Due Diligence Best Practices and Pitfalls

©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 1
Firmex Webinar Series
M&A Master Class
November 17, 2011
1:00 p.m. to 2:00 p.m.
Andrew J. Sherman, Esq.
Jones Day
51 Louisiana Avenue, N.W.
Washington, D.C. 20001-2113
202-879-3686
ajsherman@jonesday.com
Art or Science?
Due Diligence Best Practices and Pitfalls
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Joel
Lessem
CEO
Firmex

Andrew J. Sherman
Mr. Sherman is a partner in the Washington, D.C. office of Jones Day with over 2,500
lawyers worldwide.
He is the author of 23 books on business growth, capital formation and the leveraging of
intellectual property. His eighteenth (18th) book, Road Rules Be the Truck. Not the
Squirrel. (http://www.bethetruck.com) is an inspirational book which was published in
the Fall of 2008. He has appeared as a guest and a commentator on all of the major
television networks as well as CNBC’s “Power Lunch,” CNN’s “Day Watch,” CNNfn’s
“For Entrepreneurs Only,” USA Network’s “First Business,” and Bloomberg’s “Small
Business Weekly.” He has appeared on numerous regional and local television
broadcasts as well as national and local radio interviews for National Public Radio
(NPR), Business News Network (BNN), Bloomberg Radio, AP Radio Network, Voice of
America, Talk America Radio Network and the USA Radio Network, as a resource on
capital formation, entrepreneurship and technology development.
He has served as a top-rated Adjunct Professor in the Masters of Business
Administration (MBA) programs at the University of Maryland for 23 years and at
Georgetown University for 15 years where he teaches courses on business growth
strategy.
He has served as General Counsel to the Young Entrepreneurs’ Organization (YEO)
since 1987. In 2003, Fortune magazine named him one of the Top Ten Minds in
Entrepreneurship and in February of 2006, Inc. magazine named him one of the all-time
champions and supporters of entrepreneurship.

What Is “Due Diligence”?
• Due diligence is both an art and a science
• Proper due diligence involves:
– Knowing where to look
– Knowing what to ask
– Knowing what tools to use
– Knowing who to ask
– Knowing how to test premises/answers
– Knowing who should ask
– Knowing how to verify

What Is “Due Diligence”? (Cont’d)
• The “Art” of Due Diligence:
– Understanding how to extract key information
from a person or situation
– Understanding the objectives of the parties
and the underlying transaction
– Identifying key hurdles and risks
– Identifying why information might be falsified
or omitted
– Targeting the proper sources for disclosure of
information

What Is “Due Diligence”? (Cont’d)
• The “Science” of Due Diligence:
– Do your homework
– Be prepared and well-organized
– Be precise in your requests
– Be persistent in your quest for the truth
– Don’t accept the first answer as the final
answer
– Trust your gut – “if it’s too good to be true …”

Our Due Diligence “Heros”
Peter Falk
AJS
TO
PICK
PICTURE
AJS
TO
PICK
PICTURE
Curious George Sherlock Holmes

Due Diligence and Current Events
• Impact of 9/11/01 Attacks
• Impact of Dot.com failures and Enron
• The era of Sarbanes-Oxley
• Subprime Crisis
• The Madoff and Stanford scandals
• Overall global recession and financial system woes
Bottom Line:
We are in an era where everything and everyone must
be questioned and answers verified

Dealing With Due Diligence Surprises
Walk/Run AwayWalk/Run Away
Purchase Agreement
Amendments
and Protections
(Hold backs, R+W’s,
Indemnifications,
Escrows, etc.)
Purchase Agreement
Amendments
and Protections
(Hold backs, R+W’s,
Indemnifications,
Escrows, etc.)
Purchase Price
Adjustments
(or Terms)
Purchase Price
Adjustments
(or Terms)
IgnoreIgnore
Cost
R
i
s
k

Due Diligence Best Practices
• Work as a team, but have a clear quarterback/captain
• Designate a primary point of contact for each party to the transaction
• Conduct regular team meetings to compare notes and coordinate
carefully
• The more you know, the better questions you can ask
• Be organized – set timetables and deadlines for deliverables
• Use industry experts early and often
• Use technological tools available to you (search engines, data rooms,
etc.)
• Develop penalties/consequences/remedies for non-compliance
• Understand why a party may be trying to hide key facts or
circumstances
• Question everything – BE INQUISITIVE!

Overview of Analysis of
M&A Targets

Overview of the
Due Diligence Process

Overview of the Due Diligence Process
• Goal: Objectively prove or disprove the investment thesis:
– Can it be operated better? Synergies?
– Why own this business?
• Intrinsic value: Determine the intrinsic value based on cash flows
– Validate/negate assumptions
• Levels: 3 levels of Due Diligence
– Strategic and operational
– Legal and regulatory
– Financial

Importance of Due Diligence
• Ability to determine whether or not to complete the
transaction
• Ability to successfully negotiate the deal terms
• Assess in advance the ability to successfully
achieve the desired post-closing business
objectives
• A necessary prerequisite to a well-planned
acquisition though the process can be tedious,
frustrating, time-consuming and expensive
Avoid Surprises!

Purpose of Due Diligence
• Provide information to assess risks and
transaction requirements
• Understand the target business completely
• Surface issues early on to identify deal breakers
• Create a platform for a successful transaction
• Note that while buyer should resist the temptation
to conduct a hasty "once over" (either to save
costs or to appease the seller), at the same time it
should avoid "due diligence overkill," keeping in
mind that due diligence is not a perfect process

Key Objectives of the
Due Diligence Process
• Allocate discovered risks between the parties
• Address particular issues in representations, warranties and
indemnification
• Restructure original terms of the transaction based upon due
diligence
• Adjust the purchase price
• Adjust the payment terms
• Include escrows and holdbacks
• Change the legal structure of the deal
• Terminate the transaction
• Risk Allocation Options
– Indemnifications
– Escrows/Holdbacks

Due Diligence Teams
• Due Diligence Team: The purpose is to assemble a multi-
disciplinary team
– Attorneys
– Accountants
• Accountants can help give the team ammo to re-negotiate
the deal
– Investment bankers and advisors
– Operational personnel, including technology personnel
– Lenders
– Don’t forget specialty consultants (tax, intellectual
property etc.)

Common Due Diligence Mistakes
Made By The Buyer
• Mismatch between the documents provided by the seller and the skills of the
buyer's review team. It may be the case that the seller has particularly
complex financial statements or highly technical reports which must be truly
understood by the buyer's due diligence team. Make sure there is a capability
fit.
• Poor communication and misunderstandings. The communications should be
open and clear between the teams of the buyer and the seller. The process
must be well orchestrated.
• Lack of planning and focus in the preparation of the due diligence
questionnaires and in the interviews with the seller's team. The focus must be
on asking the right questions, not just a lot of questions.
• Inadequate time devoted to tax and financial matters. The buyer's (and
seller's) CFO and CPA must play an integral part in the due diligence process
in order to gather data on past financial performance and tax reporting,
unusual financial events or disturbing trends or inefficiencies.
• The buyer must insist that its team will be treated like welcome guests,
not enemies from the IRS!

Business Issues In Due Diligence
• Industry - Macro Factors
– Growth rates
– Cyclicality
– Adoption rates
– Elasticity
• Business Model - specific to company
– Understanding its products, services, niche, "reason for
being"
• Growth factors
– Barriers to entry
– Competitors

Business Issues In Due Diligence (Cont’d)
• Customers
• Suppliers
– Distribution/how, and who controls?
– Pricing
– Regulations
– Strategic relationships
– Brand recognition
• Are there areas where investors/buyers
can add value beyond?

• Management/Human Resources
– Appropriateness of background
– Track record of success
– Honesty (Background check?)
– Strengths/Weaknesses/Holes
– Sense of teamwork
– Compensation/employment contracts
– Incentives (monetary and/or equity)
– Entrepreneurial v. large co. culture
– Operational v. strategic
– Arrangements (related party)

• Other shareholders
– Who are they?
– Can you work with them?
– Incentives?
– Are their goals aligned with yours?
• Special rights?
– Financial

• Historic review
• Recasts
• Projections (reliability)
– Information systems
• Physical Plant, Property and Equipment
– Appropriateness
– Leased versus owned a Replacement value
– Projected capital expenditure requirements

Analyzing the Business Issues
In Due Diligence
• In conducting due diligence from a business perspective, you are
likely to encounter a variety of financial problems and risk areas when
analyzing the target company. These typically include:
– undervaluation of inventories or weakness of
backlog/customer orders or lack of loyalty
– overdue tax liabilities
– market trends unfavorable (margin on demand
shrinkages/erosion, highly competitive, lack of growth in
demand, etc.)
– inadequate management information systems

Analyzing the Business Issues
In Due Diligence (Cont'd)
– incomplete financial documentation or customer information
– related-party transactions (especially in small, closely held
companies)
– an unhealthy reliance on a few key customers or suppliers
(concentration issues)
– aging accounts receivable
– incomplete financial documentation or customer information
– unrecorded liabilities (for example, warranty claims, vacation pay,
claims, sales returns and allowances)
– an immediate need for significant expenditures as a result of
obsolete equipment, inventory or computer systems

Industry/Market Review
• Key problems facing the industry
• Market Characteristics
• Financial results of comparable companies
• Importance of technology, trademarks,
licenses and other intellectual property
• Impact on the industry of governmental
regulation
• Competition

Financial Review
• Activities that would disallow contemplated accounting treatment
• Accounting Policies and Procedures
• Revenue Recognition
• Profit Margins/trends
• Interim Operating Results
• Backlog
• Related Party Transactions
• Debt, Cash flow and Banking Relationships
• Budgets and Projections

Operational Review
• Management: Strengths and Weaknesses
• Internal Control Structure
• Facilities
• Compensation and employee benefits
• Information systems

Mechanics of Due Diligence

Gathering Data

Logistics of Due Diligence
• Before we understand the sources of data for the
process of due diligence, it is important to understand
certain logistics
• The buyer's lawyer should coordinate the due diligence
process so that target receives only one set of diligence
requests, rather than repetitive requests from the various
advisors (e.g., accountants and bankers).
• Even if accountants or other specialists are also
performing due diligence, the buyer's lawyers should be
responsible for at least reviewing and cataloguing all
items in a data room unless explicitly told to not review
certain items.

Logistics of Due Diligence (Cont’d)
• The target's lawyers should control the due
diligence process at least to the extent that they
receive copies of all materials that are forwarded to
the buyer. Also, the target's lawyers should
conduct their own due diligence review of the
target, particularly if they have not historically
represented the company, to ensure the accuracy
of the representations and warranties and
schedules.

Logistics of Due Diligence (Cont’d)
• When distributing a due diligence request list, the buyer's
lawyer may wish to also distribute the draft
representations and warranties so that the target can
compile information which is responsive to the diligence
request and is necessary to prepare schedules to the
acquisition agreement.

Sources Of Information
• Review Public Information
• Due Diligence Request Lists
• Site visits/Management Meetings
• Industry specific professionals
• Experienced peers
• Interviews: clients, vendors, competitors
• Investigators
• Abandoned and Failed Deals
34

Virtual Data Rooms

Virtual Data Room

Virtual Data Room
• Print and Access Features
– Enable to disable printing of documents
– Enable or disable the ability to view a document
– “Confidential” Options
• Audit
– Customized reports show date, document, time and print activity
• Maximum Reach
– All users are more productive and efficient – office, road or home
– 24/7 availability
• User Friendly
– No orientation necessary

Virtual Data Room – Sell Side Advantages
• Reduced Transaction Time
– Serious bidders identified early in process
– Deal closes sooner
– No scheduling conflicts
– No travel delays
• Detail Audit Reports
– Follow footsteps of each user
– Easily identify documents that have not been viewed
• Confidentiality
– Users never bump into one another
– Security protocols insure confidentiality

Virtual Data Room – Buy Side Advantages
• Target Risk Assessment
– Easy access to target information for due diligence review of
company and industry
• Negotiations
– Centralized catalogue of documents for negotiation key issues
• Post-Closing Document Integration
– Documents are easily accessible to various department for review
and integration

Legal Due Diligence

Due Diligence Checklists – Key Issues
The buyer's acquisition team and its legal counsel gather data to answer
the following a variety of key legal questions during the legal phase of
due diligence:
1. What legal steps will need to be taken to effectuate the transaction
(e.g., director and stockholder approval, share transfer
restrictions, restrictive covenants in loan documentation)? Has the
appropriate corporate authority been obtained to proceed with the
agreement? What key (e.g., FCC, DOJ) third-party consents (e.g.,
lenders, venture capitalists, landlords, key customers) are
required?
2. What antitrust problems, if any, are raised by the transaction? Will
filing with the FTC be necessary under the pre-merger notification
provisions of the Hart-Scott-Rodino Act?

Due Diligence Checklists – Key Issues
3. Will the transaction be exempt from registration under
applicable federal and state securities loans under the "sale
of business" doctrine?
4. What are the significant legal problems or issues now
affecting the seller or that are likely to affect the seller in the
foreseeable future? Are there any FCPA, DCAA, or other
regulatory investigations pending or threatened? What
potential adverse tax consequences to the buyer, seller, and
their respective shareholders may be triggered by the
transaction?

Due Diligence Checklists –
Key Issues (Cont’d)
5. What are the potential post-closing risks and obligations of the
buyer? To what extent should the seller be held liable for such
potential liability? What steps, if any, can be taken to reduce
these potential risks or liabilities? What will it cost to implement
these steps?
6. What are the impediments to the assignability of key tangible
and intangible assets of the seller company that are desired by
the buyer, such as real estate, intellectual property, favorable
contracts or leases, human resources, or plant and equipment?
7. What are the obligations and responsibilities of the buyer and
seller under applicable environmental and hazardous waste
laws, such as the Comprehensive Environmental Response
Compensation and Liability Act (CERCLA)?

Due Diligence Checklists –
Key Issues (Cont’d)
8. What are the obligations and responsibilities of the buyer and seller
to the creditors of the seller (e.g., bulk transfer laws under Article 6
of the applicable state's commercial code)?
9. What are the obligations and responsibilities of the buyer and seller
under applicable federal and state labor and employment laws (e.g.,
will the buyer be subject to successor liability under federal labor
laws and as a result be obligated to recognize the presence of
organized labor and therefore be obligated to negotiate existing
collective bargaining agreements)?
10. To what extent will employment, consulting, confidentiality, or
noncompetition agreements need to be created or modified in
connection with the proposed transaction?
In other words, legal due diligence will focus on the potential
legal issues and problems that may serve as impediments to
the transaction as well as shed light on how the documents
should be structured.

Critical Success Factors
Do:
• Involve an experienced, dedicated team with clearly defined roles
• Discuss potential deal breakers early and often
• Insist on full access to target
• Be persistent and skeptical
• Plan for sufficient time to complete the project
• Develop a Day 1 plan

Potential Problems to Avoid
Don’ t:
• Exclude experienced legal counsel
• Agree on contract details too quickly
• Rush due diligence
• Assume the deal is done until it is actually closed
• Be afraid to walk away from the deal before it is closed. Remember
that the key objective of due diligence is not just to "confirm that the
deal makes sense" but rather to determine whether the transaction
should proceed at all, recognizing at all times that there may be a
need to "jump ship" if the risks or potential liabilities in the
transaction greatly exceed what the buyer anticipated.

Questions & Answers

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Due Diligence Best Practices and Pitfalls

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