By Peter Moldave
As part of discussions about a possible financing or acquisition transaction, the parties will normally want to “perform due diligence.” This refers to the investigation of a company’s assets, liabilities, and business operations so that a prospective investor or acquiror has a better understanding of the potential advantages and disadvantages of the transaction.
From the perspective of the company being acquired or obtaining an investment (the “subject company”), due diligence investigations can be logistically challenging and, in some cases, risky. Many companies do not keep their records in a form which can be easily reviewed by a third party. In addition, they may have concerns about confidentiality and misuse by the investor/acquiror, especially if that other party is a potential competitor or an investor in a competitor. So a properly written non-disclosure agreement should be signed before starting due diligence, and in the best case there should be reasonably strict controls on access to documents. Many parties use “deal rooms” – either online document storage sites specially designed for this purpose, or sometimes more generally known document sharing systems such as Dropbox.com or Box.com.
In addition to document review, part of the due diligence process often involves discussion with subject company personnel. This has its own potential risks because it alerts them to the possibility of a transaction which might otherwise be kept confidential; and also potentially allows an investor/acquiror to become aware of valuable employees who could be offered employment apart from the transaction (or if the transaction fails to close).
From the subject company’s perspective it is also important to make sure that any issues disclosed in the due diligence process are properly addressed in any transaction documents. Disclosures in due diligence which are not properly documented in the transaction documents can be an inadvertent source of liability for the subject company or its shareholders – a liability disclosed in due diligence but not disclosed in a transaction document can be an easy target for an unhappy investor/acquiror wanting to make a claim.
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Due diligence from the investor/acquiror side is very important. Properly done, it alerts the investor/acquiror to potential liabilities and business challenges, which can be addressed in transaction documents, changes are potential valuation for a subject company, or in some cases to convince an investor/acquiror to abandon the potential transaction.
Due diligence also permits the creation of transaction documents which are most suitable for the relationship between the parties. Simple differences in subject company status or operations (is it a corporation or limited liability company? Does it have foreign subsidiaries? Does it have employees or contractors, and where are they located) can be addressed easily upfront in a transaction documents, where modifications to a transaction document after learning these things results in significant wasted attorney time. And sometimes issues are unusual or unique and a standard transaction agreement (used as a starting point for efficiency purposes) may not take them into account, resulting potential risk for the investor/acquiror.
The timing of due diligence and drafting of transaction documents is therefore something which needs to be considered upfront. An investor/acquiror may not want to spend significant resources in a transaction without knowing from doing due diligence that there is a likelihood that the transaction will proceed. On the other hand, the parties will want to proceed quickly after the due diligence process is completed and waiting until that happens to start drafting transaction documents can significantly lengthen the time until closing. The tradeoff between time and potentially wasted (and costly) effort is something the investor/acquiror needs to consider.
Consideration should also be given in the acquisition context concerning the sharing of certain types of information, especially given the possibility the transaction may not close, and the parties will go their separate ways. Review of the details of significant trade secrets (example: source code) will leave the subject company uneasy that they have given information to the prospective acquiror that the acquiror could use – and the acquiror could fear that the subject company will accuse the acquiror of this even if the acquiror in fact does not use it but comes up with product that are similar. In addition, sharing of specific pricing data (customer pricing, and vendor cost) as opposed to aggregate information, while valuable to understand a subject company’s economics prospects, runs the risk of third party accusations of price fixing if a transaction does not close and both companies appear to price products in parallel post-discussions.
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