Due Diligence Activities in Merger and Acquisition Transactions
Due Diligence Activities in Merger and Acquisition Transactions
When is Due Diligence conducted?
Due diligence in a merger and acquisition transaction may begin during the negotiation of a letter of intent/term sheet – typically this part of the due diligence process will be undertaken without the assistance of the target (the “Target”, which term includes not only the target of a securities acquisition, but also the target of an asset transaction and/or the assets to be acquired, depending on its use and context below) and based solely on publicly available information).
Due diligence may also be conducted after the entry into a letter of intent/term sheet – it may be necessary to conduct due diligence to determine the terms and conditions required to be included in a definitive acquisition agreement. For example, what will be covered under indemnification rights, assets and liabilities which may have to be carved out of the transaction and other items which an acquiring party (“Acquirer”) requires the Target and/or its owners to accomplish prior to closing.
Finally, due diligence often continues after the date a definitive agreement is entered into and prior to closing. It is also typical for an acquisition agreement to have a right for the Acquirer to terminate the acquisition agreement if it becomes aware of information during the due diligence process which would impact its decision to complete the contemplated transaction – i.e., if it sours on the deal due to new negative information learned through due diligence. For example, undisclosed liabilities, legal claims, obligations which the Acquirer did not bargain for or material changes in the information provided by the Target to the Acquirer during the period that the letter of intent/term sheet was negotiated. To this end, it is important to have a due diligence ‘out’ in the acquisition agreement. It can also be beneficial to provide for a breakup fee if the transaction is terminated by the Acquirer (or the Target) due to a material misrepresentation made by the Target (or the Acquirer) during the negotiation process/due diligence process and to include rights for a reduction in the purchase price if the due diligence unearths greater liabilities or less valuable assets than were originally contemplated. We for example see this often in oil and gas acquisitions where a large number of leases which were originally agreed to be transferred are shown to have title or other issues and as a result the Acquirer requires the Target to reduce the price previously agreed to, or in some cases, substitute alternative assets so the Acquirer can receive the same value out of the transaction as it originally bargained for.
Due diligence should be conducted not only on the Target, but on all of the Target’s subsidiaries and the management of the Target and its subsidiaries. Additionally, if the accountants, auditors and other service providers of the Target are not well-known, it may be beneficial to conduct due diligence on them as well – in order to determine whether the information provided by such service providers as part of the due diligence process can be trusted. For example, if the decision whether or not to move forward with an acquisition will be based on financial statements of the Target, as is almost always the case, it is important that such financial statements can be relied upon.
Who Conducts Due Diligence?
Typically an Acquirer’s legal counsel will take the lead in preparing an information request for due diligence purposes, which is prepared with the input of management of the Acquirer. These days due diligence materials are often provided via a data room (sometimes just a dropbox folder), which includes information which corresponds to the numbered items from the information request.
Once the due diligence information is received, the management of the Acquirer, the Acquirer’s legal counsel and accountants review the information and create a listing of additional information sought and questions raised.
In addition to information requested from the Target, some of the due diligence information may be obtained directly by the Acquirer. Things like copies of the Target’s (and its subsidiaries) governing documents and the results of Uniform Commercial Code (UCC) and where applicable, real property lien searches, should be obtained directly by the Acquirer and its service providers.
What Should Due Diligence Entail?
The information provided below discusses some of the categories of due diligence materials which should be reviewed by an Acquirer. Additional materials may also be called for depending on the industry in which the Target operates, the locations/jurisdictions in which it operates, the size of the Target and its operations/assets. For the purposes of reliance on due diligence materials it is important that the definitive acquisition agreement includes representations and warranties confirming that all materials provided by the Target as part of the due diligence process were complete, nothing contained or will contain any untrue statement of a material fact, or omits or will omit to state any material fact necessary to make such materials not misleading.
Corporate Organizational and Charter Issues
The status of the Target’s and all of its subsidiaries’ corporate charters should be verified and confirmed – i.e., it should be confirmed that the Target and its subsidiaries are in good standing and validly exist with their states and/or jurisdictions of organization and in any foreign jurisdictions in which they provide services or goods. Things that can cause a company’s charter to not be in good standing or be in forfeited (which typically means that the charter can be reinstated with catch up filings) or revoked (which may mean that the charter cannot be reinstated) include an entity’s failure to timely file annual reports (typically including information on directors/managers) and franchise taxes with the states in which it is organized and registered.
The Target’s organizational documents – Articles of Incorporation and Bylaws for a corporation, Articles of Organization and Operating Agreement for a limited liability company, partnership agreements for a partnership, etc. should be reviewed.
Things to look out for include, among other things, provisions which would either prevent a change of control or acquisition, provide anti-dilutive rights to any remaining security holders (including preferred stock holders) and the security holder approval required to affect a fundamental transaction – customarily defined as either a merger or acquisition of a significant amount of the assets of the Target – which typically requires approval of a majority of the Target’s stockholders in Delaware and many other states and two-thirds approval in Texas (absent a provision in the Target’s organizational documents providing otherwise). If the transaction is structured as a share exchange then all individual security holders of the Target would need to agree to the terms of the transaction in order for the Acquirer to acquire 100% ownership of the entity. While this article doesn’t go into detail regarding transaction structures, it is possible to structure an acquisition as a reverse triangular merger, whereby a subsidiary of the Acquirer is merged with and into the Target and the stockholders of the Target receive consideration (stock or cash) directly from the Acquirer. This type of transaction typically only requires approval of a majority of the security holders of the Target (depending on the terms of its governing documents and its jurisdiction of formation) and forces any non-voting security holders to accept the merger consideration, even if 100% of the vote of the Target’s security holders is not obtained (thereby bypassing the 100% approval requirement of a typical share exchange). Depending on the type of acquisition structure, stockholders of the Target who vote against the transaction may be due dissenters’ and appraisal rights under state law, which if such holders follow the applicable dissenters statutes (which is sometimes difficult and confusing to do), would require the Target to purchase such dissenter’s securities for the fair market value of such securities rather than the acquisition value provided to other stockholders.
Any preferred stock designations should be reviewed thoroughly to confirm if the holders of preferred stock have anti-dilution and/or supermajority voting rights or rights to block an acquisition or combination which will have to be taken into account, waived and/or amended in connection with an acquisition.
Through a review of these documents and materials an Acquirer can also determine whether any provisions of the organizational documents should be amended or restated after closing.
In addition to the above, the status and effectiveness of prior mergers/conversions should also be verified to make sure that the Target’s charter is really effective and valid.
We have seen situations where a company purportedly converted from one jurisdiction to another without following the requirements for such corporate action and as such the Target was locked in a form of legal limbo where it did not validly exist in either its current jurisdiction or its former one and arguably all of the securities it had issued and transactions undertaken in the past several years were arguably invalid and void.
An additional situation occurred when a company was converting its jurisdiction from one state to another state, but failed to properly file the conversion documents with the Secretary of State of the jurisdiction that it was leaving although it made the filing with the Secretary of State in the new jurisdiction. Corrective filings were needed to properly convert the domicile from the original jurisdiction to the new jurisdiction.
Officers and Directors
Any due diligence activities should include a thorough review of all employment and consulting agreements which the Target has in place. Things to look out for include provisions relating to changes in control which often trigger significant increases in severance payments due upon a change of control (for example, multiples of 2 to 3 times the standard agreement severance amounts). Because these change of control ‘kickers’ may be payable if a change of control occurs for some period of time after the termination of an employee, even if no change of control was contemplated at the time of termination – we typically see provisions whereby the change of control rights apply retroactively, even if termination occurred six months before a change of control. Employment and consulting agreements of employees and consultants which have been terminated or whose agreements have expired in the past 12-24 months should be reviewed as well to confirm there are no lingering obligations or liabilities.
Another significant issue to review in employment and consulting agreements is whether the agreement is (1) required to be assumed by an Acquirer; or (2) if an acquisition is required to be approved by the counterparty to the agreements (employee/consultant) in order for the agreement to continue to be binding. In the event the Acquirer wants the agreements to stay in place then provisions requiring assumption by the acquirer are beneficial to the Acquirer, whereas if the Acquirer does not want to assume the agreement(s) in question it is more beneficial to have agreements which do not provide for such rights.
If the Target is a limited liability company or partnership, the organizational documents of those entities should be reviewed to determine what is needed to remove management and whether any compensation provisions are triggered with a change of control.
If any officers or directors will be asked (or required) to stay on after the closing, it is important for those persons to fill out officer and director questionnaires so that any issues can be spotted prior to closing – i.e., things like prior litigation history, regulatory issues, related party transactions with the Target, health, etc.
Minutes of the Board of Directors and Stockholders
A Target’s minutes of the Board of Directors and stockholders (or managers, members, partners, etc.) can tell an Acquirer a great deal about a Target’s corporate governance and attention to detail. For example, if no minutes exist or the minutes are sparse it may mean that prior actions and transactions have not been properly approved – which may require remediation actions prior to, or after, closing. There may also be additional items disclosed in the minutes relating to the Target’s prior results of operations and future projections, trends, etc., which are helpful in valuing the Target and the potential of its future business. Finally, depending on how detailed the minutes are, an Acquirer can sometimes get a feel for any directors (managers) who may be a problem moving forward or who have their own agendas and whom therefore should be terminated/removed prior to closing the transaction.
All initial requests for due diligence should include requests for all correspondence received, or sent by, the Target to any government agencies and any self-regulatory agencies for the past three to five years. This would include any comment letters from the Securities and Exchange Commission (SEC) if the Target is a public company and any warnings received from any exchange on which the Target’s securities trade, as well as any notices or correspondence received from regulators regarding any non-compliance with federal or state rules and regulations.
This will allow the Acquirer to determine whether there are any currently outstanding and/or ongoing concerns regarding the Target and to further confirm that any prior issues have been adequately addressed and remedied.
It can also be beneficial to review copies of all press releases and stockholder/member communications over the past three to five years to determine whether anything was disclosed which could result in potential liability for the Target – for example, disclosures which didn’t include forward-looking statements or aggressive projections.
Capitalization and Securities Issues
The due diligence questionnaire should request records going back five years or more for all issuances of securities of the Target, including common stock, preferred stock, options, warrants, convertible securities and other stock and similar rights. These documents should include offering documents and subscription agreements with investors.
This information, along with the copies of the minutes discussed above, should be reviewed to determine that all securities of the Target are fully-paid and non-assessable and that a valid exemption from registration was available for the issuance – typically Rule 506 of the Securities Act of 1933, as amended (the “Securities Act”) if securities were sold privately – which requires the investors confirm their status as ‘accredited investors’ (described below), as well as other matters or Rule 701 of the Securities Act for employees (which currently allows the issuance of securities to employees, directors and certain consultants if the total value of securities issued does not exceed the greater of $1 million, 15% of the issuer’s total assets, or 15% of all the outstanding securities of that class, during each 12 month period, without any required disclosures other than the compensatory contract and allows for sales of securities exceeding those amounts with the disclosure of additional materials described in Rule 701).
The Acquirer should confirm that Form D’s have been filed with the Securities and Exchange Commission and under state law to confirm that all offerings of securities have either been registered or that an exemption from registration exists under federal and state law.
The failure of the Target to obtain a valid exemption under federal and state law for each issuance of securities can lead to the holders of such securities having rescission rights (which can be costly to an Acquirer, especially where the holders of the securities are friendly to the pre-acquisition management, but aren’t friendly to the Acquirer) and/or may create significant liability under federal and state law for the Target itself. It may be costly to remedy issues with prior offerings, including, in extreme situations, requiring a private company to file a public rescission offering with the SEC which can costs hundreds of thousands of dollars to prepare and push through SEC review.
The Target should provide a listing (and copies of all relevant documents) relating to its outstanding options, warrants and convertible securities. Similar to the rights which may be present under a Target’s charter documents, outstanding options, warrants and other convertible securities, not to mention phantom stock awards and similar rights, may include provisions which are triggered by a change of control, asset sale or combination. These may result in a significant reduction in the exercise/conversion price of convertible securities, trigger cash payments, create immediate rights to redemption or repurchase (including at values which are significantly higher than the current values of such securities), trigger anti-dilution or pre-emptive rights and/or in extreme cases, create rights for the holders of such securities to convert such securities into the securities of the Acquirer.
Outstanding convertible securities of a Target may also have put/call rights which could affect the Acquirer post-closing and/or require future registration rights. Again, all of these agreements/documents may have provisions which are dormant and have never been enforced – because all of the parties involved are friendly – but which may become issues post-closing when the holders of such rights no longer have any history with the Acquirer.
The Target should supply information on, and all relevant filings related to, any litigation proceedings going back at least five years – including settled claims (even if they didn’t result in litigation). The Target should also include information on previously threatened claims (whether in writing or orally).
In addition to the information from the Target itself, the Acquirer should undertake its own searches of court records in the state and county in which the Target is domiciled and its significant locations located and through online search sites to determine if there are any claims outstanding or threatened which are not yet known to the Target.
Material litigation or potential claims may need to be included in the indemnification obligations in the definitive agreement(s) or may force a change in proposed acquisition structure – i.e., from the acquisition of the Target itself to only its assets to avoid taking on liability associated with the Target’s pre-acquisition operations.
We represented an oil and gas company in a transaction which was in talks to acquire another oil and gas company which was involved in litigation involving prior releases of hazardous waste involving numerous parties who maintained operations over several years at a barge terminal. As part of that transaction, the Target’s owners (the sellers in the transaction) agreed to assume all obligations for the pending litigation matters and to indemnify and hold harmless the Acquirer against any damages due in connection therewith, even though such obligations would typically be assumed by the Acquirer in the acquisition of the Target. As additional comfort for the Acquirer in that transaction, the Target’s stockholders agreed to place a portion of the acquisition consideration into escrow, to be used for security to satisfy the outstanding and pending litigation claim.
The Target should supply audited (where applicable) and interim financial statements for at least the last two fiscal years and through the current date. By reviewing the financial statements the Acquirer can get an idea of quarterly and yearly revenue, net income/loss and changes in assets over time. Along with the financial statements, the Acquirer should review a summary of all liabilities and accrued expenses.
The definitive agreement should include a requirement whereby the Target delivers an updated balance sheet at closing, which is certified as correct, discloses the reasons for any changes in the closing balance sheet versus the last balance sheet provided in the due diligence process, and includes indemnification rights against the Target for any liabilities or debts which aren’t for any reason, disclosed in the closing balance sheet.
The due diligence request should seek copies of all material agreements of the Target. Typically this is determined by a dollar value cut off based on the size of the Target – for example, all agreements which involve (or which could potentially involve) more than $50,000 in value or which the Company’s operations are substantially dependent.
The request to the Target should also specifically request all copies of agreements between the Target and any related parties (officers, directors, employees, significant owners and their family members) of the Target; copies of all loan documents; guarantees; franchise and licensing agreements; and employment agreements.
Loan agreements in particular (and/or guaranty agreements in connection therewith) and franchise and licensing agreements may have covenants which would prohibit a change of control or sale of a significant portion of the assets of the Target without prior lender approval – which in some cases may only be provided in the lender’s sole discretion.
Similarly, most lending agreements will be secured by security interests and mortgages, which will in most cases need to be waived or terminated by the lenders prior to any sale (see also below for the separate discussion of financing statements).
It is also important to review the agreements relating to any prior acquisitions of assets of securities which are material to the Target’s operations. For example, it is possible for a prior acquisition agreement to include a buyback or put right which continues to apply for years down the road or even a right of first refusal requiring the Target to offer the prior seller(s) the first right to reacquire the assets/operations acquired if they were ever to be sold.
Finally, lease and rental agreements may prohibit any sale of assets or change in control of any Target without landlord consent.
It is important to begin preparing the list of required parties who will need to consent to an acquisition early so that contact can be made by the Acquirer or its legal team with such parties and the approval process can be started as soon as possible. Parties who are required to consent to acquisition transactions may each require a separate form of negotiated assignment agreement, may require the Acquirer to provide business information and financial statements, and often do not have an incentive to make a third-party consent a priority.
One category of due diligence which often gets overlooked is warranty claims for products produced by the Target – how many warranty claims are typically received each year, what the cost of servicing those claims are, and most importantly how long the Target’s warranties are currently (and historically) in place for – are all things which should be asked for and obtained as part of the due diligence process.
Finally, the Target should supply detailed information on all related party relationships, understandings and agreements. Often times when a Target is closely held and/or owned by mainly family members, the family members will provide sweetheart/non-arm’s length deals to the Target and/or allow the shared use of non-Target owned assets, operations and employees, which can skew the Target’s financial statements. It is also possible that the Target may be dependent on equipment, materials, relationships, facilities and employees which it is not in privity of contract with and/or which are owned and operated by related parties and which won’t automatically be included in an acquisition transaction. Instead the Acquirer may need to force such assets or relationships to become part of the transaction and/or require the related parties to enter into binding agreements to allow for the continued use of such items post-closing.
As previously described, as part of the due diligence process, employment agreements of officers and employees, consulting agreements and other compensatory agreements should be reviewed to ensure no provisions of those agreements are triggered by a change of control or acquisition. The total future consideration due to employees of the Target who will be assumed in the acquisition should also be studied and confirmed so that the Acquirer doesn’t accidentally take on an employee who is due to receive more compensation than they are worth moving forward, and/or who has employment terms which will make it hard or expensive to terminate the employee in the future.
Separately, the Target should be required to put together a list of its ‘key’ employees. The Acquirer should then either confirm that all employment agreements of ‘key’ employees stay in place following the closing of the proposed transaction, or negotiate with the ‘key’ employees prior to closing to ensure that all ‘key’ employees are subject to continued employment arrangements and are willing to remain with the Acquirer post-closing. The worst thing that can happen is that the Acquirer acquires valuable assets and operations from a Target but loses all of the employees who know how to operate such assets and run such operations. At a minimum, current employees should stay on for some period of time post-closing to train the Target’s employees.
As part of this same process, any officers, directors and other ‘key’ employees of the Target who are not remaining with the Acquirer post-closing should enter into a non-compete agreement – which should be a required term and condition of the closing. Again, typically, there is little value to acquiring assets and operations from a Target if the persons who created and operated such assets and operations can just turn around and compete with the Acquirer immediately, since they already have the contacts and relationships necessary to regrow the business.
Similarly, it is important to determine whether any liabilities exist for the Acquirer in connection with unfunded retirement accounts (401(k), pension or insurance) and to appropriately carve those out of any purchase and/or provide for indemnification rights.
It is also important to verify whether any workers’ compensation claims are currently pending and historically how many claims are received each year and what the extent and cost of such claims typically are. If there are historically a significant number of claims and the expense of such claims can be estimated, those costs will need to be factored into the analysis of the purchase price of the Target and projected revenues for the Acquirer post-transaction.
Finally, one of the most important things an Acquirer of a Target entity can do is verify that the Target is current in its payroll tax obligations. Officers of an entity which fails to pay payroll taxes can be personally liable for such failure, and such persons may be subject to criminal penalties as a failure to pay payroll taxes is a felony punishable by up to a $10,000 fine or five years in prison, or both.
While this article doesn’t go into detail regarding environmental laws and successor liability, suffice it to say the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”) and other federal and state laws can make a current owner of real property responsible for environmental claims and issues which exist on properties owned, even if the current owner had nothing to do with the matters giving rise to the claim and even if such owner had no prior knowledge that the issues existed. Because of this, an Acquirer always risks taking on potential unlimited liability in connection with the acquisition of plants or facilities which stored or could have stored or managed hazardous waste and it is imperative that the liability for such potential future liabilities be identified prior to closing and appropriately apportioned between the parties in the definitive agreements.
As part of the due diligence questionnaire, a Target should be asked to provide a list of hazardous (and potentially hazardous) materials stored (or previously stored) at owned and leased properties, as well as any prior known or suspected hazardous material or other spills and releases, the outcome of such events and any prior, pending or threatened investigations relating thereto.
The due diligence process should include a review and reconciliation of all material assets of the Target. This should include real property (including confirmations of title and for oil and gas leases, confirmations of leasehold interests), intellectual property (including reviews of all copyright, trademark and patent filings), lease agreements (including the assignment provisions relating thereto), and material equipment. Equipment is often leased under long-term leases and the terms of such leases should be reviewed to confirm that nothing would be triggered or tripped up by an acquisition by a third party. Additionally, all material equipment, automobiles, computers, etc., should be verified present on the premises and available to be transferred at a closing. Items are occasionally included on a listing or schedule even though the assets to which they refer have previously been sold, replaced or no longer maintained.
One issue to look into and verify for patents is that the patents are actually owned by the Target. Typically, patents are filed under the names of the inventors (which may include employees of the Target and/or former employees or consultants of the Target) and need to be formally assigned into the name of the Target (if the Target will be acquired) or the Acquirer post-closing and/or the Target will need to get approval of the actual ‘owners’ of the patents or enter into a license agreement with such owners, as part of the acquisition transaction.
Similarly, the Acquirer should confirm that any licenses required to use software or other intellectual property are in place, that no defaults exist under such agreements, and that such agreements have a significantly long-term and limited termination rights. Again, it can be potentially catastrophic to learn after closing that a Target is substantially dependent on the terms of a license agreement for its revenues and the license agreement expires in a short period of time, can be unilaterally terminated when it comes due for renewal or is already in default. Again, as discussed above, many license agreements also require approval by the licensor of any sale or transfer of such license.
This is a good point in time to recommend that the due diligence process not just include the review of written documentation and agreements, but that calls actually be made to the contracting parties on which the Target is substantially dependent – licensors, suppliers, customers, landlords, etc., to get a feel from those parties how happy they are with the Target’s compliance with material agreements and whether they are aware of any immediate concerns or changes to the working relationship. It may even be necessary/warranted in some transactions to have the counterparties to the Target’s material agreements enter into a certification/confirmation at closing to confirm that they are not aware of any events of default under the agreements and have no reason to believe the agreement(s) will be terminated prior to the end of their stated terms.
Acquirers should also confirm the current state of all properties, equipment and facilities by making physical site visits, with the goal of determining whether any such properties, equipment and facilities are in immediate need of improvements, upgrades or refurbishments, and more importantly, confirming whether such properties, equipment and facilities currently comply with applicable laws and regulations and are safe for continued use.
An important part of any acquisition is inventory. The Acquirer should determine where inventory is stored, the current state of such inventory, how long inventory is typically maintained (including whether inventory expires and/or is unsaleable at some point in time) and how long the current inventory the Target has been stored, to try to determine whether all such inventory is currently salable. A similar analysis should be made for raw materials and other related items.
All of the Target’s debt obligations, loan agreements, funding agreements and promissory notes should be reviewed to confirm that all can be assumed as part of the acquisition and that none contain any provisions, covenants or requirements which would prohibit the proposed transaction or accelerate any of the amounts due thereunder. Typically bank lending documents will include covenants which prohibit a change of control of an entity and/or a sale of material assets without the approval of the bank.
Similarly, holders of secured debt obligations will typically have filed Uniform Commercial Code (UCC) financing statements securing their debt. A UCC research and search company should be engaged to confirm which UCC filings are in place (sometimes the financing statements are filed under incorrect or misspelled names so it is important to obtain a professional search). UCC filings can encompass both current debt obligations and prior obligations for which UCC statements were never formally terminated, and which should be terminated prior to closing.
Like UCC filings, all mortgages and deeds of trust on file relating to the assets of the Target should be confirmed and documented. The obligations underlying those mortgages and deeds of trust will need to be satisfied, terminated or assigned at closing.
Acquirers should also verify if any tax liens are in place on any assets of the Target.
Once all of the outstanding liabilities and obligations are known, a determination can be made whether certain liabilities will be left with the Target (or its security holders) post-closing and/or whether the Target (or its security holders) will be required to indemnify the Acquirer against such liabilities and/or obligations post-closing.
Consents, Licenses and Permits
As discussed above, agreements of the Target may require consents for closing. These include license agreements, leases and lending agreements, which typically require consents for (1) the consummation of a change of control of transaction involving the sale of assets; and/or (2) may require the contracting party consent to the assignment of the applicable agreement and the rights thereunder to an acquirer.
Government licenses and permits are another category of items which may require consent for assignment or may need to be re-obtained/applied for separately by the Acquirer prior to closing. These include varying items such as licenses granted for oil and gas operations, lending or broker-dealer services and in some cases things such as liquor licenses. As part of the due diligence, the Acquirer should obtain a listing (and copies) of all federal and state licenses and permits which the Target or any of its employees maintain.
Relations with Customers/Suppliers
Targets should be asked early in the due diligence process for a listing of their current and historical major customers and suppliers (typically any customer or supplier representing more than 5% of total sales or purchases) over the past several years. By reviewing this listing the Acquirer can determine how dependent the Target is on a small number of customers and suppliers and how much turn over there is year-to-year.
The goal of the Acquirer is to determine how easy it would be to replace customers and suppliers and to determine what long-term agreements, if any, are in place relating to such relationships.
As part of the due diligence process the Acquirer should attempt to determine the market share of the Target and the potential for future growth.
Additionally, the Target should supply information on its historical advertising costs so that the Acquirer can calculate how much it costs, on average, for the Target to acquire new clients.
The tax returns of the Target should be reviewed and it should be confirmed that the Target has paid all taxes due for prior fiscal years. If the Acquirer was to acquire ownership of the Target and taxes were due and payable by the Target, the Acquirer (as owner of the Target) would then become responsible for such payments.
Indemnification from the Target (or its stockholders) for past taxes and amounts which may be deemed due by taxing authorities in the future – either due to audits or issues with prior returns – is something which is typically included in acquisition agreements. Similarly, Targets (or their shareholders) are typically provided rights to any reimbursements or adjustments due to prior overpayments of taxes, which are later determined post-closing.
As part of the due diligence process the Acquirer should confirm what insurance the Target has in place, both to ensure that such insurance is adequate – if the Acquirer will be acquiring the Target and its insurance policies – and to obtain similar insurance coverage for any assets of Target which are acquired separate from the pre-existing insurance coverage.
Potential Additional Issues to Consider as Part of Due Diligence Process
Potential Anti-Trust and Related Issues
Early in the due diligence process it should be determined whether the potential acquisition will trigger any anti-trust issues under the Hart–Scott–Rodino Antitrust Improvements Act of 1976 (the “HSR Act”). The HSR Act prevents certain mergers, acquisitions of assets and securities until or unless they have been approved by the U.S. Federal Trade Commission and Department of Justice and such agencies have determined that the proposed transactions do not adversely affect U.S. commerce under applicable antitrust laws.
The general rule is that notice and approval of the agencies above is required if: (1) the acquirer or target is engaged in commerce or in any activity affecting commerce; and (2) as a result of such acquisition, the acquirer would hold an aggregate total amount of the voting securities and assets of the target-(A) in excess of [$337 million]; or (B)(i) in excess of [$84.4 million]; and (ii)(I) any voting securities or assets of a person engaged in manufacturing which has annual net sales or total assets of [$16.9 million] or more; (II) any voting securities or assets of a person not engaged in manufacturing which has total assets of [$16.9 million] or more are being acquired by any person which has total assets or annual net sales of [$168.8 million]; or (III) any voting securities or assets of a person with annual net sales or total assets of [$168.8 million] or more are being acquired by any person with total assets or annual net sales of [$16.9 million] or more.
Another thing to look out for is required filings under the Worker Adjustment and Retraining Notification Act of 1988 (the “WARN Act”), which requires 60 calendar-day advance notification of plant closings and mass layoffs to certain covered employees and effects employers with 100 or more employees, not counting employees who have worked less than 6 months in the last 12 months and not counting employees who work an average of less than 20 hours a week.
Also, if the Acquirer is a foreign party, the Committee on Foreign Investment in the United States (“CFIUS”) may need to be involved. CFIUS is an interagency committee authorized to review certain transactions involving foreign investment in the United States, in order to determine the effect of such transactions on the national security of the United States.
If the Acquirer or the Target is a public company, such entity may have filing and disclosure obligations with the SEC, foreign regulatory agencies and/or the stock markets/exchanges on which its securities are traded. Often times these requirements require prompt disclosure of the entry into the acquisition agreement (for example pursuant to Form 8-K for SEC reporting companies, which must be filed within four business days of certain material transactions), require the filing of a copy of the definitive agreement (with the SEC in particular, it is possible to request confidential treatment of certain trade secrets disclosed in the acquisition agreement) and depending on the size of the acquisition or disposition, may require financial statements of the Acquirer or Target to be included in the SEC filings. All of these matters may require additional time and resources and as such it is important that any and all disclosure obligations be confirmed prior to entering into definitive agreements.
Notwithstanding the ultimate structure of the transaction, including, as discussed above, the use of a reverse triangular merger structure to avoid in most cases, the need for stockholder approval under state law, if the Target’s or the Acquirer’s securities are traded on a stock exchange, the rules of the exchange may require stockholder approval regardless. For example under the rules and regulations of the NYSE and Nasdaq, issuing securities constituting more than 20% of the issuer’s then outstanding shares of common stock in an acquisition transaction requires approval of the issuer’s stockholders. In the event the Acquirer is an SEC reporting company, this typically requires a proxy statement with financial statements of the Target being prepared, which is subject to SEC review and comment prior to mailing.
Securities Law Issues
If the consideration to be provided for an acquisition will consist of, and/or include, securities, state and federal securities laws will have to be complied with. These rules require, in general, that if securities of the Acquirer are being exchanged for or provided in consideration for the Target, that certain information regarding the Acquirer, its assets, operations and properties, as well as other matters, and in some cases require audited financial statements to be provided to Target stockholders. Furthermore, in the event securities will be issued to more than 35 non-accredited stockholders (typically individuals who have less than a $1 million net worth (excluding their residence), or made less than $200,000 for the past two years ($300,000 with spouses) and/or don’t anticipate making more than that amount in the current year, and/or entities which don’t have more than $5 million in assets or which are not owned by all ‘accredited’ investors), the entire transaction may need to be included in a registration statement filed with the SEC, which requires significant disclosures and is subject to SEC review and approval.
Fairness Opinion and Fiduciary Duties
The Board of Directors of both the Acquirer and the Target will need to undertake their own due diligence to determine and confirm that any transaction is fair to the owners of the Acquirer and Target, respectively. The Boards will need to comply with all fiduciary duties relating to the transaction, including being informed regarding the terms of the transaction and potential alternatives, if the transaction will result in a sale of substantially all of the Target’s assets or securities, and need to determine that the ‘best’ price for such assets/operations is obtained.
One way to limit potential liability is for a Board to obtain a fairness opinion whereby a third-party appraiser determines, typically based on similar transaction terms which have occurred in the Target’s or Acquirer’s industry, that the transaction is fair to the Target and/or Acquirer.
What to Do with Due Diligence Information Obtained?
So what does an Acquirer do with the information obtained through the due diligence process? First, the Acquirer, after looking at the information received, needs to make a cost/benefit analysis determination of whether the transaction and the potential benefits and costs of the transaction are still attractive to the Acquirer based on what it learns about the actual inner workings of the Target and its potential for future growth.
Assuming the Acquirer still wants to move forward, and does not want to exercise the termination rights and due diligence outs of the definitive agreements, it may want to:
- Negotiate any changes in the previously agreed to deal terms due to new facts which have come to light – i.e., better terms for the Acquirer or the inclusion of more or different assets totaling the previously agreed upon acquisition consideration;
- Require greater indemnification obligations of the Target (and/or its stockholders) for debts and liabilities which weren’t known when the original terms were agreed to – this may include adding a holdback structure to the agreements whereby a portion of the purchase consideration is held back to satisfy indemnification or other obligations;
- Include additional closing conditions – for example, the receipt of contractual or governmental approvals prior to closing or entry into employment agreements with key employees;
- Change the entire structure of the transaction – i.e., to an asset purchase versus the purchase of the entity itself which typically results in greater potential liability for the acquirer or a different change which may result in more advantageous tax liability for all parties; or
- Push more of the acquisition consideration out to be an earn-out based on the outcome of the Target’s operations (typically with the prior officers/employees staying on to help continue to build such operations), which creates less risk for the Acquirer and more incentive for prior management to stay on post-closing.