Due diligence is the process that a buyer and his advisors use to verify the accuracy of the representations of a seller and the suitability of the business for an acquisition. Depending on the transaction, there can be numerous components of the transaction that undergo scrutiny, including financial, legal, intellectual property, technology, etc. For our purposes, I will address the financial and legal aspects of due diligence, as they are common to virtually every transaction.
Financial due diligence is usually conducted by an accounting firm retained by the buyer to verify the accuracy of the selling company’s financial records and tax reporting. Among other components, it will include verification of bank deposits and payment of all types of taxes, including income, sales, payroll, excise, and sales and use taxes. One of the quickest ways to kill a transaction is for the buyer to determine that the selling company has not timely filed and paid the appropriate taxes. As part of the process, the buyer’s accountants will usually comment on the quality of the selling firm’s accounting systems and the qualifications of the inside and outside accounting personnel. For larger, more sophisticated transactions, the buyer will often request a quality of earning’s report, which will address the probability that earnings will continue. For example, a company with a diversified customer base with long term contracts will score higher than a company with high customer concentration doing business on project-to-project bid basis.
Legal due diligence addresses matters such as the proper formation of the company, outstanding or pending litigation, insurance, contracts, etc. It will also address whether or not a company is properly registered to do business in the various states in which it operates.
Generally, the selling side anticipates the type of information that a buyer will require for due diligence and assembles that information in an organized manner and made accessible to the buyer. In today’s world, that usually includes putting the information in an electronic data room with controlled access by the buyer and the buyer’s advisors.
Failing to disclose relevant information in the due diligence process can result in adverse results if litigation is involved after the transaction closes. We advise our clients that when in doubt, it is better to disclose.
The goal of a successful due diligence process is to avoid surprises. This can be accomplished by having a well-managed business and correcting anticipated problems prior to putting the company on the market.