistent and skeptical• Plan for sufficient time to complete the project• Develop a Day 1 plan
  46. 46. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 46Potential Problems to AvoidDon’ t:• Exclude experienced legal counsel• Agree on contract details too quickly• Rush due diligence• Assume the deal is done until it is actually closed• Be afraid to walk away from the deal before it is closed. Rememberthat the key objective of due diligence is not just to "confirm that thedeal makes sense" but rather to determine whether the transactionshould proceed at all, recognizing at all times that there may be aneed to "jump ship" if the risks or potential liabilities in thetransaction greatly exceed what the buyer anticipated.
  47. 47. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 47Questions & Answers
  48. 48. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 48Book Winners!• P. Freidman, SSM Health• M. Moretto Crosbie & Co• M. Kulik, Braff Group• K. Benson, Presidio Group• C. Polson, VercapCongratulations! We will be following up shortlyto get your book preference and mailing address.
  49. 49. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 49Thank YouNext M&A Master Class is Dec 8th, 1pm EasternRubber Hits the RoadEnsuring Success in Post-close IntegrationThe easy part’s done – now make your investment work.Alarmed about post-close integration failure rates? How do youincrease your chances of retaining key clients, partners and staff?Where can redundant processes and excess costs be cut? Learnpractical tips for building successful post-merger integrationprogram and avoid a deal disaster.www.Firmex.com/company/eventsToday’s Recorded Webinar, Slides, and Complementary Checklists will bemade available in a follow-up email shortly.