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When your gut feeling tells you something is awry, it

Digging deeper with due diligence will often pay off

You’re buying a private company.

You’ve already examined the civil and criminal court filings, state incorporation documents, title and tax liens, and trademark, patent and copyright records.

You’ve checked to see if the company conducted business with a public company, and if so, you’ve searched for Securities and Exchange Commission (SEC) documents filed.

You’ve talked to bankers, customers, vendors and former employees for in-depth information about the company.

Everything seems on the up-and-up, but your gut feeling tells you something is awry. It’s time to call in an expert for “due diligence,” which is the investigation of a company or a proposed venture in connection with a merger and acquisition transaction or security offering. That expert is usually an attorney who is well versed in mergers and acquisitions (M&A) work.

“In the M&A context, it is critical that both parties exchange enough information to determine if a deal can be reached,” said Sai Ireland, a member of Butler, Snow, O’Mara, Stevens and Cannada’s corporate services group in Jackson. “Internalized within any bid for a business is an assumption regarding the condition of that business and what pre-closing risks will and won’t be assumed by the bidder. Since a bidder will rarely, if ever, know a target’s business as well as the target does, it can undertake a due diligence investigation to bridge that information gap and confirm to the extent practicable whether its assumptions are correct. If they are not, then the price may be adjusted, the deal may be abandoned or the parties may find some other means to allocate such risks.”

Making it effective

Even though well done due diligence is not formulaic, important keys make the process more effective. Because industry knowledge is the most important factor in effective due diligence, a bidder should know where to look and be able to recognize a potential problem. That knowledge will allow him to prioritize his efforts to better manage the time and costs associated with the process.

“If the bidder’s management team doesn’t have in-depth knowledge of the type of business in which the target is engaged, and its legal and regulatory environment, then it needs to engage external resources that do,” said Ireland. “The process needs to be divided between business issues, financial and accounting issues and legal/risk management issues, with appropriate resources assigned to each area. Consideration must also be given to addressing the likely concerns of a target with respect to maintaining confidentiality and minimizing disruption of ongoing business operations. One effective way to minimize some of these concerns in the due diligence phase of a transaction, is through the use of an off-site data room.”

For example, if a company plans to license technology, it may want to hire experts to evaluate that technology and the rights that the licensor claims to control. Pharmaceutical companies looking to license biotechnology from development stage firms frequently initiate such in-depth investigations. Contingent liabilities, like lawsuits or other pending claims, could signal a potential source of environmental liabilities.

For specialty areas, attorneys usually outsource the matter to engineers, environmental consultants, investment bankers, accounting firms, appraisers and other experts to help in the investigation or address problems identified during due diligence.

Crossing a line?

Some potential buyers retain the services of a private investigator, who may resort to unsavory tactics to further investigate the company, including milling through trash for revealing documents, placing the target company under surveillance or eavesdropping on managers in restaurants or the executive washroom.

“I have never been in a deal where (riskier procedures) were even considered,” said Ireland. “If a buyer believes such tactics may be needed to find out what it needs to know to evaluate a target, it probably needs to look for a different deal. If a deal involves a regulated business where a past criminal record or similar matter can prevent a bidder from being eligible for necessary permits or approvals, etc., it would make some sense. Outside of that context, I would not expect to need that sort of assistance. The use of private investigators in ordinary business dealings would be very uncommon. To the extent they are required, there is no substitute for good references from people who routinely use private investigators. That usually means lawyers.”

A little-used source of potential information involves letters that independent auditors provide to their clients when they deliver audit reports. Those reports typically include auditor recommendations identifying areas of concern or internal control issues that should be addressed.

“By looking at a number of such letters, a bidder may get a sense of how seriously senior management takes its responsibilities with respect to financial reporting, what is now sometimes referred to as the ‘tone at the top,’” said Ireland.

Due diligence helps a buyer evaluate the target and identify key issues.

“This enables a buyer and seller to know which risks cannot be effectively managed except by contractual means such as indemnity escrows, earn-outs and other such techniques,” said Ireland. “Good due diligence means that important issues are addressed before a deal closes, which minimizes the chance that the parties will find themselves on opposite sides of a courtroom when an undisclosed problem arises after a deal is completed.”

Contact MBJ contributing writer Lynne Jeter at lwjeter@yahoo.com.

About Lynne W. Jeter

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