The due diligence process in the purchase and sale of a business can seem daunting and cumbersome. Any attorney or financial professional worth his or her salt will tell you that conducting adequate diligence is paramount and, despite what will almost certainly feel like an unnecessarily lengthy and intrusive process, serves to mitigate risks for buyers and sellers alike.
This post is meant to provide a very basic framework of the due diligence process in asset deals to assist buyers and sellers in understanding (a) what they are looking at, (b) what they should be looking for, and (c) setting expectations about how the process looks, and where it can go awry. This post should not be relied on as legal advice, and you should always engage counsel and other financial and tax professionals if you are considering buying or selling a business.
Seeing the Stars in the Universe
So, you’ve signed a letter of intent or term sheet outlining the basic terms of the purchase and sale of a business. The excitement of acquiring new assets or selling a business you’ve built from the ground up is quickly tempered when documents start pouring into the virtual data room (a secure, shared drive where diligence documents are housed for review by the parties to the transaction and their advisors). In an instant, you feel like a child looking through a telescope at a cluster of stars for the first time – how can there be so many?
What Am I Looking At?
First, it is important to understand what you’re looking at. Ideally, there is a variety of documents organized by category into separate folders in the data room that include, company financials and tax returns, privileged licenses the business must hold to operate (including any administrative or disciplinary history), land use permits, commercial lease(s) for the location(s) used to operate the business, any contracts with vendors that serve the business (think utilities, phone/internet, waste disposal, etc.), employee lists with wage and hour information, along with disclosure of any employment claims, and MANY OTHER THINGS. Even more ideal, and perhaps aspirational, these documents are accurate, complete, and easy for your counsel and advisors to read and analyze.
What Should I be Looking For?
Once you and your professional team have a handle on what documents and data you have, you can begin to narrow the universe of information to find what you should be looking for. Remember that part of the diligence process for buyers AND sellers should include a reasonable opportunity to ask questions and have them answered. If you feel like your questions are not being answered, or you are unsatisfied with the responses, you should consult with your professional team to determine next steps.
Below are examples of what you should be looking for in various diligence documents by category. The list below is by no means exhaustive and is meant only as a starting point. Remember to always consult with your professional team regarding general scope of diligence and specific matters to investigate or disclose by category.
- Work with your CPA or financial and tax professionals to ensure the company financials appear accurate, complete, and prepared in accordance with Generally Accepted Accounting Principles.
- Are there out of the ordinary expenses?
- Is there significant debt? Remember, even in an asset deal where a buyer is not acquiring liabilities, loans frequently give rise to liens that may attach to the assets you are purchasing or selling.
- Are there significant discrepancies between the company financials and tax returns?
- Real Estate – (Most transactions involve commercial leasing, which is the focus of this section. If a land/building purchase is involved, other items will be disclosed and reviewed.)
- Review the lease in its entirety and never assume the lease is on “standard terms”. Assume that most landlords, if they are willing to permit an assignment of the lease to buyers (see next bullet point below), will likely be averse to modifying many legal and business terms, meaning you should be prepared to accept the lease on the terms as written. While there is room for negotiation, be prepared to offer something in exchange for new and favorable lease terms post-closing.
- Most commercial leases contain a no-assignment clause, meaning you will almost always need consent of the landlord to assign the lease to buyer, or buyer and landlord will need to enter into a new lease. Either way, engaging in discussion with landlords early in the process is essential to staying on track for closing, as the process of assignment or negotiating a new lease can be lengthy. Assume this process may take anywhere between 1-6 months at a minimum.
- Work with your CPA or financial/tax professional to ensure the company tax returns (a) are accurate and reflective of the company financials, (b) were filed timely, and (c) were paid in full. Although different jurisdictions have different laws regarding attachment of tax liabilities to buyers in asset deals, exposures like tax liens being attached to the assets being purchased and sold, or violations for non-payment of taxes against a privileged license being transferred can arise, even if a buyer does not assume prior tax liabilities by contract or statute.
- Are the licenses used to operate the business transferrable, or must the buyer apply for new licenses?
- Are all necessary licenses to operate the business after closing in good standing?
- Is there any negative licensing history, such as regulatory violations or other stipulated agreements with the licensing authority that limits the exercise of the privileges granted by the license or makes the license probationary?
- Land Use
- Is the parcel of land on which the business is located properly zoned to operate the business as presently operated? Are any modifications or additional permits necessary for planned future operations after closing? Remember, zoning is often very specific to a particular type of use. Additionally, many zone use violations go unnoticed or are not enforced by relevant authorities. Do not assume that your planned future use is “close enough” to the current use permitted by the zoning code, or that a long history of prior use by a seller in violation of local zoning ordinance will not result in an enforcement action after closing.
- Assumed Contracts
- What services or vendors does the business need to operate? Does the buyer intend to assume these contracts, or will the seller terminate those agreements on closing?
- Vendor contracts, like leases, can contain no-assignment provisions, so it is important to work with your counsel to understand whether a particular service or vendor contract may be assigned to the buyer on closing.
- Employment matters are complex and should not be overlooked. There are many moving parts in the employment realm within an asset transaction. Above all else, work closely with your counsel and professional team and remember, whether you are a buyer or seller, to err on the side of more disclosure.
Depending on the type of transaction and others context, what you should be looking for by category and within certain categories is very likely far more expansive than described above.
What Should I Expect?
If you are like most of buyers and sellers, you are already likely feeling overwhelmed, even based on the drastically abridged version of due diligence above. We understand that you likely are embarking on the journey of an acquisition or sale for the first time, and it is ok to feel like you are floating aimlessly among the stars. The most important thing to understand is that throughout the diligence process and the various transaction phases, you will be tired. You will likely get fed up. You may even want to quit. In those moments, remember, we do this all the time and are here to help you get through it. Conducting diligence in the right way, despite leaving you tired, fed up and possibly wanting to quit, will be worth it in retrospect. Most importantly, this process will drastically reduce the risk of latent exposures associated with cutting corners in diligence, or not conducting diligence at all.
Remember, it will be rewarding in the end if we do it right. We look forward to sharing a beer after closing and looking up at the stars together with the sense of pride that comes only after accomplishment through perseverance.
ABOUT THE AUTHOR
Colin joined Milgrom & Daskam in March 2022 and focuses on a variety of business matters including regulated cannabis, pet care, financing, real estate, formation/governance, M&A, commercial transactions, business licensing, regulatory compliance, and general corporate.
FinCEN and Real Estate: Additional Disclosure Requirements May Be On the Horizon for Real Estate Transactions￼
As part of the anti-money laundering regime under the Bank Secrecy Act of 1970 (the “BSA”), in late 2021, the Financial Crimes Enforcement Network (“FinCEN”) division of the Department of the Treasury issued an advanced notice of proposed rulemaking (“ANPRM”) seeking to address potential money laundering through real estate transactions. The comment period for the ANPRM closed on February 21, 2022. This ANPRM comes closely after the notice of proposed rulemaking related to the implementation of the Corporate Transparency Act (the “CTA”), which you can read more about here. Both the CTA and the proposed regulations under the ANPRM would require significant levels of disclosure regarding the beneficial ownership of companies and real estate in non-financed real estate transactions. These measures aim to reduce money laundering, and assets held by undisclosed foreign investors. It is estimated that between 2015 and 2020, at least $2.3 billion was laundered through U.S. real estate, though the actual figure is likely much higher Accordingly, both FinCEN and Congress are trying to limit the number of real estate transactions used to launder money.
Two new laws are set to take effect in the coming months that will require employees to examine their current practices and make changes to bring themselves into compliance.
When I joined Milgrom & Daskam at the height of COVID, I wasn’t sure what the future would look like for me or this relatively young firm. We were giving up our physical office space in downtown Denver and embarking on a new vision for remote workers. Up until then, much of my professional work life was spent in an office environment, surrounded by colleagues My days were punctuate by in-person meetings–formal, over coffee or meals.in the hallways–and bookended by my daily commute between Denver and Los Angeles which ranged anywhere from just under 30 minutes to more than an hour.