Ready to Sell or Raise Financing: Have You Done Due Diligence on Your Company?

on February 13, 2014 by Tenaglia & Hunt, P.A.

Today, we feature a guest blog post by one of our friends & colleagues, Jeffrey W. Berkman – the founder of the Berkman Law Firm, PLLC in New York. Jeff has practiced law for nearly twenty-five years, focusing on business law matters, including new business and corporate structuring, partnership/joint venture relationships, corporate transactions, business purchases, private equity/venture capital deals, legal due diligence, contract drafting and review, and serving as outside general counsel to start-ups, small and emerging businesses.

 

Ready to Sell or Raise Financing: Have You Done Due Diligence on Your Company?

Even if you have very little experience purchasing a business or its assets, you are likely aware of the importance of doing due diligence on the target company’s business.  Due diligence regarding legal, financial, operational and personnel matters is essential before purchasing a company or its assets or investing in a company through a private equity or debt financing transaction.  Now, let’s say the company is considering selling its business or seeking additional financing through the issuance of issuance stock or debt:  have you considered the importance of conducting due diligence of your business before seeking potential purchasers or investors?

A company contemplating a sale of its business or raising money should conduct a meaningful evaluation and due diligence of its legal, financial and business operations before putting the company on the market to avoid issues arising after a potential suitor has been found.  In the sale of a home, a buyer will often rely on the home inspection report and appraisal to try to knock down the negotiated price, and in the sale of a company the buyer will try to do the same with information learned in the due diligence investigation.  Therefore, a thorough review of your company’s legal, financial, business operations and personnel matters prior to seeking to sell or raise financing will allow you to not only address potential obstacles to the transaction but also reduce the chances the buyer or investor will try to renegotiate the purchase price (or valuation) for the business.

 

1.  Is the Company’s Legal House in Order?   Legal due diligence is a significant aspect of the investigation that any potential buyer or investor will perform.  There are numerous legal areas the buyer will review, and the scope and of the due diligence will vary greatly depending on a number of factors, including the nature of the business and the underlying transaction.  Obviously, there are some common questions relating to organizational structure, material contracts, existing or threatened litigation, ownership of assets, intellectual property, labor/employment, and environmental questions.  But, there are also some less obvious issues that should be carefully vetted.  While not an exhaustive list, consider the following:

 

(a)  Corporate Structure:  Of course, you will want to make sure the company’s organizational documents and records are in order, but also verify that there aren’t potential obstacles to the transaction.  For example, do any of the shareholders/members or any other third parties have a right of first refusal, or other rights, that could interfere with the transaction?  Is there anything in the By Laws (of the corporation) or Operating Agreement (of the limited liability company) mandating a supermajority or even unanimous approval of a sale or the issuance of new stock?  These kinds of rights are often freely granted when emerging companies are desperate to obtain financing, and may come back to haunt the company when trying to sell or raise additional financing.

 

(b)  Permits/Compliance with Laws:  The target company will need to show it has the necessary permits or licenses as may be required for the business, but it also that it is in compliance with the laws of any jurisdiction where it operates.

 

(c) Assets/Intellectual Property:  Can ownership/title to assets be demonstrated?  Does the company own or license necessary intellectual property?  If your business is licensing any key intellectual property or other assets, make sure the license is assignable/assumable in a sale or that the rights do not revert to licensor upon a “change of control” of the business.  Another major concern is that the company has Invention Assignment Agreements or can otherwise establish its rights to intellectual property developed by third parties or even by founders, partners, employees or consultants.

 

(d) Material Contracts:  All material contracts should be reviewed to ensure they are assignable and that they don’t terminate in the event of a sale of the business or change of control.  Further, the financial/business terms need to be vetted to confirm that they do not include unfavorable terms, including near-term expiration or onerous financial obligations.

 

(e) Employment/Labor Matters:  Make sure all the company’s records are in order detailing information as to employees, including salary, sick/vacation time, and benefits.  Is there an employee manual?  Are there pending issues or litigation relating to employment matters?  Have employees/consultants executed Invention Assignment, Confidentiality and possibly non-competition agreements?  Has the company improperly classified employees as consultants, raising the potential of exposure for underpayment of employment tax obligations?

 

(f) Litigation:  If there are pending litigation matters, be prepared to summarize the claims and procedural status for a potential buyer or investor.  Does the litigation raise material issues as to the rights of the company in any of the assets, expose the company to substantial monetary damages or even potentially undermine the operations of the business? Also, consider, how you will propose to address these claims in the transactional agreements.  Has the company been threatened with any lawsuits or other claims that will need to be disclosed?

 

(g) Loans/Liens/Encumbrances:  Are any of the assets subject to a security interest, are there (secured or unsecured) company loans, or liens (arising, for example, from tax claims or a judgment)?

 

(h)  Taxes:  Is the company current on all income, sales and employment tax obligations.  Have all tax returns been filed?  Has the company been the subject of a tax audit, and was there a final resolution?

 

2.  Are the Financial Records Properly Maintained?    Work with your company’s accountant and internal finance department (if you have one) to make sure all of the financial records are well-organized and financial events properly recorded.  The buyer/investor will ask to see balance sheets, tax returns and audits, profit and loss statements, accounts, ledgers and all the back up information.  Disorganized financial records will leave doubts in the mind of a buyer or investor about the accuracy of the financial information provided by the company.  The financial information needs to support the valuation of the company otherwise the potential purchaser or investor will seek to renegotiate or even walk from the deal.

 

3.  Keep Company Books and Records Well Organized.  Make it part of good corporate procedures to maintain orderly books and records from the start.  Do not wait until there is possible exit opportunity to then run around trying to gather the due diligence materials the buyer will certainly request — for example, the company does not want to have to chase down an employee for a copy of an Invention Assignment Agreement or a release from a litigation that settled many years ago.  The more organized the files, the easier the due diligence will proceed.

 

4. Detail Processes and Prepare a Disaster Recovery Plan.  Maintain copies of key documents, files and computer programs.  Prepare a road map of important business processes and procedures as a buyer will appreciate anything that makes for a smooth transition and investors will be impressed that work flow and processes are documented in the event of the departure of a key employee.  The point:  for all important aspects of the business have a disaster recovery plan in place.

 

In sum, a company does not want to learn from a potential buyer or investor that a major issue has been discovered — especially if it could have been addressed by the company prior to the due diligence.  Due diligence issues can result in a reduction of the purchase price or valuation of a business or create obstacles to closing the transaction.  At the very least, due diligence issues discovered by a buyer will raise transaction costs as the parties, accountants and lawyers try to resolve and then document any agreed solution.  Additionally, it is generally less expensive for a lawyer to draft the Purchase Agreement and accompanying disclosures and schedules if company records are well maintained and the purchaser’s attorney is made aware of the issues, if any, at the outset of the transaction.  Lastly, retain professionals (an accountant, a lawyer, a business consultant, technology/computer networking consultant, payroll company, environmental consultant etc.) who understand your business and work with you from the start of your company.  By doing so, you are reducing the chance that the buyer or investor’s due diligence will uncover legal, financial, or business operation issues that either dramatically undermine the value of the company or result in a termination of the transaction.

 

*Jeffrey W. Berkman is the founding partner of The Berkman Law Firm, PLLC, representing entrepreneurs, companies, investors and inventors in connection with business formation and start-up matters, venture capital, intellectual property matters, franchising, commercial contracts and business transactions in the United States, Asia, and Europe.  Jeff is a member of the Board of Directors of Carmike Cinemas, Inc. (NASDAQ: CKEC), and the Berkman Law Firm was chosen as a 2012 finalist by the New York Enterprise Report’s Best Accountants and Attorneys for Privately Held Companies. He is the author of Due Diligence and the Business Transaction:  Getting the Deal Done (Apress 2013), and writes about business law issues relating to small and emerging businesses on his blog www.mybizlawyerblog.com.  Jeff may be reached at jeff@berkmanlawfirm.com.