Considerations in Due Diligence

Due diligence is a process initiated when sufficient interest on the part of a potential buyer has been communicated to the seller which signals a serious intent to proceed with an acquisition. The process is preceded by a “Letter-of-Intent” (LOI). An LOI is a document prepared by the potential buyer and then agreed upon by both parties. It outlines both binding and non-binding terms for engaging in discussions and the sharing of detailed information about the business being considered for acquisition.

A “Letter of Intent” (LOI) represents a serious commitment by both buyer and seller to work cooperatively in understanding and verifying all aspects of the business prior completing the sale. A fundamental objective of due diligence is to arrive at a fair market value for the business agreeable to both parties.

Beyond that, an LOI allows the buyer to obtain an in-depth understanding of the company’s operations, its people, the products, and markets served, and various other details about the company. Importantly, it affords the buyer the opportunity to identify potential risk or liabilities and the challenges involved in integration.

Prior to putting an LOI in place, a summary of the business is provided to the perspective buyer. It typically includes an overview of the company, its history, financial data for three to five years, the markets they serve, the products they manufacture and other relevant details on the seller’s company. This information is provided to interested buyers.

Its intent is to give potential buyers sufficient information on the business so they can determine if there are sufficient reasons to explore the opportunity further.

Due Diligence Check List

A detailed list of information requests is prepared by the potential buyer. This list is provided to the seller at the outset of the due diligence process. This “check list” outlines the information gathering tasks that need to be addressed by the seller. This list is normally developed by the buyer through a collective effort from all departments and/or business units which will be involved or responsible for a transition if the acquisition is completed. In general, the requested list of information is extensive and covers all aspects of the business. Table 1 provides a partial list of information that is typically requested by the buyer at the outset of due diligence.

Comments on Some Elements of Due Diligence

Among the due diligence issues which often have a high level of importance to the buyer and seller are those listed in Table 2.

The following comments are offered on these select items that highlight various key issues that need to be assessed during due diligence.

Tax Implications and the Structure of the Sale

The structure of the sale has important implications for both the buyer and seller which need to be sorted out early in the due diligence process. There is an option to structure the sale as an asset sale or a stock sale. When the business is a sole proprietorship, an LLC, or a partnership, the stock option does not exist.

If the company is incorporated as a C corporation or an S corporation, a decision needs to be made between the buyer and seller on which way to go.

The tax implications this choice represents has important consequences for both the buyer and seller. An asset sale has the buyer purchase all the assets of the company. This includes inventory, equipment, IP, formulas, etc. The seller retains cash and legal responsibilities for the company and any outstanding long-term debt up to the date of closing. Net working capital including inventory, accounts receivable, accounts payable, and expenses are also valued and included in the purchase price paid for the business. This provides what is essentially a “clean slate” for the buyer.

In a stock sale, the buyer gains ownership of the company through a direct purchase of the shareholder’s stock. Buyers own the business entity in a stock sale. This can include the buyer now owning the prior environmental and regulatory obligations of the company, including future liabilities that may arise from the past after the sale. In industries that are highly regulated, such as coatings and specialty chemicals, this can represent a significant potential risk for the buyer.

In either an asset sale or a stock sale, it becomes important for the seller and buyer to understand the best way to structure the value of the assets of the business based on applicable federal and state tax laws to minimize the tax liabilities. Taxes can be as capital gains or as ordinary income which will be at different rates of taxation. These issues are eventually outlined in the asset purchase agreement between the two parties.

Communications and Transitions with Suppliers and Outsourcing Arrangements

Key raw material suppliers and outsourced manufacturing sources are normally not aware of a pending sale. At the same time, the buyer needs to begin to communicate with those key suppliers to understand their operation.

For outsourced manufacturing, this includes learning their capabilities to manufacture, inventory products, and ability to protect any IP they may have access too.

It is up to the seller to establish some ground rules on how each of these key supplier relationships should be handled during due diligence. Most often, the seller takes the lead in contacting these companies, advising then of the pending sale, and providing an introduction for the buyer to initiate discussions with them. This normally happens at the point during due diligence where there is a reasonable comfort level on the prospects of completing the sale of the business between both parties.

Contractual Obligations and Agreements - Distributors, Manufacturing Reps, Customers

Assessment of the overlaps and business conflicts that may exist between the two parties is a necessary consequence of an acquisition. In due diligence, it is critical for the buyer to identify contractual commitments or agreements that the seller has in place.

This includes customer supply contracts that have penalties associated with them for failure to meet certain obligations for supply, quality, etc. Since such contracts are often written with major accounts that represent a significant source of revenue for the company, risks assessment on the part of the buyer is a necessary element of the due diligence process.

Contractual commitments that have been established by the seller within elements of their supply chain can be in direct conflicts with those of the buyer. Distributor relationships, where both parties are engaged as principles with competing companies, need to be sorted out during due diligence to make sure a suitable path forward can be identified. It is not necessarily a given that the buyer preference will prevail when all aspects of the situations, including contractual obligations, are considered.

Individual sales reps or rep organizations used to targets specific accounts, certain geographies or specific market segments, fall into a similar category. The strong personal relationships and market knowledge they contribute can be critical to maintaining certain customers or an overall market presence in specific sectors.

Technology, IP, Patents And Trade Secrets

When the business includes commercially valuable intellectual property, it is critical to protect it during the process of information transfer. The IP of the business can represent a key element in the valuation of the business placed on it by
the buyer.

The form of the IP clearly varies with the nature of the business. A strong patent position that strengthens the buyer’s current market position can add significant value to the acquisition. Alternatively, IP is often contained as unpublished knowledge or trade secret. This can be as a key raw material in the formula, specific process conditions in product manufacturing, a new or unique use for a particular product, etc. This type of IP can bring significant added value to the seller’s business. How and when this information is transferred to the buyer during due diligence is a key concern for the seller.

The goal of the seller (in planning for the transfer of such information to the buyer) is to make sure that critical aspects of the IP are protected until closing. Documents provided to the buyer need to be screened. Organized visits to facilities that manufacturing product need to be planned with sufficient care to avoid inadvertent or unintentional disclosure of such intellectual property prior to closing.

Environmental, and Regulatory Compliance: Liabilities, Litigations

In a highly regulated industry like coatings, a primary risk for the buyer in an acquisition is often found in issues of environmental and regulatory compliance. The process of due diligence needs provide the buyer with a clear picture of all aspects of compliance as unexpected surprises can emerge. The consequences for not identifying and addressing these issues in due diligence can be devastating and long lasting for the buyer.

Product line compliance, based on individual product compositions, need to be assessed in terms of the current and also proposed regulatory actions. Depending on the markets involved, product compliance can include a variety of government agencies along with industry standards or specifications that may require testing and approval for use in certain applications.

Regional differences in regulatory compliance requirements also exist as well. If the intent of the acquisition includes entry into an unfamiliar geographic area or a new market, it is important to validate the regulatory acceptability of the products prior to a decision to purchase the business.

When manufacturing facilities are included as part of the acquisition, site history and supporting documentation of its acceptability to local, state, national government agency requirements is
a necessity.

Depending on the complexity of the product lines being manufactured and the geographies involved, the effort and time required to complete the due diligence process can be protracted. This is especially true when regulatory compliance issues and potential liabilities are involved. 

Table 1: Partial List of Information Requests from the Buyer

• Financial records for three to five years
• Markets and competitive landscape
• Sales and marketing organization
  o Sales force, compensation
  o Channels-to-market
  o Contracts, supply agreements
• Manufacturing facilities details
  o Capacity, capacity utilization
  o Inventory- finished goods, raw materials.
  o Financial metrics line turnover
• Technology, product details
  o IP, patents, trade secrets
  o Products,
• Information technology issues
  o Software
  o Promotional and communications effort
• Liabilities, litigations, environmental, and regulatory compliance
• Operations
  o Organizational structure, responsibilities
• Other

Table 2: Select Topics in Due Diligence

• Taxes and the structure of the sale
• Transitions with suppliers and outsourced manufacturing
• Channels-to-market structure and obligations
• Contractual obligations and agreements
• Intellectual property
• Environmental, regulatory compliance