Berkman Due Diligence and the D Business Transaction u e Getting a Deal Done D i l Due Diligence and the Business Transaction: Getting a Deal Done is a practical guide i g to due diligence for anyone buying or selling a privately held business or entering into a major agreement with another company. e When you’re buying a business, it’s wise to conduct due diligence. That's the process n of investigating and verifying the firm’s finances, labor record, exposure to environmental c issues, store of intellectual property, hard assets, ownership structure, and much more. e If you don’t, you may later stumble into serious, costly problems, or you may pay an inflated price for the business. This book not only shows you how to conduct such an a examination and what to look for, but it will also help you uncover hidden issues that n some sellers might not want you to know about. d Conversely, this book shows smart business sellers how to conduct due diligence t on their own firms to arrive at the right sales price, uncover issues that might scare off h buyers or investors, solve lingering problems before a sale, and more. Done right, due e diligence can help sellers ensure they sell the business for the best price and with the B least risk. Due Diligence and the Business Transaction will help you understand when to conduct due diligence, whom to include, and how to spot the red flags that signal u danger. In addition, you will learn: s • How to conduct due diligence when contemplating a joint venture, business i n loan, franchise opportunity, or manufacturing deal • How to calibrate the correct scope and breadth of the due diligence investigation e depending on your situation s • How the results of due diligence may and often will change the elements of the s final deal • How to draft due diligence documents so they protect your interests T • What successful deals look like r a Corporate attorney and due diligence expert Jeffrey W. Berkman interweaves critical n action points, guidelines and procedural steps, case studies, and due diligence ques- tionnaires, checklists, and documents. The veteran of many business deals, Berkman's s advice will help you avoid business- crippling mistakes and make the best deal possible. a c t i o n ISBN 978–1–4302–5086–9 53499 Companion eBook Shelve in: 9 781430 250869 Business/Entrepreneurship www.apress.com For your convenience Apress has placed some of the front matter material after the index. Please use the Bookmarks and Contents at a Glance links to access them. Contents about the author                                             ix Preface                                                      xi Chapter 1: introduction                                       1 Chapter 2: What is Due Diligence?                             7 Chapter 3: the Due Diligence Questionnaire                     25 Chapter 4: tailoring Due Diligence to the transaction             51 Chapter 5: a Material legal issue Can Kill the Deal               79 Chapter 6: Has Due Diligence Created an opportunity to improve the Deal terms?                                    93 Chapter 7: applying Due Diligence Principles: the Franchise Purchase                                        129 Chapter 8: Resolving the issues                               167 Chapter 9: the Due Diligence Process and Pragmatic Considerations                                   211 appendix a: Due Diligence Plan for KMF Franchisee, llC, investment                                       231 appendix B: Due Diligence Questionnaire for KMF Franchisee, llC   239 appendix C: Due Diligence Questionnaire for overlook, inc        255 appendix D: Due Diligence Questionnaire for aBB, inc            261 index                                                       269 C H A P T E R 1 Introduction A Client Walks into a Lawyer’s Office to Discuss the Results of a Due Diligence Investigation . . . No, this is not the beginning of another lawyer joke, but rather the start of a dramatized discussion of a typical problem often revealed during a due dili- gence investigation in the context of the sale of a business. The conversation between the lawyer and his client, Jack, unfolds as follows: Date: October 22 Place: Office of Jack’s Attorney Lawyer: Hi, Jack. Thanks for coming to the office. I know you wanted to complete the purchase of the business of ABB Internet Retailer Company to take advantage of the holiday season, so let me fill you in on the status of the transaction. Jack: Actually, I’m glad you asked me to stop by. Leah, the seller, has been calling me every day, wondering whether we’re going forward with the purchase of the company. She’s complaining that we negotiated and executed the letter of intent some time ago, and she’s put a lot of time into preparing her employees and clients for the transition to my company. She’s wondering why the transaction has been dragging on for so long. She even said the other day: “This isn’t some multimillion-dollar Wall Street transaction. Do you have other motives, such as backing away from the deal or looking to reduce the purchase price?” I assured her that we aren’t trying to renegotiate the deal and that I’m as anxious as she is to complete the purchase. 2 Chapter 1 | Introduction Frankly, I’m concerned as well. I need to close the deal and turn my focus to integrating ABB’s web site and business into my business so we’re ready for the holiday season. However, I can’t do this until I’m sure if, and when, the deal will close. Lawyer: I understand your concerns completely. I realize the holidays are approaching and you’ll lose holiday revenue if the transaction doesn’t close soon. I’ve been trying to push this transaction forward, but the seller’s attorney has been slow in responding to my due diligence requests. Unfortunately, I had to wait several weeks for the seller’s attorney to return the due diligence questionnaire and provide copies of the documents I requested. When you and I reviewed the LOI, remember that I said I don’t advise proceeding with the purchase until I’m satisfied with the results of the due diligence investigation. In fact, in general I prefer not to spend too much time reviewing a draft of an asset purchase agreement until completing the due diligence for two reasons. First, the information that’s disclosed by the seller or uncovered by me during the due diligence process affects how I approach the draft of the purchase agreement. For instance, I might demand that the purchase agreement include certain additional warranties, postclosing indemnifications, and holdback of a portion of the purchase price to cover material due diligence issues. Second, the due diligence investigation can uncover issues that are so significant that my recommendations could be (1) to renegotiate the purchase price or other terms, (2) to walk from the deal, or (3) to agree to proceed with the transaction only if the issue or issues can be addressed before closing or through post-closing assurances from the seller. The last scenario is the situation we have here. I’ve discovered a major issue and I don’t recommend moving forward until the seller resolves the matter. Jack: That doesn’t sound good at all. I also don’t understand what issues there could be. My review of the web site and the seller’s unique order processing software—the key asset I’m really after in this deal—looked great. So what’s the problem? Lawyer: If you recall, due diligence involves several different aspects, depending on the nature of the transaction. In this case, the key areas were financial review, due diligence relating to the customer list, review of the technology, and due diligence regarding various legal matters. Although you’re satisfied with the functionalities of the web site and the ABB order processing software, there are legal issues relating to it. It seems that Leah had a partner, Dana, who developed the ABB proprietary software that is at the heart of business assets you are purchasing. Due Diligence and the Business Transaction 3 Jack: That doesn’t seem like a big deal. Dana is no longer part of the business; Leah bought her out for a hefty sum last year. Lawyer: Well, that’s the issue. Dana never assigned her rights in the ABB software over to ABB Internet Retailer Co. Jack: Leah told me months ago that, even though Dana developed the software before she entered into the business with Leah, at the time ABB was formed, Dana contributed the software to the company. Lawyer: That may have been the intention and, in fact, the understanding between Leah and Dana, but the problem is that there are no documents showing that the ABB software was assigned to the company. Because Dana created the software, under copyright law she is the author and thus the owner. Although Leah may have a claim that it was contributed to the company, and the partners understood the software was owned by ABB, none of this is sufficient to give me comfort that Dana cannot claim, at some point, that she owns the software, not ABB. You want to buy the assets of ABB, not a potential lawsuit. Even if you ultimately won the suit, it would cost you a lot of money to litigate. If you lost, it would require purchasing or licensing the software from Dana at a substantial cost. Jack: [silence] That shouldn’t be a problem. Dana and Leah are still friends, so Dana will sign whatever is needed. Lawyer: It may not be that easy. We don’t know how Dana will respond until Leah discusses the issue with her. However, I can tell you from experience that when there is money on the table, ex-partners are not always happy to say yes without some compensation. Jack: Regardless, you come well recommended so I’m sure you can resolve this without additional cost or delay, right? Lawyer: I’ll certainly look for ways to resolve this as quickly as possible without substantial cost, but the ball is very much in Dana’s court. However, I can’t recommend moving forward until the matter regarding the ABB software is resolved. Jack: This isn’t what I expected to hear today. I need to call Leah and find out why she didn’t take care of this huge issue before Dana left ABB. Lawyer: OK. Also, I have a couple other issues we need to discuss that were uncovered during the due diligence, but they’re smaller issues that can be addressed through the terms of the asset purchase agreement, and require the seller to agree to a reasonable holdback in escrow of part of the purchase price. 4 Chapter 1 | Introduction Jack: I need to run to another meeting—ironically, with another retailer who I was hoping to convince to enter into a joint venture after I integrate the ABB software into my business. I can’t stomach any more bad news right now, so let’s talk about the other issues you found after my meeting. Lawyer: I’ll contact Leah’s attorney about the software issue and my other concerns. In particular, I’ll advise him that the seller needs to get an assignment of the software from Dana before we can proceed. I’ll circle back with you on this and the other issues after I speak to the seller’s attorney. However, if you don’t want to hear any other bad news, I suggest avoiding a call from your computer consultant as he found some bugs in the software. Due Diligence: Critical in a Business Transaction Although the foregoing dialogue between Jack and his lawyer about Jack’s intended purchase of Leah’s company is fictional, it faithfully represents a type of conversation that commonly results from due diligence investigations undertaken before the purchases of businesses. It is an unsettling conversation for anyone buying or selling a business, because it calls into the question the ability of the parties to close a transaction into which each party has invested substantial time and money and which has been a major distraction from the operation of his or her own business. Yet due diligence is a critical part of the process. This book will periodically tune into the ongoing conversations between Jack and his attorney—comprising “Case Study 1: The ABB Transaction”—because they will illustrate due diligence themes that are important to you as a party or agent to a business transaction, including the following: • How to conduct due diligence when contemplating buy- ing a business, investing in a company, providing a business loan, becoming a member of partnership, licensing intel- lectual property, or buying into a franchise • How to calibrate the correct scope and breadth of the due diligence investigation depending on the nature of the transaction and your tolerance for cost and delay, especially in smaller or apparently simple deals • How the results of due diligence may and often will change the elements of the final deal Due Diligence and the Business Transaction 5 • How to draft the due diligence questionnaire and information requests so they protect your interests • How the results of the due diligence affect the scope, terms, and conditions of the definitive transactional document. When you are buying a business, it is essential that you conduct due diligence. The nature of the transaction, the type of products and services offered by the company, and the scope of the target company’s business operations dic- tate the breadth of the investigation. Financial and legal advisors are obvious participants during the process, but transactions often also require assistance from other professionals in a wide variety of fields to investigate and advise on such issues as: environmental matters; patent or other intellectual property review; foreign tax, accounting, or legal questions; privacy, the Health Insurance Portablility and Accountability Act, data management, and security matters; and new or evolving technologies. If you do not conduct proper due diligence, you may later stumble into seri- ous or even devastating problems, or you may pay an inflated price for the business. This book shows you how to conduct a due diligence examination, what to look for, how to spot red flags, and how to uncover hidden issues that sellers might not want you to know. It also explains how information learned through due diligence can lead to termination of the deal or a substantial alteration of the material terms. Due diligence is not just for business buyers and investors; it is often no less essential for business sellers and companies that are seeking to raise financing. Sellers and companies raising capital will learn from this book how to conduct due diligence on your own firm, how to uncover issues that might scare off buyers or investors, and how to solve lingering problems before commencing a significant business transaction. My goal in this book is to provide you the due diligence road map that I devel- oped through stewarding investigations in transactions running the gamut from the acquisition of mom-and-pop businesses to multimillion-dollar private companies, private equity transactions, and commercial real estate projects. The due diligence principles, case studies, and sample plan and questionnaires set forth in this book offer a practical guide to due diligence for anybody who is buying a business, selling a business, investing in a startup or emerging com- pany, or entering into a major agreement with another company. The next chapter returns to the pending transaction between Jack and Leah by flashing back to the conversation Jack had with his lawyer when he initially engaged him on the deal. C H A P T E R 2 What Is Due Diligence? The Importance and Parameters of Due Diligence Let’s back up in time and listen to the first face-to-face conversation Jack had with his lawyer about due diligence in connection with Jack’s intended purchase of Leah’s gift card company. Date: August 24 Place: Office of Jack’s Lawyer Jack: Thanks for meeting with me. As I told you on the phone, I have an Internet greeting card company and I recently made an offer to purchase ABB, an Internet gift card company that offers customized gift cards from a variety of apparel, jewelry, electronics, appliance, and other large retailers. What makes ABB an interesting company for my business is (1) its relationship with its retailers, (2) ABB’s customer list, and, most important, (3) the company’s web site and ABB order processing software. I don’t want all of ABB’s business—only certain assets: the web site, the ABB software, certain trademarks/trade names they use for the gift card business, the customer list, and the agreements with the stores. I don’t want the ABB employees, except one whom I’ll need post closing to help with the transfer of the retailer relationships to my company and the integration of the ABB software onto my current platform. 8 Chapter 2 | What Is Due Diligence? Lawyer: As I mentioned in our previous phone conversation, the deal should be structured as an asset purchase, because you don’t want the entire business of ABB and you certainly don’t want to be liable for any obligations of ABB. It’s typical for the seller’s attorney to prepare the initial draft of the asset purchase agreement, so I’ll look at that carefully when it comes in. But for now, we need to focus on the due diligence investigation. Jack: I think I understand generally why a due diligence investigation is important, and I already mentioned to ABB that I want someone to look at the software and the back end of the web site. Leah, the sole owner of ABB, commented to me that I should tell my lawyer not to waste time or increase the costs of the deal with unnecessary due diligence. She said, “It’s a straightforward deal, after all.” Lawyer: I certainly have no intention to running up the costs of either party, but I need to protect your interests, and that includes a due diligence investigation, which is appropriate based on the nature of the transaction. It’s not something you want to forgo. So, let me review with you, in general, what is involved in a due diligence investigation, and then we can talk about specific financial, legal, and other matters that should be examined given the nature of the transaction. The lawyer has tried to explain to his client that due diligence is an impor- tant component of a business transaction. Reasonable anxieties about cost, delay, or the seller’s walking from the transaction must be weighed against the harm that could result from blindly entering into a deal. What the lawyer also makes clear is that due diligence is not the same for each transaction and that the appropriate strategy depends on a number of factors. Preliminary to considering the variable factors that enter into the design of a due diligence strategy appropriate to a specific situation, the next section answers the gen- eral question, what is due diligence? Due Diligence Defined Dictionary definitions of due diligence are descriptive, alluding to the research and analysis of a company or organization done in preparation for a business transaction. However, as with any simple definition, reducing an understanding of due diligence to a few words of description paints a woefully incomplete picture of its significance in a business transaction. The true significance of due diligence is as much prescriptive as descriptive, as distilled in the following admonition: