Abstract
An overarching theme of the due diligence investigation is an attempt to verify the business story as told by the seller, potential partner, or the company seeking financing (hereafter, “the seller”). Chapter 5 discussed examples of how the discovery of certain types of legal issues results in termination of a proposed deal because they undermine the business story. Some deals fail because they are legally impossible to complete or simply too risky, costly, or uninteresting from a financial or business standpoint. Not all issues discovered during the due diligence process end in termination of a proposed transaction, however. Rather, there are usually financial, legal or business solutions that can remedy the issue or issues. For the party conducting the due diligence investigation (hereafter, “the buyer”), the discovery of information challenging a seller’s story can create an opportunity to renegotiate financial or legal terms, or aspects of the proposed deal, or may to require the seller to make changes to its business operations. Any solution proposed by a buyer must still be acceptable, of course, to the seller. In many cases, however, the seller may have no choice but to accept revisions to the original deal terms if it wants the transaction to proceed. This chapter explores common due diligence issues that can create an opportunity for the party conducting the due diligence investigation to negotiate more favorable financial terms, deal structure, or rights when the other party is motivated to move forward with the deal done.
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- 1.
Most transactions have a few standard preclosing conditions, such as a board resolution authorizing the transaction or certification by the company regarding the continuing validity of the representations and warranties contained in the contract. The preclosing conditions referred to here (and discussed in detail in Chapter 8) are specific conditions incorporated in the definitive agreements to address issues discovered during due diligence.
- 2.
A key employee insurance policy provides the company insurance proceeds on the death or disability of a significant business partner or employee. The insurance is intended to address at least the initial financial impact from the death or disability of the key partner or employee.
- 3.
If there material misrepresentations by the seller that come to light only after the closing, the investor may have legal claims. Enforcing any claims, however, can be costly and may not provide a timely solution if the company needs to restructure operations immediately.
- 4.
A board seat can also bring risk, especially when there are several other members or shareholders. If a shareholder believes she has a claim against the company, she might join the directors. Some, but certainly not all, closely held companies have Directors and Officers Insurance (D&O), which provides indemnification for liability and litigation costs in many cases. Even if there is a D&O policy, the investor may not want to the potential exposure and hassle of being a defendant in a lawsuit.
- 5.
Reorganization can include, for example, the conversion of the entity to a different business entity form, formation of an entity in a tax-efficient jurisdiction, or use of a licensing, service, manufacturing, marketing, or distribution entity to reduce the taxes of the parent company by shifting some of the income to the subsidiary.
- 6.
As an example, an operating agreement can contain a provision that requires the company to make distributions to members to cover any tax obligations arising from the ownership of the LLC (a “tax distribution”).
- 7.
Chapter 8 includes a discussion of clauses that can be added to a purchase agreement requiring postclosing cooperation from the seller.
- 8.
Documenting workflow and company policies and procedures makes excellent business sense even if a company is not considering a sale, given just some of the potential operating risks discussed in this section.
- 9.
In the ABB transaction, the buyer is purchasing all of the assets, including customer lists and related data stored on a computer network that is part of the deal. While the buyer may plan to migrate the data to new data storage system, until such time the buyer must be comfortable with the stability of the seller’s network of computers and data storage system.
- 10.
During Hurricane Sandy, many companies were confronted with the unfortunate fact that the companies providing electronic information backup were equally devastated by the hurricane. Of course, Sandy was an unprecedented weather event, but businesses should consider the need for multiple operational and information backup redundancies.
- 11.
Accidental release, or the access and eventual release of customer information resulting from hacking, poses a major concern for all companies that store customer information electronically. Credit card companies, financial institutions, and merchants face substantial damages (which can put a company out of business) when safeguards protecting customer information are not implemented and followed properly.
- 12.
Exceptions include disclosure to professional advisors, with consent or as required by law.
- 13.
It, admittedly, can be difficult to get existing employees to sign invention assignment agreements. They will be concerned about giving up rights, and some may even refuse. The buyer then needs to decide whether to make this a nonnegotiable deal condition.
- 14.
In the dotcom era, it was shocking what some companies called employment manuals and yet were able to raise tens of millions of dollars. Some manuals featured funny pictures of employees, the right to bring dogs and cats to work, statements about the importance of a fun working environment, and very little (if anything) about important workplace policies.
- 15.
Companies need to follow state and federal laws regulating employment background checks, and potential hires should be informed of their rights and must provide consent, in writing, to these checks.
- 16.
Other parties can also have rights of first refusal, including lenders and convertible note holders, which demonstrates the importance of reviewing all the material contracts, agreements, and undertakings during due diligence.
- 17.
The investor has to understand the capitalization table and which shareholders are aligned or will likely vote in a block before determining the vote percentage that makes sense. In the Karly Medical situation, the chairman owns 30% and the investor owns 33%, leaving 37% representing other shareholders. If the investor is concerned that at least 33% of the other shareholders are controlled by the chairman, the only meaningful approach may be to demand all votes on material transactions be approved by a supermajority consisting of 75% of the outstanding shares.
- 18.
Pre-closing conditions and post-closing covenants, as well as the mechanisms for enforcement of any post-closing rights are addressed in Chapter 8.
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© 2013 Jeffrey W. Berkman
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Berkman, J.W. (2013). Has Due Diligence Created an Opportunity to Improve the Deal Terms?. In: Due Diligence and the Business Transaction. Apress, Berkeley, CA. https://doi.org/10.1007/978-1-4302-5087-6_6
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DOI: https://doi.org/10.1007/978-1-4302-5087-6_6
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