From the time a seller accepts a letter of intent until the closing date, lots of “due diligence” work goes on for the buyer to check out the seller. Such work includes examination of financial information, study of legal commitments likely to be important to the buyer, review of key people in the company, and more.
The time period for the due diligence process generally runs from the date of the Letter of Intent, to the closing date. The closing date normally is clearly and decisively indicated in the LOI, and if the process delays the closing due to issues discovered during due diligence, the buyer would usually ask for an extension, via an addendum to the LOI, to proceed under similar terms. (If the LOI has an exclusivity provision, the buyer needs such an extension to avoid losing exclusivity during this time period. That is a fairly significant issue, because the buyer should be afraid of the opening the door to introduction of new competition.)
The negotiated letter of intent provides for a time period of perhaps 60-90 days for buyer due diligence. We have had transactions completed in as little as 30 days (rarely), or occasionally as long as 120 days.
Buyer “protocol” for conduct of due diligence should be established in the LOI, but if not, the buyer is likely still bound by the non-disclosure they originally signed to look at the company. Such “protocols” would deal with access to information during the due diligence process, and would address intent for buyer or buyer agent access to information during the process. We have had buyer and buyer agents receive all information via email, or we have had buyer agents investigate data as if they were working for a lender or other outside third party, to reduce internal staff’s potential consternation about pending sale.
During due diligence, buyers commonly request the ability to inquire of customers to assess customer relationships and future intentions regarding seller products or services. We suggest allowing buyers to talk to customers only if this is done like a “customer satisfaction survey” – without mention of the fact that the company may be sold. We also would provide that either an owner of the seller company, or a representative from Douglas Group, also be allowed to listen in on such “survey” inquiries, to ensure that customer access is conducted only as agreed in advance between buyer and seller.
Buyers also sometimes feel it is important for them to interview certain key employees, before closing. This cannot usually be done without seller permission, because the buyer will be bound by the non-disclosure agreement they signed to originally look at info on the company. However, as the due diligence process nears the end, we often get determined focus from buyers to insist on such access. We encourage sellers to consider allowing such interviews, at the very tail end – usually in the week before closing. This still can be alarming to employees, but the resulting tension is generally minimized, if the known outcome is defined quickly (as in, a week before close.)
During the due diligence period, buyers will want to make sure that the financial summary information they have seen, to arrive at their pricing commitment, agrees to the seller’s books of original entry. It is very normal during such process for buyers to have detailed questions regarding the nature of expenses, and the concentration of customer activity. If specific contracts are in place, defining either the customer relationships, or the commitments for ongoing costs, the legal basis for those relationships will likely be reviewed by buyers and their counsel.
Often in recent years, buyers may also have a “Q of E” (acronym for “Quality of Earnings” study) done, often by a CPA firm, as a part of the due diligence process. The Q of E looks into financial histories, recent trends, and “recast” financial performance, to assess the reasonableness of a multiple of earnings bid for the seller company. This process can take anywhere from a few weeks to a few months, depending on the buyer stipulations for hire of the service, and can be important in identifying any significant trends or likelihoods for changes in earnings in the go-forward period.
Agreements that may need to continue post-closing, may require buyer discussions with the pertinent third party. If the transaction is an asset format instead of a stock deal, post-closing arrangements between the buyer and certain third parties may need to be discussed in advance. Most such arrangements will not cause great concern on the part of buyers, because outside third parties are often fine with a buyer assuming a similar relationship. However, if such transition might require the assumption of significant additional risk by the buyer, that could make a more complex renegotiation important. For example, we once had a situation where the seller had a significant long term lease, with a powerful personal guarantee by a wealthy shareholder, which the lessor found comforting and felt was important. The lessor was reluctant to sacrifice the protection offered via the personal guarantee. In that situation the buyer was able to offer a guarantee by the purchasing organization, which was adequate to reassure the lessor. However, if that had not been resolved, basic occupation of the main facility could have been at odds, with costly outcomes for buyer and seller.
Sometimes the seller may have advantaged relationships via some sort of long term agreement in place. If that advantaged relationship would not easily transfer to a new owner, the buyer will need to become aware of the issue. In those cases, the buyer may need to anticipate a potential change that may be required, in order to consummate the deal. We had a situation recently where a seller had a dramatically advantageous lease for one of the facilities, which the lessor would certainly be unwilling to transfer in an asset sale to a new owner. In that case, we were aware of the issue as we considered offers, and buyers were encouraged to consider a stock purchase format, so the lease could remain intact.
As the due diligence process proceeds, the seller will often be reviewing a Definitive Purchase Agreement draft simultaneously. Sometimes issues may have arisen during the course of due diligence, which are defined and dealt with explicitly in the purchase agreement. That’s not shocking or unexpected, since the purpose of the due diligence was always to make the buyer knowledgeable about the circumstances they’re buying into. However, care and attention to those likely issues in advance, along with thorough disclosures, can reduce the likelihood of transaction trauma. Solid planning in front of the due diligence process to provide for full and fair disclosure can dramatically reduce potential for a derailed transaction.
These are only a handful of the many common issues likely to be identified (and hopefully resolved) during the due diligence process. Careful consideration and meticulous disclosure in advance of acceptance of the letter of intent, can enhance probability of good results from the due diligence process, and improve probability of successful close.
For more information, contact Debbie Douglas