An Overview of the Purpose and Process of Due Diligence in Buying a Business

Introduction

Acting on behalf of clients who are purchasing a business is often a core component of a business lawyer's practice. While most business lawyers share a common goal of getting their deals closed, they don't necessarily follow the same procedures when attempting to achieve that goal. The kinds of searches and inquiries they make and documents they review vary from lawyer to lawyer.

Even though numerous books and articles have provided checklists of the things lawyers should do when carrying out a share or asset purchase, many of these checklists have become somewhat dated, especially given the impact of recent technology on the practice of law and on the economy in general. Many businesses being purchased today consist of significant assets stored in electronic form. Many pre-closing searches are now conducted electronically.

Yet despite these changes brought about by technology, lawyers still have to evaluate information relating to vendor and target companies and still have to verify this information through outside sources wherever possible in order to properly protect their purchasing client's interests. This evaluation and verification is the essence of due diligence.

This paper attempts to provide an overview of the due diligence process to be followed by lawyers acting on the purchase of a business in this electronic era. It will focus on the due diligence to be undertaken in negotiated purchases, not on the due diligence that may be undertaken in prospectus financings or hostile take-over bids, and is intended to be of greatest assistance to lawyers acting on the purchase of private companies with assets located in Ontario. It does not address the various investigations that may be necessary or desirable in other provinces or countries.

Furthermore, this paper is only an overview of the due diligence process and represents a brief summary of the other papers being presented at this programme which deal with specific topics and issues. It should be considered in conjunction with the accompanying checklist prepared by Nora Osbaldeston. Because it runs the risk of stating many generalizations which don't apply in a number of specific circumstances, the other papers should be considered in detail.

Given the lead time required to permit printing of the programme materials, some of the comments made below and in the other papers, particularly as they relate to the methods of searching, may have become obsolete by the date of the programme due to technological advances. Many recommended inquiries currently made in person or by phone or fax will soon be made by way of the Internet. For example, Industry Canada's Strategis web site may one day provide "one stop shopping" for all searches of federally maintained registers, whether for bankruptcy, intellectual property, ships, bank security, aircraft, and rolling stock, as well as for federally incorporated companies.

And in light of recent trends towards cellular, PCS and satellite communication systems, perhaps the sequel to this programme will be entitled "Due Diligence in a Wireless World".

Why conduct due diligence?

While due diligence requires time and money to be conducted properly, and often more time and money than a purchasing client might be prepared to expect, there are definite benefits to be gained from the due diligence process.

From the purchaser's perspective, conducting due diligence helps to ensure that the purchase price is fair and falls within an acceptable range of appropriate values. It allows a purchaser to rely on information provided by sources independent of the transaction, not just provided by the vendor or target company alone. It helps to determine whether any dealbreakers exist, and allows for the attempted removal or rectification of such dealbreakers early on in the process, even though in practice some of these dealbreakers are revealed only days before the closing. Due diligence assists in evaluating the likelihood of future claims being brought against the target company, the purchased assets and even the purchaser itself by lenders, suppliers, partners, licensees and other parties having commercial dealings with the target company. Instead of having to wait for some time after the deal is closed to discover problems and then pursue legal remedies based upon the purchase agreement and other closing documents, a purchaser given advance warning of such problems may be in a position to renegotiate the basic business terms, perhaps by requesting an abatement of the purchase price or payment of the purchase price in installments, or by requiring certain third party consents, guarantees, discharges or subordinations.

From the lawyer's perspective, the results of due diligence investigations provide backup for any legal opinions which may be required as closing documents. Due diligence also provides guidance to those lawyers who are drafting the purchase agreement and various closing documents, and gives support to the many representations and warranties that may be contained therein. The wording in draft documentation is often changed to reflect what has been learned from the investigations being carried out. The less conclusive the investigations, the more comprehensive the documentation tends to get, to cover all the questions and concerns that haven't been satisfactorily disposed of during the due diligence process.

But regardless of individual perspective and despite whatever is necessary to motivate those involved to carry out the investigations which ought to be done, the overriding purpose of the due diligence process and common goal of those acting on the purchaser's behalf should be to make sure that the purchaser's expectations are realistic and can be met once the deal is closed.

There are, however, limitations as to what can be accomplished through due diligence. No matter how thorough the professionals undertaking due diligence tend to be, many interests and encumbrances are simply not registered or documented. Searching various public registries won't disclose possessory and statutory liens and certain kinds of intellectual property. For those property interests which are registered, registration may not necessarily be proof of ownership or ensure priority, but merely give rise to a presumption of validity.

What's to be looked at?

Generally anything that confirms the status and capacity of the vendor and target companies, and anything that confirms the assets and liabilities of the target company, should be the subject of a due diligence investigation.

On-site inspections of the tangible assets of the target company may have already been conducted by the purchasing client to determine their operating condition long before the time when counsel is retained to act on the transaction. But additional physical inspections may be required throughout the due diligence period and extend even beyond closing to a post-closing audit of inventory and other assets. Environmental assessments may necessitate a number of visits to the properties being acquired.

Numerous public records and registries may have to be searched. Records maintained by the provincial Registrar General for individuals, and by the companies branch for provincial corporations and business names and by the corporations directorate for federal corporations, will usually be searched at the outset to determine the status of the parties involved. Other records maintained by the Superintendent of Bankruptcy, Revenue Canada, the various tax branches of the provincial Ministry of Finance, the Workers Compensation Board, the Labour Relations Board, and the courts may also have to be searched. Title records and records of liens and other encumbrances concerning the assets of the target company which are maintained by the registry or land titles office, personal property security office, Ministry of Environment, local office of the Bank of Canada, Sheriff's office, bulk sales office, Canadian Intellectual Property Office, the federal Registrar General, the Registrar of Shipping, the Aircraft Registration and Leasing Division of Transport Canada, and the title records maintained by other offices may all have to be searched.

An examination of all required licenses, permits and other regulatory consents to operate in all jurisdictions where the target company appears to be carrying on business may have to be carried out. A comprehensive review of the target company's business records, including employment records and benefit plans, its financial records, including financial statements and tax returns, and its corporate records, including minute books and share certificate books, may also have to be conducted, along with a review of its marketing and sales materials, insurance policies, environmental reports and many other types of documents.

And numerous kinds of agreements may have to be looked at: financing agreements, security agreements, equipment leases, premises leases, supply agreements, joint venture agreements, shareholders agreements, partnership agreements, non-competition agreements, customer contracts, trust agreements, sales agency agreements, employment contracts, licensing agreements, distributorship agreements, non-disclosure agreements, collective agreements, and so on. While emphasis may be given to detecting within the various documents certain types of restrictive covenants, such as those relating to assignability, change of control, type of business being carried on, territory of operations, and dealing with competitors, a comprehensive search for clauses covering early termination, cross default, rights of first refusal, set off, extended warranties and indemnities, and many other items imposing unexpected liability may nonetheless have to be done.

Ascertaining the existence of any unregistered or undocumented encumbrances, restrictions and other interests affecting a target company continues to be a challenge, particularly in respect of intellectual property. As the Internet expands to contain information about all companies and the available search engines become more focused and less random in yielding useful results, some of these interests may be revealed by Internet searches alone. However, it may not be possible to eliminate entirely the need to conduct personal interviews with those who may have a potential claim against certain assets, or who manage such assets, in order to discover unrecorded interests.

Where do you look?

The inspection of assets and review of records and documents generally take place at the various offices and plants of the target company where the assets and records are located, and at the offices of the vendor where the vendor's records may be located. While many of the records and documents to be reviewed may be brought together by the vendor in a centralized "data room", it is unusual for all the essential records and documents to be in just one location.

The various public records and registries mentioned above may have to be searched in those jurisdictions where the vendor company and target company are incorporated, where they have their executive office or principal place of business, where they have assets, and where they carry on business. Fortunately searches of many of these records and registries can now be conducted without having to arrange for someone to actually attend at a government office, and can be completed either by fax or through "dial-up" or Internet access with the use of a PC and modem located in the lawyer's office. Provincial and federal corporate, personal property security, bankruptcy, Bank Act security, aircraft, patent, trade mark, and real property searches can now be accomplished "on-line".

Who do you look with?

While many of the searches and document reviews discussed above will be carried out by the lawyers retained by the purchaser, the due diligence process often requires a multi-disciplinary team of professionals to work along side with the client in conducting some of the inspections and investigations. The client may directly or through its counsel retain accountants to examine financial records, actuaries to review any pension and benefit arrangements, environmental experts to conduct an environmental assessment of any real property, technology specialists to investigate any intellectual property, and various other consultants and advisors deemed necessary, including those recommended by the financial institution, venture capital firm or other party which may be financing the purchase.

The client itself may have, and often does have, greater expertise in conducting much of the due diligence, and may prefer to use its own staff, for the sake of expediency and cost-effectiveness, in carrying out some of the investigations and document review.

When do you look?

Many purchase transactions have four stages during which due diligence may be conducted, although the length of each stage may vary from a few hours to many months, and some stages may be combined. The first commences before the signing of a confidentiality agreement, the second runs between the signing of a confidentiality agreement and signing of a letter of intent, the third runs between the signing of a letter of intent and signing of a purchase agreement, and the fourth runs between the signing of a purchase agreement and the closing.

Because carrying out comprehensive due diligence is very time consuming and expensive, the purchasing client is often influential in deciding what things should be done first. Ordinarily the basic status searches on the vendor and target companies, and preliminary title and encumbrance searches on only the most essential assets, tend to be conducted before a letter of intent is signed. If some of the records and documents to be reviewed have been assembled by the vendor in a centralized location for examination by a number of potential buyers, they may be accessible for review immediately after a confidentiality agreement is signed.

A larger part of the due diligence investigation may take place once the letter of intent is signed, especially if the letter of intent is legally binding and contains a clause providing for the purchaser to be compensated by the vendor in the event the purchase transaction doesn't close. If the letter of intent is non-binding, much of the due diligence may be deferred until the purchase agreement is executed, despite the assistance earlier due diligence can provide to the drafting of representations and warranties in the purchase agreement.

Do you look differently for share purchases than for asset purchases?

While the due diligence process is generally the same for share purchases and asset purchases, certain tasks may be given more emphasis than others depending upon the transaction structure. For asset purchases, only the specific assets being acquired and specific liabilities being assumed need to be investigated, whereas all of a target company's assets and liabilities need to be looked at in a share purchase. For example, the carving out of certain inventory or equipment may obviate the need to review lengthy supply agreements and equipment leases or to conduct an on-site inspection around the time of closing.

For share purchases, considerable time may be spent conducting a thorough review of the minute books and share registers of the target company, with a view to determining what rectification efforts should be undertaken by the vendor prior to closing. For asset purchases, the production on closing of a certificate of incumbency and a certified copy of the board resolution of the target company authorizing the transaction may be about as close to the company's minute book as purchaser's counsel gets.

How do you organize all this?

The checklist accompanying this paper serves as the main organizing tool for the due diligence process. Once the main business terms of the transaction have been agreed upon, the checklist can be tailored to fit the particular assets and liabilities of the target company, often by simply deleting from it those specific searches, investigations and document reviews which relate to excluded assets or liabilities in an asset purchase, or to non-existent assets in a share sale. As mentioned above, the purchasing client may exercise some influence in determining priorities amongst the various items on the working checklist.

Assigning responsibility for carrying out certain items on the checklist to various members of the due diligence team can be a frustrating task if the team is comprised of professionals from different disciplines and different firms, engaged at different times throughout the process. Although it may not be necessary to prepare a formal critical path model indicating the various milestones to be met, each item on the working checklist should have a due date and a named individual assigned to its completion.

Someone should be selected as the team leader through whom the results of all investigations flow and are recorded. That person should also have the unenviable task of ensuring that the named individuals complete their assigned items by the applicable due date. More importantly, that person should be directly involved in negotiating and drafting of the applicable documents, or work closely with those who are.

If every member of the due diligence team has access to a common computer network containing the working checklist and relevant documents, and can send status reports and drafting comments to each other via E-mail, coordination of the team's efforts may be easier to accomplish.

Final thoughts

Since many of us "don't know what we don't know", the real benefit to carrying out due diligence is finding out what we don't know, instead of making assumptions based upon what we do know. Once the good as well as the bad news is in, the purchasing client and its advisers can evaluate all the news and decide what's really important and what isn't, and what constitutes an acceptable level of risk. Hopefully then, the overriding goal of the due diligence process will have been satisfied and the purchaser's expectations will have been met.

And we as lawyers, assisted by the new technologies, will have performed our role in the process without suffering some of the line-ups at government offices, the missed courier deadlines, the incomplete fax transmissions and many of the other delays, costs and annoyances associated with the paper shuffle of due diligence in the not-so-distant past.

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A. Paul Mahaffy practises business law with Bennett Best Burn LLP of Toronto, with particular emphasis on purchase and sale agreements, technology transfers, joint ventures, strategic alliances and financing, and can be reached by e-mail at pmahaffy@bbburn.com

Copyright 1998 A. Paul Mahaffy. Reproduction by any means in whole or in part without the author's written consent is strictly prohibited.