You started your business years ago and today there is a buyer – the reward for your hard work! Over the years, “contracts” may have been handshakes; “promises” might have been made; you may not have read the fine print or boilerplate; and family members may have loaned you money with no documentation. What were good ideas then are now issues because the buyer is conducting “customary due diligence.”
Due diligence is a simple concept. The potential buyer should know all the facts about the business that a smart buyer needs to know in order to make an informed decision. Clients ask me if a buyer is fair in asking for detailed information. The answer is a question: “Is this something that you would want to know if you were the buyer?” Due diligence is a typical and fair process that takes time and effort.
Can due diligence hurt a deal?
In any transaction, there comes a point where speed to closing is the key. A lengthy due- diligence process where the buyer finds many “skeletons” or finds the skeletons one at a time over many weeks may delay closing. To speed the process, set up “virtual data rooms” where the seller engages a Web site host to post all the company records in a secure fashion. This allows for 24/7 “desktop” access to records. When you get the due-diligence request list from the buyer, you should dedicate a smart team to respond quickly and with transparency.
What are the common problems?
• Third-party consent: Start now to review all contracts that may require third-party consent for a sale. While a merger or a stock sale is usually not an “assignment,” many contracts require consent for a change in control. Plan ahead so that few, if any, contracts require consent. If consent is needed there are several concerns. First, the transaction may be disclosed before you want it announced. Second, the other party may use your request for consent as an excuse to amend the contract. Third, it may take time to get the consent signed.
• Unlicensed software: Take the time now to audit internal software. Buyers are wary of accounting, inventory management and other internal-use software that are not properly licensed.
• Promises of stock: When you announce a sale, employees and others may try to achieve a big “pay day.” Former and current employees, vendors and partners may recall that a promise was made or may recall conversations differently than the owner. Never discuss stock rights unless you are committed to make the grant and you sign an easy-to-understand contract. One universal issue for all buyers is to verify company ownership.
• Unwritten contracts: Business people often “agree” on a relationship and then conduct business without anything in writing. Those handshakes are enforceable and the other side might try to take advantage. Naturally, your buyer will ask for an explanation of the deal terms and a summary of your “course of dealing.” You may be required to approach the business partner and ask for a contract when you have no leverage. Written contracts need not be complex or long; but they do need to be complete.
• Unsettled disputes: Years ago you received a letter about a dispute with another business. Simple advice – get it resolved. That letter must be disclosed to the buyer and the buyer will ask “what happened?” To avoid an indemnity or price adjustment you need to show that the matter is resolved. While the best solution is a settlement agreement, you could also document your position in a response letter that requires a reply by a certain date.
• Poorly maintained records: A buyer will review the business’ history, including board and stockholder records, stock grants, employment records, governmental filings and contracts. You might hire a chief financial officer to establish and maintain document control so that your CFO can quickly find all the documents in an orderly sequence when asked by a buyer. This will minimize doubt on the quality of your records.
• Accounting short cuts: Don’t use an off the shelf software package for financials and don’t ignore prudent business practice in areas such as properly accruing vacation pay or being conservative on revenue recognition.
The advice is simple. Plan ahead for a potential sale and get organized. The cost and effort today will pay off in the future in a faster closing and higher purchase price. •
Jonathan Karis is a partner with Nixon Peabody LLP and is chair of the firm’s Venture Capital and Emerging Growth Company Practice Group. Mr. Karis’ practice includes the representation of startup and venture capital-backed businesses in New England.
