Preparing for Acquisition Due Diligence Carrie Keller, Partner, SmithAmundsen John Finger, Partner, SmithAmundsen The purpose of the due diligence process in an acquisition is to investigate the target business and to confirm the accuracy of information that the seller has provided. This involves an examination of the seller s operations, sales, financial performance, assets, liabilities and other factors that may have had a past impact or will have a future effect on these factors. The end goal of due diligence is to identify risk factors of ownership of the business or assets, obstacles to the proposed transaction or its financial objectives, and any factors that may affect the decision to acquire or the purchase price. Diligence Request Lists This article focuses on items to include in legal diligence request lists. The legal diligence process is focused on understanding the seller s structure, its assets, ongoing contractual obligations and liabilities, as well as determining any potential risk exposure for the buyer. The following areas should be addressed in any diligence request. Organizational Documents - Corporate Books and Records: Seller s organizational documents, registrations in foreign jurisdictions, annual reports, governing agreements (bylaws, operating agreements, partnership agreements, buy-sell agreements) and all amendments, list of equity owners, minutes and consents for the past 5 years, joint venture agreements, and agreements affecting or restricting ownership or voting. Employees - Benefit Plans: Employee list including name, position, compensation and benefits; information regarding employee benefit plans, fringe benefits and benefit arrangements including copies of all plan documents; collective bargaining or union agreements; summary of labor disputes or strikes at each of seller s locations. Contracts and Commitments: This request should address all documentation regarding loans, material vendors, material customers, contracts requiring third party consent to assignment, license agreements, distributor agreements, leases, purchase agreements, employment agreements, samples of seller s purchase orders, invoices, terms and conditions, warranties.
Litigation: Summary of all pending or threatened litigation; summary of all litigation from the past 5 years; copies of settlement agreements, consents or binding orders; notices or demands sent to seller for which no litigation has been filed; notices or communications from government agencies regarding employee safety, hazardous materials, workplace conditions; communications from seller s insurers related to coverage continuation, termination, reductions, premiums or cancellations. Environmental Matters: Copies of environmental permits, notices of violation, noncompliance or violations; environmental investigations, audits or assessments; detailed description of any known or suspected contamination at seller s locations. Intellectual Property: All patents, copyrights, trademarks, service marks (including registered and pending applications), domain names, customized software, license agreements, work made for hire agreements, intellectual property assignments. Real Estate: All real estate owned or leased by the seller, including copies of leases, legal descriptions, copies of deeds, surveys, title exceptions, easements, real estate tax bills, assessments, reassessments, zoning, subdivision and building code approvals. Regulatory Matters: Copies of all permits, licenses, approvals or qualifications issued by governmental authorities along with any notices, deficiencies, consents, decrees, judgments, settlement agreements or similar binding agreements from governmental authorities. Miscellaneous: Audit response letters from seller s attorney to seller s accountants. Other documents or information which are significant with respect to seller s business. Searching Public Information The following records should be searched: Corporate Records: Records filed with the Secretary of State (or similar authority) in all jurisdictions where seller is located. SEC Filings: Even if seller is not publicly traded, searching SEC filings may still be helpful if a publicly traded company entered into a transaction with seller and the transaction was disclosed to the SEC. Real Estate Records - GIS Maps: Deeds and instruments relating to real estate, including mortgages, deeds of trust, and certain types of liens. GIS maps can provide further information including zoning classifications and neighboring property owners. County Assessor: The county assessor where seller is located will have publicly accessible information including copies of real estate tax bills and personal property tax bills. Litigation and Judgments: Search state and federal courts (including bankruptcy court) having jurisdiction over seller s location(s). 2
UCC Filings: Financing statements reflecting security interests in seller s assets. USPTO: Search for any trademarks, service marks, or patents owned by seller. Google: Not the most sophisticated legal search tool, but it is worthwhile to Google search seller and its principals. Specific Areas of Concern Taxes: Tax liability will depend upon the form of transaction. In an equity purchase, buyer will inherit seller s tax liability, so verifying seller s taxes are current, and understanding seller s tax liabilities, is an important part of the diligence process. Asset acquisitions generally offer more protection to buyer with respect to seller s pre-closing tax liabilities; however there are still risks to buyer for successor liability for certain taxes. As part of the diligence process, buyer will need to analyze state (and sometimes local) laws with respect to various types of taxes. o Real Property and Transfer Taxes: Each state imposes a tax on ownership of real property. Some states also impose a real property transfer tax on the transfer of real property and/or the recording of a deed transferring real estate. If seller owns or leases real estate, as part of its due diligence review, buyer must determine all states where seller owns or leases real property. For purposes of real property taxes, buyer will need to request copies of the past 3 year s real estate tax bills for each property owned by seller to verify tax liability and special assessments. The buyer should also request documentation pertaining to any tax assessment appeals or reassessments for that period. If seller leases real estate, buyer will need to analyze any lease to determine the tenant s responsibility for tax payment and ability to contest tax assessments. Not all states impose a real property transfer tax. The buyer will need to analyze the laws of each state in which seller s real estate is located to determine the following: if the state imposes such a tax, whether the tax would apply to buyer s intended purchase of real property (note: entity level sales may trigger transfer tax liability), and the amount of the potential tax liability. o Personal Property Tax: Not all states impose a tax on tangible personal property. For sellers with assets in multiple locations, some assets may be subject to personal property taxes while others are not. As part of its due diligence, buyer will need to request copies of any tangible personal property declarations and tax bills for the past 3 years. In addition, buyer will need to analyze the laws of each state in which seller s assets are located to determine whether the state imposes a personal property tax and the amount of the potential tax liability. o Bulk Sales Acts: Bulk sales laws may impose additional transfer liability upon the sale of a business. Bulk sales laws differ greatly from jurisdiction to 3
jurisdiction but in general refer to a transfer in bulk of all or substantially all of a seller s personal property, merchandise, equipment and/or inventory outside of the ordinary course of business. Because of the varying applicability of these laws, the inquiry is highly state specific. As part of its due diligence, buyer will need to analyze state and local laws to determine which, if any, bulk sales acts may apply to the transaction, the notice and response requirements and liabilities for non-compliance. o Successor Liability: Buyer could potentially be exposed to successor liability if seller did not properly withhold or report payroll taxes or other special taxes or assessments, file appropriate sales or use tax returns or if tax deficiencies arise after closing. In order to avoid these types of successor tax liability, some states allow the seller to request a certificate or other evidence from the state s department of revenue (or similar authority) providing that no tax is due from the seller or the amount of taxes that are due. If a buyer obtains such a statement from the state authority within the required time period, the buyer usually will be released from liability for those taxes. Employment and Benefits Issues o WARN Act Requirements: Be aware of WARN Act applicability and notice requirements. The Worker Adjustment and Retraining Notification Act applies to employers with 100 or more employees and requires 60 calendar day advance notice of any plant closing or mass-layoffs. As part of the diligence process the buyer will need to determine if the WARN Act is applicable, and, if so, make a determination of whether buyer s plans with respect to seller s employees has any WARN Act implications. o Employee Benefit Plan Diligence: The buyer should review every current employee benefit plan along with the employee handbooks (which may provide insight into any informal plans). The seller will also need to provide any relevant documentation including the written plan (and amendments), summary plan description, IRS Form 5500, service agreements with any third party administrators and any nondiscrimination tests or corrective actions taken as a result of those tests. Other issues to verify as part of the review may include: (1) does the sponsor have the right to terminate or amend the plan? If not, the buyer may have to continue to provide the benefits under the terms of seller s plan for employees who were participants as of closing, and (2) will the transaction trigger any acceleration, vesting, payments or other consequences? Intellectual Property: Due diligence with respect to intellectual property can be distilled into one concise instruction verify seller s rights in its intellectual property. o Trademarks and Service Marks Does seller own those marks outright or are they licensed from third parties? For marks owned by seller, has seller complied 4
with all maintenance filings on a timely basis? If the marks are licensed from third parties, can seller s rights be assigned or sublicensed to buyer? Does seller license any of its marks to third parties and what are the third parties rights in those marks? What are the terms of any licensing agreements? o Patents Understanding patent ownership may require patent lawyer assistance. If patents are involved, consider with buyer the cost-benefit analysis of engaging patent counsel to provide an opinion of seller s existing patents and patent applications. o Copyrights Research seller s copyright registrations. For any copyrighted material licensed by seller from an author, review the terms of those license agreements and verify whether or not they are assignable or can be sublicensed to the buyer. o Rights in Works Created by Employees Has seller entered into intellectual property assignments with its employees? Are there work-made-for-hire agreements? Customer and Supplier Contracts: As part of the diligence process the buyer should make its own assessment of what constitutes material and ask seller to disclose its material customers and suppliers. Legal counsel should review the agreements with those customers and suppliers and verify they are assignable to buyer. Carrie F. Keller, Partner, SmithAmundsen, can be reached at 314-719-3794 or ckeller@salawus.com John W. Finger, Partner, SmithAmundsen, can be reached at 314-719-3780 or jfinger@salawus.com 5