Short Form Due Diligence Request List We are often approached by small businesses that are seeking capital in connection with strategic and operational advice. For anyone corresponding with us, or frankly for anyone starting to get a handle on an existing business, here’s a short due diligence request list. This list would also serve a new director well to become acquainted with the business and its strengths and weaknesses. (We have steadily maintained that even small private businesses would benefit from outside advice, even if you don’t cede actual control to a board of directors.)

The key insight here is that the due diligence process is not the completion of the checklist. We have seen too many people gather information and fail to review it, or having reviewed it, fail to incorporate it into a transaction (investment or acquisition) plan. The due diligence process starts with a list of documents, that upon review, may trigger additional questions or information requests. One simple goal is to use the diligence process to consider the financial model underlying a proposed business transaction and illuminate the assumptions, stated and unstated, upon which the model rests.

In our framework, we look at due diligence as part of the Informed Decision-Making stage (IDM); even though the analysis of due diligence materials is part of the Data-Driven Analysis stage, the use of that analysis and its impact on the terms, structure, and price of a transaction are squarely within the IDM stage.

Here’s the list. Every transactional lawyer and banker has a vastly more detailed list, as do we. But the purpose of this list is to introduce the process to owners/founders/CEOs/directors of smaller businesses who don’t have ready access to experienced practitioners.

1. Copies of all historical financials for existing operations: Income Statement, Balance Sheet, and Cashflow statements.
   

• The easiest course of action is usually to provide a "backup copy" of a QuickBooks, or other accounting program, file (with the password!). [NB: We will soon replace this requirement with a basic UFS, or unified financial statement, after we write more on that topic.]

2. A list of property, personal or business, that might serve as security for debt financing

• Even if the owner’s desire, as one might expect, is not to encumber personal assets, many lenders are more comfortable knowing that a principal in fact has assets at risk, even if those are not security.

3. A current list of customers (should be in QuickBooks) and any LOI's/contracts with price and volume commitments (for existing as well as future business).

4. Management reports for sales rep performance and quotas for future work

5. Sales pipeline, backlog, or similar analysis, in the format used by management
   

6. A capitalization table, showing fully diluted capitalization

7. Copies of current articles/certificate of incorporation & bylaws

8. A current list of suppliers (should be in QuickBooks) and any LOI's/contracts with price and volume commitments (for existing as well as future business)

9. Other material agreements

10. Description of any pending litigation, whether company is plaintiff or defendant

11. Any audit letters from auditors if financials have been audited in last 3 years

12. Employment terms with employees regarding bonuses, commissions, stock options, profit-sharing, or anything material other than salary reflected in QuickBooks

13. Copies of all reports provided for board in the last 18 months or similar periodic management reports for the last 12 months

14. A description of any off-balance sheet obligations or other liabilities

15. A summary of any related-party transactions, individually or in the aggregate greater than $25,000

Labels: DDA, deals, due diligence, IDM

Monday, November 24, 2008 :: posted by Rick Colosimo @ 4:09 PM

How to allocate risk you find in due diligence We generally subscribe to the theory that commercial contracts are about allocation of risk in a transaction. Dealbook today writes about a clause in the Merrill Lynch / Bank of America merger agreement.

Here's the clause: "(c) No investigation by a party hereto or its representatives shall affect the representations and warranties of the other party set forth in this Agreement." It's found in Section 6.2(c) of the merger agreement.

The purpose of the clause is questioned. In our experience, buyers typically use language like that found in this specific clause to hold targets to the terms of the reps and warranties. The idea is that even though you perform due diligence on an issue, such as reviewing a stack of material contracts, your own diligence investigation does not excuse the target's failure to make adequate disclosures.

The situation could play out like this: material contracts are provided to the buyer that include the terms of a real estate lease that show that it must be cancelled six months before the expiration of the five-year lease or it will auto-renew. The six-month deadline has passed and so the lease will auto-renew. The target reps that there are no leases that are not cancelable on thirty days' notice, a deadline that has not passed. When this situation starts to resolve itself, targets often say "we gave you the documents, and you reviewed them." They may note that an item was specifically noted to be in contradiction with the rep as a reason for excusing the breach. With the quoted language in place, the due diligence investigation by the buyer is not a defense to the breach of the rep.

To outsiders, this sounds like the sort of weasel legalese that the public now expects from lawyers. A few other examples showcase the benefits: first, imagine a dispute about the legal effect of a notice (the target sent a notice that it believes is legally valid to cancel the lease, and the buyer disagrees. Under the rationale we've described, the deal can go forward and allocate the risk of the notice being ineffective to the target. Second, imagine further that there's a lawsuit pending (but not served) regarding the termination of the lease. The buyer will certainly want to know about it but may not want to underwrite the litigation. Using a "no threatened litigation" representation, the buyer can shift the risk of loss from the issue to the target.

Why should targets do this? Why would they take these risks? The proper allocation of risk is much like an insurance analysis -- the risk should generally lie with the party best able to manage and minimize the risk and control the outcome actual underlying event/issue. In almost every case, the target is far better equipped to at least know about the nature of the risk and appropriately price it rather than requiring the buyer to price the risk as part of what's included in the purchase price. Usually, a knowing omission from the disclosure schedule, which is how this shift of risk is typically accomplished, is only appropriate for material risks that are hard to manage and difficult for a buyer to investigate. For example, we have used this explicitly in a situation where the founder of a technology company was being challenged by a former employer about whether the employer's trade secrets were being used in the new company's products.

Labels: contracts, deals, due diligence, law

Sunday, September 21, 2008 :: posted by Rick Colosimo @ 2:03 PM

Yahoo board takes fire A few pieces are detailing Carl Icahn's foray into Yahoo and his decision to take up the proxy fight Microsoft appears to have abandoned. This Dealbook article gets my vote today because of this quote from Icahn:

It is unconscionable that you have not allowed your shareholders to choose to accept an offer that represented a 72 percent premium over Yahoo’s closing price of $19.18 on the day before the initial Microsoft offer.

Regular readers will remember that we raised this exact issue recently; the premium was so high that we think it likely that Yahoo's board could not have avoided presenting the opportunity to shareholders, even if it recommended against acceptance. It would have been perfectly acceptable for the board to negotiate a transaction that provided for no breakup fee, a strong fiduciary out, and even limited Microsoft's due diligence before signing up the deal to reduce Yahoo expenses. All of those make sense in terms of protecting Yahoo's value without reducing freedoms or eliminating opportunities for shareholders. Not wanting the company to be acquired or or not wanting to work for Microsoft is woefully insufficient justification for the actions of the board and management. It's not their company; it's the shareholders'.

Labels: deals, governance

Thursday, May 15, 2008 :: posted by Rick Colosimo @ 12:26 PM

Freedom of Contract Cerberus Capital, a well-known private equity fund, recently won a short trial in the Delaware Chancery Court allowing it to terminate its acquisition agreement with United Rentals and pay the $100 million termination fee set forth in the contract. The WSJ article spells out the details and the background well, referencing the actual parties and the negotiations backdrop. The critical item of analysis, missing from much of the commentary we've seen [link to WSJ law blog?], is an analysis of the points on which the opinion turns. (For simplicity, we'll generally refer to all Cerberus defendants as Buyer and United Rentals as Target.)

Reviewing the actual opinion, here is the critical language relied on by Cerberus from Section 8.2(e), part of the termination provision:

In no event, whether or not this Agreement has been terminated pursuant to any provision hereof, shall [Buyer] ... be subject to any liability in excess of the Parent Termination Fee for any or all losses or damages relating to or arising out of this Agreement or the transactions contemplated by this Agreement, including
breaches by [Buyer] of any representations, warranties, covenants or agreements contained in this Agreement, and in no event shall the [Target] seek equitable relief or seek to recover any money damages in excess of such amount from [Buyer] or any of their respective Representatives.

(NB: the opinion is available here: WSJ link.)

The language United Rentals suggested was controlling involved a specific performance provision (Section 9.10) of typical structure allowing for the seeking of injunctions to compel performance, but specifically exempting Section 8.2(e) from its purview (and Section 8.2(e) specifically notes that it supersedes 9.10).

The opinion first describes why the interpretations of the parties are both reasonable, eliminating the opportunity to resolve the case by summary judgment. Then, the opinion describes the extrinsic evidence about the shared intention of the parties, concluding essentially that the Buyer consistently rejected the specific performance remedy and that Target eventually acquiesced to edits that Buyer believed eliminated that remedy. The case might indeed be one that turns on procedure as much as anything else; Target had the burden of proving Buyer's intent and was unable to meet that burden; the opinion notes that the matter is an "exceedingly close question" in some respects. Also, the use of the forthright negotiator principle indicates that openness in negotiations actually can be rewarded: since Buyer's belief that the termination fee was Target's only remedy was well-communicated to Target, Target's failure to respond with its interpretation of the contract language during negotiations works against it during litigation.


The key point for business and lawyers to remember is that a party is captain of its offer; that is, the party making the offer to the other has the right to set whatever conditions it wants on the offer and acceptance (short of public policy violations). In other words, it's perfectly reasonable for Cerberus to reject any specific performance remedy in the contract and, by extension, perfectly reasonable for United Rentals to reject a deal that allows Cerberus to walk away. Moving to a deeper level of analysis, the meaning of contracts is tied inextricably to the remedies afforded in the event of breach. Both risk and reward are equally linked in this
respect.

A wise deal champion, listening to experienced counsel, will strive to create deal structures that are either self-enforcing, such as dead-hand provisions operating to implement conditions subsequent or covenants, or are clear about what the downside looks like for both parties. Discussing risk during the negotiation of a contract is not weakness; it's sophistication. Experienced deal participants know that deals break down in a variety of ways for a variety of reasons. Ignoring these possibilities to appear to be "positive" or "trusting" or "a team player" is foolish; only by harping on the negative do you eliminate those perceptions. It's often been said, and often repeated by us, that good deal structures don't require one party to trust the other; they make the deal support the development of trust between the parties by getting out of the way of that trust rather than relying on it.

In a later post, we'll discuss this concept of proper structure in light of the actual costs of small-business litigation, the sort of <$250,000 claim that can arise in any number of businesses.

Also, the discussion that the deletion of the offending specific performance provision rather than the circuitous "subject to" language would have been less ambiguous reminds us to discuss the practical effects of simply working too much. We assume that Buyer's counsel worked an incredible amount on this transaction and probably many others as well. More to follow.

Labels: contracts, deals, law

Monday, December 31, 2007 :: posted by Rick Colosimo @ 6:01 PM