DUE DILIGENCE IN REAL ESTATE ACQUISITIONS First Run Broadcast: August 2, 2016 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) This program will provide you with a real world guide to due diligence in real estate transactions what information you need, where to get it, and the timeframes involved depending on the type of transaction involved. The relationship between the length and depth of due diligence and the state of the market how hot markets involve more risk because sellers or other counterparties are reluctant to give lengthy diligence periods will be discussed. The program will also cover what to do with diligence information, the practical process of using the information obtained to draft specific reps and warranties. This program will provide you with a real-world guide to planning due diligence in real estate transaction essential information to obtain depending on the transaction involved and how to tie that information the transaction s reps and warranties. Planning diligence what information you need, where to get it, and timeframes Relationship between diligence and market conditions willingness of sellers to cooperate or not Using diligence tying information obtained to specific reps and warranties Review of leases, rent rolls, and financial statements Service contracts, condominium HOAs, and other contracts Title work liens and other encumbrances Zoning, regulatory and tax issues Geological/soil/environmental how to identify risk, what assessments to order Notices of new or special tax assessments Evidence of insurance Speaker: David C. Camp is a partner in the Denver office of Senn Visciano Canges, PC, where he represents clients in all aspects of real estate transactions. He has extensive experience in leasing, development, construction, financing and ownership issues. He also has substantial experience in commercial finance matters, most frequently corporate and real estate financing, including mezzanine loans, construction loans, and traditional loan matters. Mr. Camp received his B.A. cum laude from Middlebury College and his J.D. from the University of Pennsylvania Law School.
VT Bar Association Continuing Legal Education Registration Form Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name Middle Initial Last Name Firm/Organization Address City State ZIP Code Phone # Fax # E-Mail Address Due Diligence in Real Estate Acquisitions Teleseminar August 2, 2016 1:00PM 2:00PM 1.0 MCLE GENERAL CREDITS VBA Members $75 Non-VBA Members $115 NO REFUNDS AFTER July 26, 2016 PAYMENT METHOD: Check enclosed (made payable to Vermont Bar Association) Amount: Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # Exp. Date Cardholder:
Vermont Bar Association CERTIFICATE OF ATTENDANCE Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: August 2, 2016 Seminar Title: Location: Credits: Program Minutes: Due Diligence in Real Estate Acquisitions Teleseminar - LIVE 1.0 MCLE General Credit 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
REAL ESTATE DUE DILIGENCE David C. Camp Senn Visciano Canges P.C. Denver (o) (303) 298-1122 DCamp@SennLaw.com WHAT IS DUE DILIGENCE AND WHY IS IT IMPORTANT I. Who performs due diligence? A. Buyer, but recognize that they will be second guessed by any additional investors, and any lenders, future tenants, etc. B. Sellers trying to be prepared to support this purchase price. II. Why perform due diligence? A. To identify risks and problems that would affect your decision on whether to purchase the property (e.g., superfund site). B. To identify adjustments to purchase price (e.g., no term on anchor tenant). C. To identify items that must be addressed prior to closing (e.g., deemed maintenance). D. To be sure you understand the property well enough to make an information, rational decision. III. What do you do with due diligence information? A. Walk away from the deal. B. Adjust the price. C. Demand that something be addressed pre-closing. D. Agree to post-closing obligation (but be sure that there will be assets in the seller or sufficient to actually ensure compliance). IV. Preparing for due diligence. A. Seller side. 1. Prepare up front. The better organized and well prepared you are up front, the easier the process goes. 2. Anticipate questions. 3. Fix obvious problems. 4. Line up tenants for estoppels (may ask to sign up front, but lenders and buyers may not accept if too stale. B. Buyer side. 1. Start as soon as possible to get decisions made before deadlines run out. 2. Line up inspectors and experts you trust. {009999 / DCC / 00334527. 3} 1
3. Prepare for cost and understand the goals. If the reality is that the existing building will be torn down upon purchase, don t spend too much time investing its structural integrity. But, do spend time to ensure that you understand remediation cost for any asbestos, etc. 4. Be sure you process each piece of information and decide whether anything needs to be addressed and what needs to be done to address it. PROCESS Set up a weekly meeting to ensure that due diligence is progressing. Define what documents are missing. Decide what actions need to be taken on matters disclosed by the due diligence. {009999 / DCC / 00334527. 3} 2
DUE DILIGENCE FOR PROPERTY ACQUISITION John S. Hollyfield Norton Rose Fulbright, LLP - Houston (o) (713) 651-3717 john.hollyfield@nortonrosefulbright.com Scope of due diligence (how much or how little; limits; third party v. internal due diligence; control and distribution of due diligence materials Length of time to conduct this is market driven; Title/survey Rent roll; estoppel certificates Zoning; CC&R review; confirm no delinquency/default of CC&R obligations Condition of property; deferred maintenance; repair costs; code violations; costs to cure or correct UCC search Service contracts survival and termination Property income and expense analysis Government records review; permits; records of property repair and maintenance; records relating to insurance claims; litigation; incident reports of criminal activity; interviews with staff; correspondence from tenants Environmental inspection; other non-destructive testing; history of enviro violations; prior use of hazardous materials at site Plans/specifications Appraisal Right to rely on existing 3rd party due diligence reports Existing management agreement; free or reduced office space rent for manager; free or reduced rent for management/leasing personnel at apartment project Existing listing/brokerage and commission agreements Employee termination/retention; severance/vacation payments; Ad valorem tax history and assessed valuation; tax appeals 21831846.1-1 -
DUE DILIGENCE IN BUSINESS TRANSACTIONS April 5, 2016 C. Ben Huber Greenberg Traurig, LLP 1200 Seventeenth Street, Suite 2400 Denver, Colorado 80202 303-572-6586 huberb@gtlaw.com
OUTLINE I. What is Due Diligence? II. III. IV. Who Conducts Due Diligence? Purpose and Impact of Due Diligence Organizing Due Diligence Target s Perspective V. Organizing Due Diligence Buyer s Perspective VI. VII. Conducting Due Diligence Reviewing Due Diligence Information VIII. Tracking Results of Due Diligence IX. Due Diligence in Other Contexts EXHIBIT A Sample Due Diligence Request List EXHIBIT B Due Diligence Issues
I. WHAT IS DUE DILIGENCE? The term due diligence originates from the Securities Act of 1933 where it serves as a defense by directors and underwriters against liability for failure to disclose certain matters in public offerings. That is, if directors and officers can demonstrate that they conducted reasonable diligence on the issuer in preparing, reviewing and approving a registration statement, they can shield themselves from securities fraud liability. This defense is not available for the issuer. Today, the term more commonly means the investigation of a business through researching public records, reviewing documents, interviewing people with knowledge and inspecting facilities, equipment and inventory. The purpose and scope of due diligence changes depending on the type of deal as well as parties and industry involved. This webinar is geared towards due diligence in private M&A transactions. II. WHO CONDUCTS DUE DILIGENCE? Diligence of a target business ( Target ) is typically driven and conducted by the purchaser of the Target ( Buyer ). Lenders who provide acquisition financing to Buyer and insurers who provide representation and warranty insurance will also conduct diligence but often piggyback on the results of Buyer s diligence. Targets will conduct nominal diligence of a Buyer to understand who the Buyer is and to assess the cultural fit. Sometimes a Target will conduct more extensive diligence if the consideration is to include any Buyer equity or if there are any concerns about Buyer s genuine interest in Target or Buyer s ability to close. In other contexts - lenders will conduct diligence of borrowers in debt financings; issuers, underwriters, investment bankers and lead investors will conduct diligence in securities offerings; and counsel will conduct diligence of its client when giving legal opinions. The party conducting due diligence typically outsources much of it to outside counsel, accountants and other consultants (though the extent to which they outsource will depend on their level of sophistication, culture and available in-house resources). 1
III. PURPOSE AND IMPACT OF DUE DILIGENCE Understand the business at issue enable clear and intelligent communication among the parties involved. As counsel, this is especially important for effective communication with your client and counsel for the other side. Identify items that influence primary business considerations underpinning transaction namely, the purchase price or value of Target. The results of diligence may lead to concerns about earnings, customer retention, liabilities, etc., resulting in price adjustments or earn-outs. Identify significant liabilities and risks of the business and potential impediments to closing. o Risk Assessment. Diligence can reveal risks that need to be considered, quantified if possible and then addressed in the reps and warranties and indemnification sections of the acquisition agreement (discussed below). o Termination. In extreme cases, diligence can uncover impediments that rise to the level of deal breakers causing the parties to walk away and terminate the deal. Common culprits are unfunded pension liabilities, recent loss of major revenue sources, disputes over ownership of Target or key business assets, and significant or unquantifiable environmental liabilities. o Closing Conditions. Diligence identifies problems or issues that must be taken care of before closing. For example, corporate clean up, consents and waivers, governmental approvals, HSR clearance, assignment of leases, debt payoff, lien releases, etc. Determine documentation, including ancillary agreements, needed to paper and close the transaction, including the best forms or precedents to use as a starting point (e.g., employment agreements, transition services agreement, license agreements, leases and estoppel certificates). Draft transaction documents, including definitive agreement, ancillary agreements and other collateral documents. o Representations and Warranties. Buyers obtain assurances regarding the Target and the business being purchased from it. These should not only be tailored to the type of transaction (e.g., asset versus stock sale) and the Target s business but also to diligence findings. o Disclosure Schedules. These go hand in hand with the reps and warranties and either identify exceptions to them or set forth information required by them. 2
Diligence provides the information necessary to complete the reps and warranties and how to qualify them where appropriate. o Covenants (Pre- and Post-Closing). Pre-closing obligations are typically geared towards (i) pushing the deal towards closing and satisfaction of closing conditions (e.g., requiring the Target to obtain consents, make HSR filings, release liens, etc.), (ii) maintaining the status quo (e.g., continuing to operate in the ordinary course), and (iii) not taking certain actions that could jeopardize the business (e.g., incurring significant debt or making extraordinary dividends) or the deal (e.g., soliciting or talking to other potential Buyers for the business). Diligence can provide a window into certain activities that you may want to require the Target to take or prohibit the Target from taking prior to Closing. Post-closing obligations may include certain types of transition assistance, maintaining insurance, paying employment obligations, or non-compete and non-solicitation provisions. Financial Buyers, such as private equity firms, typically need more transition assistance since they often don t have their own existing infrastructure. Diligence will help determine where such assistance will be needed most. o Indemnification. Negotiated remedy section for breaches of reps and warranties, covenants and other specifically identified issues discovered in diligence. The results of diligence will help inform the (i) scope of indemnification, including the survival period of reps and warranties; (ii) baskets, caps, and other limitations on indemnification; and (iii) the necessity for escrows or hold-backs, and carve-outs or special indemnities. o Special Note regarding Fraud Claims and Sandbagging. Buyers and sellers often argue about the extent to which sellers have disclosed everything in due diligence and, more specifically, whether Buyers have a right to bring fraud claims based on Target making material misstatements or omissions outside of the contract, really during the diligence process. Sellers want Buyers diligence to serve solely for evaluation purposes kick the tires kind of stuff - and limit all claims to breach of contract actions. If buyers want protection, sellers argue, then buyers should include a representation and warranty and any breach should be run through the indemnity section (with its survival periods, caps, baskets, etc.). Buyers, on the other hand, want to expand their remedies and ensure they can not only sue for breach of contract but also 3
for fraud outside of the contract. Who wins this battle usually turns on who has more leverage. To limit Buyer s from bringing claims outside of the contract (e.g., for problems with diligence), sellers will want to make sure the acquisition agreement contains: (i) an exclusive remedy provision (i.e., that buyer s only claims are those available under the indemnification provision; and a (ii) a strong non-reliance provision (i.e., where Buyer represents that it is only relying on the representations and warranties in the definitive agreement and not on any other representations or warranties outside of the definitive agreement). If seller can get it, seller should also try to get a due diligence provision (i.e., that buyer has conducted all the diligence it deems necessary or appropriate) and an integration provision (that the agreement constitute the entire agreement of the parties with respect to the entire subject matter). Conversely, to ensure that a buyer has the right to bring claims outside of the contract for fraud, buyers will not want to make sure that the acquisition agreement does not have an exclusive remedy provision (or, if it does, include a carve out for fraud). It will also want to resist a non-reliance provision. Finally, if a buyer can get it, it should seek a full disclosure or 10b-5 representation (i.e., that seller has fully disclosed all material information to buyer). This can provide additional grounds to bring a fraud claim and perhaps lead to recovery for damages without even having to show intend given its contractual nature. Notwithstanding the foregoing, this is a murky area of the law which has been written about a lot. How all these provisions interact and the extent to which courts will permit people to contractually give up claims for fraud is still an open question. Another area impacted by diligence is sandbagging. Sandbagging is where a buyer s close a transaction with knowledge that one of the seller s representations or warranties is false (e.g., from information that it discovered in diligence) and then sue the seller for breach and damages after the closing. Buyers often attempt to negotiate a provision that expressly permits them to do this but, even where they don t, the common law in some jurisdictions, including Delaware, permits buyers to do this. Accordingly, if a seller wants to avoid being sandbagged, it should negotiate an anti-sandbagging provision that states that if the buyer discovers a breach of a representation and warranty (in diligence or otherwise) prior to closing, it can either terminate the agreement and 4
walk or accept the breach and close (but not sue). As a practical matter, buyers often advise sellers of any breaches they find and negotiate a solution (which often involves an accommodation to buyer). IV. ORGANIZING DUE DILIGENCE TARGET S PERSPECTIVE Be organized and prepared As soon as decision to put Target up for sale is made, commence internal diligence. o Locate and organize information and documents (financial statements and backup accounts and schedules, tax returns, minute books, key contracts, permits and licenses, human resources information and benefits, etc.) o Understand the Target s business, including its assets and liabilities and strengths and weaknesses. Set realistic expectations and address potential issues preemptively (e.g., have an explanation for a recent decline in sales). You may even be able to convert a problem into a potential opportunity (for the right Buyer). o Identify and address problems that are capable of quick resolution upfront. o Identify and be prepared to explain problems (and offer potential solutions, if applicable) that are not capable of resolution upfront. o Messy record keeping, missing documentation or unsolved problems can create red flags for a Buyer leading to broader representations and warranties and greater indemnity obligations for Target. o Identify any regulations that might prohibit disclosure of certain information. For example, exam reports for banks or pricing information where there are anti-trust concerns. Need to identify the issue but consult experts. o Avoid surprises as much as possible Surprises kill momentum, delay closing and often result in re-trading of the deal. Non-Disclosure Agreements. o Prior to making any disclosures to any potential Buyer, make sure there is a strong non-disclosure agreement in place. o But... an NDA is just a piece of paper. If breached, it will only give rise to a lawsuit which can be expensive and hard to prove. Consider providing due diligence information in stages disclose most sensitive information (e.g., customer lists and pricing data) as late in the process as possible when you are 5
comfortable there is a deal. Or, if there are sensitive facts to be confirmed, consider limiting disclosure to Buyer s counsel only. Appoint a point person to manage due diligence, including populating the data room, coordinating interviews and providing responses to diligence questions. If an investment banker has been engaged, they typically fill this roll. If not, Target s counsel will often act as the point person. Sometimes, it makes sense to have different point people for different parts of diligence. Consider secrecy issues. What access will be given to facilities, employees and customers and when? Once access is provided, people will know the Target is being sold. This can create angst among workforce (affecting moral and possibly retention) and adversely impact other business relationships (e.g., trigger customer concerns about supply, service and pricing). Also, if the deal does not close for any reason (e.g., even one that is not Target s fault such as Buyer s financing falls through), it can create stigma that the Target is flawed. One option use a cover story such as refinancing. Be wary of strategic Buyers (typically competitors) who may just be fishing for information. V. ORGANIZING DUE DILIGENCE BUYER S PERSPECTIVE Understand the due diligence budget, scope of investigation, including your client s goals, primary focus areas and key concerns (e.g., potential deal breakers), timing and how your findings should be communicated during the diligence process and at the end of it. These should be discussed with your client at the outset. Determine Scope of Diligence. How much diligence should be done? Every deal is different. It depends on many factors but needs to be determined early on because the scope will influence how many people are needed, how much time is required, whether and when outside experts should be engaged and the depth of the diligence team s review. Common factors influencing scope are: o Deal Structure In a stock acquisition or merger, Buyer likely will want information on the entire business of the Target, its history and the equity owners. In an asset acquisition, the Buyer may just wish to focus on the assets (and liabilities) that it is acquiring from the Target. o Industry The industry in which the Target operates may impact due diligence. If the Target operates in a risky industry (e.g., oil and gas, mining, chemicals), there will be more of a focus on environmental liabilities, permits and worker safety than if the Target operates in a safer industry such as professional services. 6
o Business Assets The focus and scope of diligence will be impacted by the Target s core assets. If the Target owns a lot of real estate and facilities, examination of title, surveys, zoning, physical premises and environmental conditions will be necessary. If the Target owns a lot of intellectual property, more time will be spent reviewing ownership, validity, infringement and licensing issues related to the intellectual property. o Competition If the Buyer and Target are in competition, e.g., a strategic Buyer versus a financial Buyer, they may want or need to limit each other s access to certain information such as pricing and customer lists (at least until it is fairly certain that the deal will close). o International Business If the Target operates or sells products or services overseas, the Buyer will want to investigate compliance with anti-bribery and corruption laws (e.g., FCPA) o Deal Size Clients may be inclined to conduct more diligence in larger deals where there is more money at risk. o Target History The longer the Target has been in existence, the more likely there may be skeletons to be concerned about, warranting a further look back to older operations and activities. This is especially true in stock and merger deals where Buyer will generally assume all of Target s known and unknown liabilities by operation of law. o Access to Target Target may wish to restrict access to limit interference with business operations, to prevent discovery of potential sale by employees or customers or to protect sensitive information. o Timing The parties may wish to close the transaction in an aggressive timeframe or one of the parties may have more leverage and require a quick closing, limiting the time available to conduct diligence. o Cost Buyer may be sensitive to due diligence expense and limit costs. It may also wish to conduct due diligence in phases, increasing due diligence spending as the likelihood of a deal gets greater and greater. o Goals Does your client want you to identify high level issues that impact valuation, structure and timing? Buyer may have very limited or specific concerns that it wishes to address in diligence (e.g., title to assets and absence of liens) given its familiarity with the Target or its owners, trust in Target s management, bargain price to be paid for Target or sensitivity to due diligences costs. Or does your client want an in-depth understanding of the Target, including detailed summaries of its operations, contracts human resources, etc., for post-closing administration and integration? 7
Practice Tip Buyers increasingly unhappy with traditional broad-based, shotgun approach to due diligence. Ask client: What are top five reasons you would not do this deal? and start diligence there. You may also suggest trading diligence for broader representations and warranties and increased indemnification coverage depending on leverage (sellers likely to resist). Clearly define the diligence task with client (budget, scope, key concerns, experts, deadlines, and deliverable). Assemble the Due Diligence Team. o Size and composition of team depends on scope and parameters of project but typically includes business, accounting and legal specialists. o Determine what expertise is needed and allocate responsibility accordingly. o Client typically handles business diligence in-house or with consultants such as investment bankers or industry specialists. o Accountants and other tax professionals assist with financial review of the Target and its business (e.g., financial statements, accounting policies and tax returns). o The legal team typically handles most other aspects of due diligence and consists of the following (on an as needed basis): Corporate lawyers review of organizational documents, minutes and resolutions, stock ledgers, voting agreements, shareholder agreements, commercial agreements, financing documents (debt and equity), joint venture agreements, and merger, acquisition and sale agreements, etc. They will often also conduct a high-level review of financial statements, with a special focus on the notes, if any. Employee benefits lawyers review of summary plan descriptions (health and wellness), Form 5500 Annual Reports, equity incentive plans, deferred compensation arrangements, parachute payments, etc. Labor lawyers employment agreements, review of union contracts, EEOC claims, employee handbook, etc. Tax lawyers review of tax correspondence and audits (but typically not tax returns) and facts that may bear on more efficient tax structuring of deal. Real estate lawyers review of title commitments, surveys, zoning issues, deeds, mortgages and leases. Environmental lawyers review of Phase Is, Phase IIs, environmental audits, investigations, and correspondence from EPA and state agencies, environmental permits and licenses, remediation or reclamation plans, etc. Intellectual Property lawyers review of patents and trademarks, patent and trademark applications, trademark usage guidelines, copyrights, 8
invention assignment agreements, IP licenses, confidentiality agreements, etc. Litigators review of litigation history as well as pending and threatened lawsuits and claims for exposure. o There may be overlap depending on competencies of lawyers working on the deal. For example, an experienced corporate lawyer may be able to handle employment agreements, real estate matters, IP licensing, etc. o Sometimes other outside specialists are also needed (e.g., insurance brokers, HR consultants, environmental consultants, title companies, surveyors, landmen, etc.). Specialists can be more cost effective and deliver better results but pay attention to engagement letters (scope, fees, expenses, confidentiality, reliance and ability to share results, particular focus or expertise, etc.). o Determine who needs to be on the diligence team as early as possible, whether your client has established relationships with any needed outside specialists and who will engage them (privilege issues). o The due diligence team can consist of anywhere from 1-2 people to 15 or more. o Designate point person to coordinate and manage Buyer s due diligence efforts typically an attorney. Create a working group list for everyone on the diligence team. Manage the Due Diligence Process (Point Person). o Have a kick off meeting among diligence team to make introductions, divvy up responsibilities, address process and any discuss key deadlines. o Determine method for communicating with Target regarding due diligence requests and follow-up. Does Target have a point person (often third party such as investment banker or lawyer)? Or are their different point people depending on subject matter? o Understand Target s sensitivity to due diligence. Is there a need for a cover story? If so, develop one and ensure all diligence team members, including outside consultants, are aware of it and use it consistently. o Stage due diligence as necessary, especially where real property and facilities involved, and set deadlines for each stage. Keep the process on track to meet deadlines, sending out reminders as appropriate. o Obtain periodic updates and collect due diligence reports from all members of due diligence team, both legal specialists and other consultants. 9
o Establish method and timing of communication with client regarding due diligence (e.g., weekly status calls) but, in any event, communicate results to client promptly, especially significant discoveries. Practice Tip It is critical to understand the timing of the transaction, including how long it will take to complete diligence, including third party investigations and external reports (e.g., Phase Is and IIs, surveys, title commitments, accountants review). This may be impacted by the industry or where parties are located. Some industries and some places slow down significantly at different times of the year (e.g. automotive industry in December, most of Europe in the summer, etc.) and it can be difficult to get ahold of people. The bigger the deal and the more assets involved or the more third party consultants required, the longer diligence will typically take. Diligence will often uncover a few issues that need to be resolved and a number of consents, approvals and waivers that need to be obtained at or prior to closing. It is best to figure these out early on so there is more lead time to resolve and obtain them. Be conservative and realistic anticipate and plan for problems and delays. There never seems to be enough time to complete due diligence. VI. CONDUCTING DUE DILIGENCE Get the big picture first Sit back and think about the particular business. How does Target make money and what are the major risks? Where does the money come from and where does it go? Review the Target s website; Google the Target and executive management; conduct high level Internet research on the Target s industry. Management Interviews. o Best place to start and learn about the Target business. Schedule meetings with management or department heads (finance, operations, legal, IT). o More work up front but will save time later on. Open discussions about Target s business and issues can streamline diligence, permitting Buyer to focus on key areas. Need to ask good questions. o Key question what keeps management awake at night? Due Diligence Request Lists The bulk of diligence is conducted through the use of a due diligence request list. A sample list is attached as Exhibit A. o Comprehensive list provided to Target requesting a substantial amount of documents and information covering Target s entire business. o Tailor list to the Target as best you can. Don t ask for documents or information you don t need or are not going to review. For example, if the Target is a 10
manufacturing business with no intellectual property other than off-the-shelf software, you can limit your intellectual property requests. o Keep scope and client s goals in mind as you prepare list and review documents and responses. Publicly Available Information. o UCC, Tax and Judgment Lien searches (Secretary of State and counties where real property located). o USPTO (patent and trademark) and Library of Congress (copyright) searches. o Litigation searches. PACER Federal docketing system. Local courts (state of formation, location of principal office, jurisdiction(s) where Target does most or a significant amount of its business). o SEC filings for public companies (e.g., financial statements, material contracts, business descriptions and analysis, risk factors, etc.). SEC filings for private companies primarily limited to Form Ds, which may be helpful if Target has raised money through private placements of its securities. Data Rooms. o Online Data Rooms. The norm today. Services provided by financial printers, investment bankers and law firms. Some Targets will set up their own online data rooms using cloud services such as Dropbox but that raises security concerns. Provide lots of control over process for Target. Limit who has access and who can review what folders and documents. Limit whether documents can only be reviewed online, printed and/or downloaded. Automatically watermark documents with legends denoting different levels of confidentiality. Gather intelligence who is looking at what, how often can indicate level of Buyer interest, especially in auctions. 11
o Physical Location. The exception today. Sometimes still used for very sensitive confidential information that Target doesn t want copied or disseminated (e.g., customer contracts) and large amounts of old information that is less important and would be burdensome to upload (e.g., company minute books dating back several decades). Obtain index in advance to determine if specialists need to be brought in. Determine which documents can be copied and which cannot so you can use your time most efficiently. o Overnight Courier/E-mail. Due diligence responses sometimes sent directly to Buyer or its representatives by e-mail or overnight courier. Often easier, especially when responding to follow-up inquiries, but not best practices (loss of control and may result in different bidders receiving different information in auction). VII. Diligence is an iterative process As documents and information are reviewed, follow-up questions are asked and additional documents are requested. The responses may then raise further questions and document requests. REVIEWING DUE DILIGENCE INFORMATION Although the focus of each diligence project will change depending on the transaction and parties involved, attorneys should usually plan on reviewing the following areas. Organization and Governance. Review of charter documents (articles/certificate of incorporation/formation, bylaws, limited liability company agreement, partnership agreement), minutes and resolutions, stockholder agreements, voting agreements, etc. Looking to (a) confirm due formation, foreign qualification, and good standing of Target, (b) understand governance structure and determine what approvals are required to authorize and consummate the transaction, (c) identify any unusual rights such as rights of first refusal, preemptive rights, poison pills, etc., and (d) generally assess the quality of record keeping and compliance with corporate formalities. It is also important to confirm the Target s and perhaps its owners legal structure, ownership, and tax classification as they may provide opportunities to structure the transaction that is more tax efficient to the parties. Minutes and resolutions can also reveal significant corporate actions that may be of interest. 12
Capitalization and Financing. Review of stock ledger, equity transactions and debt financing documents. Looking to understand capital structure of Target, including how it has been financed and who has what interests in Target, which may include the distribution waterfall in limited liability companies and partnerships. Also want to confirm clear ownership of Target as disputes can disrupt the deal or result in unwanted interference with Buyer s ownership post-closing. If the Target has raised capital through the issuance of equity, any disclosure documents it used in connection with those activities can provide valuable information. You will also want to ensure that the Target complied with applicable securities laws selling securities. As for debt financing, you will want to understand the basic terms of the loans, including any security interests the lender has in the Target s assets or equity. You will also want to know the payoff terms, including notice requirements and prepayment penalties. Financial Statements. Review of financial statements. Although attorneys are generally not trained as accountants, it is important to understand the Target s financials at a high level. Looking to obtain general understanding of Target s assets and liabilities as reflected on balance sheet, including current assets and current liabilities (in anticipation of working capital adjustments), and revenues and expenses as reflected on income statement, including year over year changes. I also tend to look for unusual entries or descriptions, contingent liabilities, capital expenditures, and reserves. In addition, one should always review the notes to the financial statements, if any (unaudited financial statements often don t have any and are not required too). These are an exceptionally good source of information about the Target. Ownership. Review of asset lists, deeds, titles, security agreements, mortgages, liens and leases. Looking to understand mix and identity of assets, including hard assets (e.g., real property, facilities, equipment, rolling stock, inventory, raw materials, furniture, etc.) versus soft assets (accounts receivable, contract rights, intellectual property, goodwill, etc.) as well as the location of the assets. Need to understand which assets are owned versus leased and what the material lease terms are. If there are any crown jewels, those need to be given special attention. If an asset sale, also need to understand which assets are titled or registered in the name of the Target (e.g., real property, vehicles, patents, trademarks, copyrights), to determine what filings will need to be made to legally transfer them to the Buyer. Finally, need to understand which assets are encumbered and what will be required to obtain releases so they can be acquired unencumbered at closing. 13
Customer and Supplier Relationships. Review of customer and supplier lists, aging reports and customer and supplier agreements. Looking to understand key customer and supplier relationships, including payment terms and history. Want to confirm stability and consistency of revenues and expenses and, if there is softness or lumpiness, why (e.g., seasonal business, loss of critical customer, unexpected increase in price of raw materials, etc.). Also want to determine what customer and supplier consents may be required as a result of anti-assignment or change of control provisions in their contracts. Finally, want to determine if there are other unusual provisions which might affect transaction or operation of Target business (e.g., purchase or sale requirements, exclusivity, noncompete, or most favored nation clauses, etc.). Labor Issues. Review of employee lists, employment agreements, employee handbooks, employee claims, collective bargaining agreements, and benefit plans. Looking to understand (a) composition of workforce (i.e., employees versus independent contractors), including general terms of employment and employment policies, (b) who has employment agreements (e.g., key employees) and what are the material terms, (c) if the transaction will trigger any accelerated bonuses or vesting of equity, (d) whether any employees are entitled to golden parachute payments or deferred compensation that might violate 290G or 409A of the IRC, respectively (e) extent of employee grievances or claims, (f) if any part of the workforce is unionized, and (g) employee benefits to determine workforce entitlements, costs and expectations. Also want to make sure Target is in compliance with all benefit plans and that benefits are fully funded. If any portion of workforce is unionized, Target may participate in a multiemployer pension plan, in which case there are almost certainly withdrawal penalties that need to be analyzed and addressed. Related Party Transactions. Buyer should diligence Target s relationships with its affiliates. It is not uncommon for affiliates to provide favorable terms which may not be available to the Buyer post-closing or when the agreement comes up for renewal. If these can be identified in diligence, they can be addressed (e.g., in post-closing covenants). Special Note regarding Consents. It is important to determine the extent to which the Target s relationships and contracts are important assets because contracts often require consent to be transferred, both in asset and stock or merger deals. In determining what consents are necessary, you need to determine which of 14
the Target s contracts contain anti-assignment provisions (for assets deals) and which contain change of control or transfer by operation of law provisions (for stock or merger deals). You can t just rely on headings. Instead, you need to review how an assignment or change of control has been defined. Sometimes a change of control will include a transfer of assets and vice versa. In addition, some courts have found that certain types of merger transactions (e.g., a reverse triangular merger in California, for instance) constitute an assignment by operation of law and therefore are covered by an anti-assignment provision. As a result, the governing law of the Target s contracts also may be important in determining what consents are needed. Since obtaining consents can be a contentious issue among the parties and a gaiting item for closing, it is important to determine what consents will be required early on, if they are capable of being obtained, who will obtain them (e.g., business people versus counsel), when they will be sought and at whose cost (e.g., who bears burden if counterparty demands consideration for its consent?). Practice Tip. It is helpful to prepare an Excel spreadsheet using columns to provide (i) basic identifying information for each contract such as by date, counterparty, etc., (ii) a ranking system for relative importance of the contract (e.g., by value), (iii) whether the contract has antiassignment, change of control, or notice provisions, including the basic requirements of each, and (iv) what the governing law of the contract is. It should also be set up to be easily sortable. The spreadsheet can be used to manage the consent process and be converted into the inevitable disclosure schedule requiring this information. In anticipation of a material contracts disclosure schedule, it may also be helpful to add columns for non-competition, exclusivity, most favored nations, indemnification and guaranty provisions since buyers often require disclosure of agreements that contain such provisions. A more comprehensive list of key information and issues to look for in diligence (which generally corresponds to the sample due diligence request list) is attached as Exhibit B. VIII. TRACKING RESULTS OF DUE DILIGENCE Keep track of what you have reviewed and what you have learned. Make good notes using a separate notepad or folder for due diligence is advisable. It will help in preparing a diligence memo and, even you are not preparing one, it will establish a record of your review and enable you to answer the inevitable questions that arise after you have forgotten what you have done. Client Deliverable The type of deliverable, including its purpose, should be part of the client discussion about scope and determined ahead of time as it can impact the organizational approach to diligence and how the deliverable is drafted, especially if the deliverable is to be shared with third parties such as lenders providing acquisition financing. o Verbal reports to client. 15
o Written summary. o Detailed memo. Practice Tips o Get diligence results to client in timely manner (if memo, before closing). o Privileged and confidential (and potentially attorney work product) generally not addressed or provided to third parties. o Know your audience make it easy to read and not too cryptic. o Organize thematically (e.g., track sections of request list). o Highlight big issues by putting them in boldface. If a detailed memo, consider including a summary of the big issues up front. o Don t just identify issues, resolve them or provide options for handling them (goes for verbal reports too). Also, if an issue is capable of quantification, quantify it. Clients appreciate it. If an issue is not capable of quantification, attempt to categorize it (e.g., is it an ordinary course, industry specific risk? Is the risk covered by insurance or indemnities from other parties? Has Target established reserves for the risk and, if so, what are they and how did it make the determination? Is there claims experience with similar risks? Etc. ALWAYS INFORM THE DUE DILIGENCE TEAM AND THE CLIENT OF ANY BIG ISSUES YOU DISCOVER IMMEDIATELY. AVOID SURPRISES. IX. DUE DILIGENCE IN OTHER TRANSACTIONS Public M&A Similar to private M&A but most information is obtained from public filings with the SEC (material information publicly available and concerns about disclosure of material nonpublic information). Financing Transactions Lenders conduct diligence on borrower primarily to assess credit risk, sufficiency of collateral of borrower, special covenants in loan documentation and steps necessary to perfect and obtain priority in collateral. Securities Offerings Issuers (officers and directors), underwriters and investment advisers all conduct varying degrees of diligence on the issuer in preparing disclosure documents for public and private securities offerings to ensure accuracy, make any governmental review process smoother, determine pricing and, in some cases, to establish due diligence defense. In some private placements, such as a venture capital with one or two lead investors, the lead investors 16
will also conduct diligence on the issuer to assess value and risks of business it is investing in (as well as to assist with drafting of the equity purchase agreement). Legal Opinions Counsel conducts diligence on its client to establish factual back-up for legal opinions (where it cannot rely exclusively on support certificates from client). Diligence in all of these other scenarios is similar to diligence in private M&A but typically not as comprehensive. * * * * 17
EXHIBIT A SAMPLE DUE DILIGENCE REQUEST LIST (See attached)
LEGAL DUE DILIGENCE REQUEST The following should serve as a checklist for information to be assembled in connection with our legal due diligence review with respect to the proposed acquisition of [ ] and its subsidiaries (collectively, the Company ). This checklist covers major categories of documents and information; not all potential areas of information are covered (additional categories may be added as we become familiar with the Company) and not all categories listed are necessarily material or relevant. The categories listed refer to the Company and any subsidiaries or affiliates, if any, since inception (unless specified otherwise). Please indicate Provided (VDR Folder), To Be Provided or Not Applicable under the columns provided next to each line item. If the document or information has been provided, please also indicate where it is located in the virtual data room. In addition to the listed matters, the Company should provide any other information it believes to be material to the business of the Company or which it believes would be otherwise relevant to a prudent investor making an investment decision with respect to the Company.
Preliminary Due Diligence Request List Provided (VDR Folder) To Be Provided Not Applicable 1. General Corporate 1.1 Copy of the Company s entire minute book. 1.2 Articles/Certificate of Incorporation of the Company as originally filed and all amendments thereto. 1.3 Bylaws of the Company as originally adopted and all amendments thereto. 1.4 Minutes of all meetings, and all written consents, of (a) the Company s Board of Directors, (b) any committee of the Board of Directors and (c) the shareholders, since inception of the Company. 1.5 Stock ledger and copies of stock certificates issued by the Company. 1.6 Samples of any certificates representing securities, which certificates have been approved by the Board of Directors. 1.7 A list of each jurisdiction (domestic and foreign) in which the Company does business (e.g. makes sales, operates a sales office or where its employees reside) and a brief summary of the Company s activities in each jurisdiction. 1.8 A list of each jurisdiction in which the Company is authorized or qualified to do business as a foreign corporation and a current good standing certificate from each such jurisdiction. 1.9 A list and organizational chart of any subsidiaries, affiliates, parent, or predecessor entity of the Company, specifying corporate name, state of incorporation, relationship to the Company, and the percentage ownership of voting securities. 1.10 Any shareholders agreements relating to any subsidiary or affiliate of the Company. 1.11 Copies of all offering memos, business summaries and other materials and information prepared for or delivered to potential purchasers of the Company or otherwise used in connection with any prior proposed sale of the Company. 2
Provided (VDR Folder) To Be Provided Not Applicable 1.12 All agreements, memoranda and any other documents pertaining to any bankruptcy proceedings in which the Company has been involved. 2. Equity Securities Issuances 2.1 Capitalization table or other records that list the issued and outstanding securities of the Company. 2.2 A list of all shareholders, warrant holders and option holders, specifying name, address, number of shares, price paid, date of purchase/grant, name of seller (if other than the Company), exercise price, expiration date and which options/warrants are currently outstanding. 2.3 A list of all holders of other rights to acquire equity securities of the Company, specifying name, address, date of issuance, description of rights, exercise or conversion price, and any other relevant terms. 2.4 Any shareholders agreements, buy-sell agreements, voting trust agreements or other restrictive agreements relating to the sale or voting of shares of capital stock. 2.5 All securities offering documents for the Company since its incorporation, including private placement memoranda, prospectuses, offering circulars, registration statements, stock purchase agreements and any written proposals of any oral proposals for the acquisition of the Company s securities. 2.6 Any forms filed by the Company with the SEC to qualify an offering of the Company s securities for an exemption under the federal securities laws (e.g. Form Ds). 2.7 Any agreements that may restrict the ability of the Company to (a) issue or redeem its own securities, (b) assume additional indebtedness, or (c) sell, lease or transfer any of the assets or capital stock of the Company. 2.8 All permits, notices of exemption and consents from state securities regulators regarding offerings of the Company s securities and any other evidence of qualification or exemption of securities under applicable blue sky laws. 3