Performing Due Diligence

Performing Detailed "Due Diligence" Vital When Considering Purchase of a Business
By Ken Bloom, J.D., LLM & Jonathan Goldberg, J.D., CPA
For many business owners, a way to expand their current business is to purchase another business.. Before purchasing a business various factors must be considered to determine if the purchase of a business is appropriate and to make certain the business to be acquired is a financially sound investment.. The process of reviewing the proposed business or "due diligence" is intended to help understand all the specifics about the business and to determine whether or not to buy the business.

Due diligence is the investigation and analysis performed in connection with a proposed acquisition of, or investment in, a business.. The purpose of due diligence is to confirm the legal status, financial condition, and assets and liabilities of a business, which can then be used in structuring, negotiating and consummating the proposed acquisition.. In addition, by performing due diligence, the buyer will identify actions that are required to be taken, such as obtaining third party consents, making government filings or other required actions to complete the purchase.

Upon completion of due diligence, the buyer should have the information required to make an informed decision whether to determine if the real value of the business is worth the purchase price.

The due diligence process may vary depending under the circumstances.. Generally, a sale of a business will consist of either an asset sale or a sale of stock.. An asset sale occurs when the buyer acquires only specified assets or only specified liabilities.. In the sale of stock, the buyer generally takes over for the seller as it relates to all the assets and liabilities.. The decision to purchase the assets of the business or the stock of the business is complex and there is no uniform rule for every purchaser.. The decision is usually determined by tax and liability considerations.. Under either purchase arrangement there are different areas of due diligence that may be emphasized.

Scope of Due Diligence Varies Depending on Specific Situation
The scope and magnitude of the due diligence research by a buyer can vary depending upon the exact situation of the purchase.. However, in general, there are a few areas that should always be included in a due diligence investigation.. To begin the due diligence process, typically, the buyer should provide the seller with a checklist of documents and information the buyer seeks to review.. Prior to providing the checklist of documents and information, the seller and/or the buyer may want to enter into a confidentiality agreement so that information may not be provided to any outside parties. If a confidentiality agreement exists, the parties should be aware of the provisions as well as for the return of the provided materials and information in the event the transaction is not consummated.

It is important to determine how the business is legally structured.. The buyer should review all organizational documents.. An entity to be purchased may be a sole proprietorship, a partnership, limited liability company or corporation.. With some of these types of entities it will be necessary to obtain documents filed with the State of Michigan or with the respective county where the business is located.. It may be necessary, for example, for a corporation to review the articles of incorporation or for a limited liability company to review the articles of organization.

Another item that should be reviewed is the list of the owners of the respective entity as well as any prior owners of the entity.. In the event an owner has died, it will then be necessary to determine if the remaining partners are the complete owners of the entity or if the deceased owner is still a legal owner of the entity.

When the seller is a corporation, the buyer should review in addition to the articles of incorporation, the bylaws as well as any shareholder agreements.. It is also recommended that the minutes of the corporation also be reviewed.. The listing of the directors and officers should be provided by the seller.

In the event the seller has businesses outside of Michigan, it is recommended that a review be done to determine if the seller is qualified to do business in other states as well as that they have good standing in the other states.. It also may be necessary to review any assumed names in other states that the seller transacts business.

If a sale is a stock sale, the purchaser will want to review all the stock certificates for the stock transfer records.. A buyer should also review any employment agreement that the selling individuals have with the entity.. Any plans relating to stock options or the right to purchase stock of the selling entity should also be reviewed.. In addition, stock that is pledged as collateral should also be reviewed.

Reviewing Financial Condition of Business, Tax Returns Important Part of Due Diligence
Another important aspect of the due diligence process is to review the financial condition of the seller.. To help determine the financial status of a business, it is vital for the buyer to review the financial statements of the business.. We generally recommend three to five years of the seller's financial statements.. In the event there are audited financial statements, auditor letters or inquiry letters to management should also be obtained.. It is also necessary to review accounts receivable reports, account payable reports, inventory evaluation as well as backlog reports in addition to pricing policies and compliance matters.

The financial statements may also identify any legal issues of a seller.. The notes to the financial statements are of importance because they may reflect contingent liabilities of the seller.. The financial statement notes also will provide information about debt of a seller, debt restructuring or acquisitions, future commitments, tax matters, litigation and other contingent liabilities.

It is vital for the buyer to review the tax returns of the seller.. This will provide information on revenue as well as expenses of the seller.. A buyer needs to know what taxes have been paid or unpaid, what taxes might be owed, and what types of tax responsibility the business has on an annual basis.. This would include state and federal tax returns, sales and use tax returns, evidence that all payroll, withholding, real and personal property taxes have been paid.. In addition, correspondence regarding any audit or investigation inquiries should be obtained.. These documents should be reviewed for all states in which the business has offices, plants, employees or representatives.

In the event of an asset purchase, it is necessary to obtain a conditional tax clearance certificate by the seller.. The final purchase agreement should provide for an amount to be set aside by an escrow agent to make certain that the seller's Michigan sales, use, withholding, single business tax and Michigan business tax have been fully paid.. The buyer will also need to set aside part of the escrow funds in obtaining the tax clearance certificate for unemployment taxes as well.. Until a conditional tax clearance certificate is issued, the buyer will be subject to successor liability of the unpaid taxes of a seller.. Once the certificate is issued, the money held in escrow is released to the seller and the buyer is relieved of the successor liability.

It will also be necessary for the buyer to inquire the same type of successor liability legislation in states where the seller has facilities, employees or sales representatives.

Another important item is the requirement of the seller to provide a MESC notice to notify the buyer of the MESC (unemployment tax) tax rate payment history.. There are specific requirements that the seller must provide to the buyer including the seller's unemployment tax rate, payment history, employees currently employed by the seller, employees separated from employment from the seller within the last 12 months, seller's outstanding unemployment tax liability, and any unrecorded liability and benefit charges for the last five years.. The unemployment tax information must be provided to the buyer more than two days in advance of the purchase.

In addition to the specific financial condition, a review should be made of contracts of the seller and types of clients the seller has as its customer.

One must also review leases and subleases of the seller.. This also consists of any equipment leases.. Maintenance contracts, service records and documents of title and listing of inventory must also be reviewed.. A buyer should inspect the specific assets that will be purchased.. In addition, the warranties on the assets should be reviewed by the buyer as well.

If one is also purchasing real property, separate requirements should be done for the due diligence for the real property.. This includes reviewing title insurance policies, deeds, land contracts, mortgages, leases and subleases, surveys, easements and rights of way, real estate appraisals, continued obligations on expiring leases, zoning status and verification of payment of real property taxes.. Furthermore, one should physically inspect the property for issues of the property.. It may be necessary to make environmental studies of the property with regard to hazardous waste.

Where the seller is a tenant of a leased real property, if the purchaser is to take over the lease of the seller the buyer should be provided with an estoppels certificate from the landlord stating that the lease is in effect, the lease and all options granted are assignable, there are no defaults under lease, and the lease is complete, accurate and unchanged.. Furthermore, it will be necessary to obtain the landlord's consent to become the new tenant and to take over the seller's lease.

The buyer should also perform a Uniform Commercial Code search to determine if there are any liens on the assets.. If there are liens, those specific documents must be reviewed to determine if the assets that have liens are transferable to the buyer.. Furthermore, if liens have been terminated but a termination statement has not been filed with the UCC Division, it will be necessary to obtain termination statements.

Due Diligence Should Include Review of Intellectual Property
One of the most important assets any business can have in today's world is intellectual property.. Things such as patents, copyrights, trademarks, service marks, and even trade secrets, proprietary software, customer list and internet domain names can make the difference between a business being successful and non success.. Understanding what aspects of intellectual property one is purchasing can make a significant difference between success and failure of the business.. A buyer should review what intellectual property rights the seller owns or utilizes through a license.. A buyer should also review that intellectual property rights have been properly assigned to the company.. The owner of a business may hold the patent or intellectual property right individually without assigning it to the company.. One should also review employment agreements with regard to covenants not to compete and confidentiality agreements.. Agreements signed by employees or key people of the seller that contain a covenant not to compete or confidentiality provision would prevent an employee or key people of the seller from using the confidential information or proprietary information against the buyer.

In the event of a stock purchase it is important to understand what the business is committed to in terms of contract obligations.. These may include loans and credit, employment agreements, equipment leases, franchise agreements, vendor agreements, guarantees and even insurance.. As the purchaser of a business you may now be liable for all these contracts and agreements, so you need to understand what you are liable for and the associated cost.

It is necessary to determine if a transfer by the seller is a breach of contract or a default under some type of agreement.. The transfer to a buyer may result in an accelerated payment either by the seller or buyer.. Furthermore, it must be determined if certain contracts and commitments are assignable by the seller.. For example, in a franchise situation, it is generally necessary for the franchisor to approve of the transfer.

The buyer should also obtain as much information regarding the products and services of the seller as possible.. This may be obtained through its own investigation, discussions with the seller and outside parties.

Depending on the type of business being purchased the buyer should review agreements with sales representatives, employees and distributors.. The buyer will need to determine if the seller relies too heavily on a single customer, supplier, sales representative or distributor.. This may impact the buyer's decision with regard to the sale and/or the purchase price.

Many types of businesses, including manufacturing, transportation, chemical, gas stations and even dry cleaners must adhere to local, state and federal environmental guidelines regarding hazardous waste, water and sewer, emissions, and other aspects governed by government agencies.. It is important to understand the business history and scope regarding all environmental matters before purchasing.. In addition, the buyer should review the seller's insurance policies for such matters as coverage, exclusions, limits and terms.. A complete list of any ongoing and past litigation is a requirement to determine what legal ramifications, if any, the business may be facing in the future under the buyer's ownership.. A litigation search should be obtained, and as previously mentioned, financial statements should be reviewed regarding contingent liabilities.

Another item of review is worker compensation claims or work related lawsuits.. A complete review of employees, who the key employees are, employment contracts and issues, and all compensation benefit plans, is necessary to determine both the cost factors involved with the employee aspect of owning the business, and any potential employment issues that one may face in the future that could impact the business.. Personnel manuals, employee handbooks and employment policies should be reviewed of the seller.

Diligence is typically conducted after the letter of intent has been signed and before the signing of the definitive purchase agreement.. However, even before executing the letter of intent, the buyer should have preliminarily reviewed the seller's financial statements and any offering memorandum or similar materials provided by the seller.

As you can see, details in diligence in these and other areas can provide a potential purchaser with the information needed to make an informed decision on whether or not to purchase a business by identifying what issues the purchaser will face in the future; the chances that the business will be a good investment and be successful in the future; and help determine what the business is worth.

For more information, or to schedule an appointment, contact Jonathan Goldberg at 248-932-5200.