Due Diligence for Private Mergers and Acquisitions

by Practical Law Corporate & Securities

Maintained • USA (National/Federal)

A Practice Note discussing what due diligence is and why it is necessary, how to organize the due
diligence process, what to look for, and how the findings impact the transaction.

Contents

What is Due Diligence?

Reasons for Due Diligence

Seller Due Diligence

Scope of Due Diligence

Organizing the Due Diligence Process

Defining the Due Diligence Task

The Due Diligence Team

Due Diligence Request

Sources of Information

Distribution and Organization of Materials

Competitively Sensitive Information

Reviewing Materials: What to Look For

Categories of Materials and Common Issues

Specialist Review

Due Diligence Considerations for Private Equity Buyers

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Impact on the Transaction

How Due Diligence Impacts Buyer’s Knowledge

Recording and Communicating the Findings

Importance of Communication

Due Diligence Summaries

Due Diligence Report

Third-Party Reliance on the Due Diligence Report

Assignment and Change of Control

Anti-assignment Provisions

Change of Control Provisions

Due diligence is the investigation of a person or business. In the context of mergers and acquisitions,
the parties use the due diligence process to gather information about each other and about the
business or assets that are for sale. Although the seller occasionally conducts due diligence on the
buyer, the due diligence process is usually more significant for the buyer. This Practice Note explains
from a buyer’s perspective:

• Why due diligence is necessary.

• How to organize the due diligence process.
• What to look for.
• How the findings may impact the transaction.

This Note assumes the target business is (or is part of ) a private company. For information on the due
diligence review of a public company, see Practice Note, Due Diligence for Public Mergers and
Acquisitions.

What is Due Diligence?

Reasons for Due Diligence

In any significant merger or acquisition the buyer gathers information about what it is buying before
making a commitment. Primarily, the buyer uses this information to decide whether the proposed
transaction is a sound commercial investment. In an extreme case, a buyer may decide to abandon the
transaction after performing due diligence, but more commonly, a buyer uses the information to
negotiate contractual protections (such as indemnification) or to adjust the purchase price (for more
on indemnification clauses, see Practice Note, Indemnification Clauses in Private M&A Agreements).
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A due diligence inquiry should establish the following key information about the target business:

• Confirm that the seller has good title to the stock or assets of the target business.
• Investigate potential liabilities or risks.
• Confirm the value of the target business.
• Identify steps necessary to integrate the target business.
• Learn more about the operations of the target business.
• Identify any impediments to the transaction, such as third party consents, a required stockholder
vote, or prohibitions on transfer.
• Determine whether any ancillary documents will be needed.

Seller Due Diligence

If the buyer is issuing stock to the seller as consideration or if the transaction is a merger
of equals, the seller needs to conduct a more thorough due diligence investigation.

If the buyer is issuing stock, the seller should:

• Confirm that the buyer has authority to issue the stock.

• Confirm the value of the buyer’s stock.
• Identify any impediments to the issuance.

In a merger of equals, the parties need to:

• Confirm the value of the transaction.

• Identify steps necessary to integrate the companies.
• Learn more about each others’ businesses.
• Identify any impediments to the transaction.

Scope of Due Diligence

The scope of a due diligence investigation is determined by many factors. It is important to determine
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the scope at the outset because it influences how many people are needed, how much time is required,
whether outside experts are engaged, and the depth of review. Common factors that determine the
scope of a due diligence review are:

• Deal structure. For example, if the transaction is a stock acquisition or merger, the buyer will
likely need information on the entire business. In an asset acquisition, the buyer may only focus on
the specific assets (and liabilities) it is acquiring.
• Industry. The industry of the target business may influence what areas of due diligence to
concentrate on. For example, if the buyer is acquiring a chemical manufacturing company,
extensive environmental due diligence may be required. If the target operates in a heavily
regulated area, the buyer needs assurance that the target business is in compliance with
applicable regulations.
• Global presence. If the target business has global operations, it is important to assess its
compliance with applicable bribery and corruption laws such as the requirements of the Foreign
Corrupt Practices Act of 1977 (see Practice Note, M&A Due Diligence: Assessing Compliance and
Corruption Risk).
• Competition. If the buyer and seller compete with each other they may want (or be required by
antitrust laws) to keep certain information (such as pricing) confidential until after the transaction is
consummated (see Box, Competitively Sensitive Information).
• Access to seller and target business. The seller often restricts access to itself or the managers
of the target business in order to limit interference and protect its proprietary information.
• Cost. The buyer may limit the scope of the due diligence investigation to reduce its expenses.
Sometimes, a buyer conducts its investigation in stages and only increases spending when the
likelihood of the deal closing increases.
• Time constraints. The parties may wish to complete the transaction by a certain date (such as
fiscal year end) or the seller may have enough bargaining power to limit the time allowed for due
diligence (for example, in an auction).

Organizing the Due Diligence Process

Usually the corporate legal team (most often a junior corporate attorney) acts as the “control center” for
the buyer’s due diligence process. This entails defining the due diligence task, requesting materials,
distributing materials, and ensuring communication among the due diligence team (see Private Mergers
and Acquisitions Due Diligence Checklist).

Defining the Due Diligence Task

Before beginning the due diligence review, counsel should establish with its client:

• A due diligence budget.

• The scope of review (see Scope of Due Diligence).
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• What type of oral or written report is required (see Due Diligence Report).
• The deadline for completing the due diligence review and delivering the report.
• Whether any outside consultants should be engaged.
• If certain areas should be a primary focus.
• If there are any threshold issues that could make or break the deal (known as deal breakers).
• The process for communicating with the seller and the management of the target business. For
example, counsel may be required to communicate through a third party such as an investment
banker.

Once the due diligence task has been defined, counsel can assemble the due diligence team. It is
important to explain any limitations or restrictions to team members and any areas which are significant
to the client.

The Due Diligence Team

The make-up of the due diligence team depends on the specifics of the transaction, but usually
includes legal, business, accounting, and tax specialists. Generally, the legal team consists of
corporate lawyers and other specialists (such as environmental, employee benefits, real estate, and
intellectual property lawyers). The buyer may conduct its own business due diligence or hire investment
bankers or other consultants to review information. Usually the buyer will also engage accountants and
tax specialists to assist with the financial review of the target business. In some cases it may also be
necessary to retain outside consultants in other areas such as regulatory compliance, environmental, or
insurance.

Depending on the complexity of the transaction and the budget allocated to due diligence, the team can
range from two or three people to a team of more than 20. Because the due diligence team can be
large and comprised of multiple organizations, it is important to have a point person to organize and
coordinate the process. The point person may be the buyer, but often the buyer delegates this
responsibility to its lawyers.

Due Diligence Request

Sometimes the seller will make due diligence materials available at the outset of a transaction, but often
a buyer must submit a due diligence request for information. A due diligence request is a list of
questions and requests for documents organized by topic (see Standard Document, Due Diligence
Request List: Private Mergers & Acquisitions). The initial due diligence request is usually supplemented
by further requests as the negotiations proceed and as the buyer learns more about the target
business.

The size of a due diligence request depends on the scope of the due diligence review. For example, in
a stock acquisition the due diligence request should cover the entire company. On the other hand, if the
buyer is only acquiring real estate assets, the request will be limited to materials relating to those
properties. Although a due diligence request must be broad enough to include a wide range of

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information, counsel should tailor its due diligence questions to the specific target business and the
industry it operates in. For example, if the target business is a financial services company, it has
different types of material contracts than a manufacturing company. If a due diligence request is too
generic or too broad, a seller may not understand what documents counsel is looking for. For example,
if counsel requests “all material contracts,” the seller may have a different view of what constitutes a
material contract than the buyer.

Sources of Information
Documents
The bulk of due diligence review involves reading documents of the target business, including
contracts, financial reports, and corporate records. Usually due diligence materials are stored on an
online data site. Sometimes, especially in smaller transactions, the seller may either send the buyer
electronic or hard copies of documents. If the seller wants to limit dissemination of materials, the seller
may create a physical data room at its offices or the office of the seller’s attorney.

If the materials are stored on an online data site, the seller determines who is invited to the data site
and gives password protected access. It is important to determine which due diligence team members
need access to the data site so that counsel can submit a comprehensive request for access to the
seller.

Access to Management
Some information is difficult to learn from just reading documents. The buyer will often ask to visit the
target business site and talk with members of management. Counsel may also have follow-up
questions after reading due diligence materials which can be answered more completely during a
phone call.

Publicly Available Information

If the target business is part of a US public company group, counsel should review information available
on the SEC’s EDGAR system before making any requests. Even if the target business is privately held,
counsel can often find background information, financial reports, and press releases on the seller’s or
the target company’s website.

Distribution and Organization of Materials

If the due diligence materials are available electronically or sent in hardcopy form, they need to be
distributed to the due diligence team. Usually a junior corporate attorney is responsible for distribution
and organization of the materials. If the materials are sent via hardcopy, counsel should first create an
index (if one is not provided) to keep track of what materials have been provided. If the materials are
stored on an online data site, the data site usually generates an electronic index which can be printed
out. If the materials are stored online they need to be printed (if permitted) and distributed to the
appropriate team members.

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It is helpful to develop a system for organizing the materials at the outset. A common way to organize
materials is to place all due diligence items in folders with labels indicating the name of the document
and index reference. Often a paralegal can help with this process. Counsel should also determine what
the firm’s record retention policy is. Some firms retain a complete copy of all due diligence materials. If
this is the case, counsel should make an extra copy of the due diligence materials before distributing
them to the team. Because the data site is updated with new materials throughout the transaction, it is
important for one person to periodically check for any additions. Counsel may think that it does not
have time to organize the due diligence materials, but counsel will invariably save a significant amount
of time later in the process. Often, counsel will be asked a question about a document that was
reviewed days or weeks before. It will save anxiety and impress the team if counsel can locate the
document quickly.

Competitively Sensitive Information

If the parties are competitors, the seller may impose additional restrictions on the
dissemination of materials. Competitors are prohibited by law from sharing certain
information (for example, pricing). Even if not prohibited by law, a seller may be wary about
sharing information (such as customer names) before consummation of the transaction is
certain. Parties can redact sensitive information or develop a procedure to limit access to
those materials. Often only the attorneys will be provided access. In that case, the
attorneys can review the documents for other important terms (for example, a change of
control clause) and will be prohibited from sharing the confidential information with their
clients. The parties should determine if any documents are competitively sensitive and
agree on a procedure before beginning the due diligence review (see Practice Note,
Information Exchange and Integration Planning in M&A: Antitrust).

Reviewing Materials: What to Look For

Categories of Materials and Common Issues

A corporate attorney encounters many different types of documents in a comprehensive due diligence
review and should watch for many different kinds of issues. The types of documents and issues will be
determined by the specifics of the transaction and target business.

The following is a list of common categories of documents encountered in a due diligence review and
common issues that arise (see Private Mergers and Acquisitions Due Diligence Checklist).

• Organizational documents. These documents include the certificate of incorporation, by-laws,

limited liability company agreement, or stockholders agreements. Common issues that counsel
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should consider are:

• Capitalization and equity ownership: Who owns the equity in the target business? Is there an
equity holder or group of equity holders that has control of the target business? Are there any
subsidiaries? What equity is outstanding? How much equity is authorized? Is there room for
further issuances?

• Consent issues: Are any votes or consents required in connection with the transaction? What
actions require consent of equity holders or the board of directors?

• Transfer restrictions and preemptive rights: Are there any restrictions on the transfer of equity?
Do equity holders have preemptive rights in future issuances?

• Dividends: What is the dividend policy? Can the board of directors change this policy without
stockholder approval?

• Unusual provisions: Look for any provisions that could impact the transaction or future operation
of the target business. For example, counsel should note if there is a poison pill or if a
stockholder is guaranteed representation on the board of directors.
• Contracts. These include customer and supply contracts, operating contracts, and licenses.
Common issues that counsel should consider are:

• Parties: Who are the parties to the contract?

• Change of control: Is there a change of control provision? Does this transaction constitute a
change of control? See Box, Assignment and Change of Control.

• Assignment: Is the contract assignable? Is consent required? How is an assignment defined?

Does the transaction structure require an assignment? Does a change of control constitute an
assignment? See Box, Assignment and Change of Control.

• Termination: When does the contract terminate? Is there an automatic renewal provision? Can
either party terminate without consent? Does a change of control give either party a right to
terminate the contract?

• Economics: What are the basic economics of the contract? Are the economics of the contract
fixed or do they fluctuate? How is the pricing determined?

• Unusual provisions: Look for any provisions that could impact the transaction or future operation
of the target business. Are there any provisions that restrict the target business or provide
benefits to the other party? For example, counsel should note a most favored nations
provision (MFN) or non-compete provision.

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• Final executed copy: Is there a final executed copy of the agreement? If not provided in the
diligence materials, does one exist?
• Merger and acquisition agreements. Common issues that counsel should consider are:

• Parties: Who are the parties to the agreement?

• Purchase price adjustments and earn-outs: Are there any outstanding purchase price
adjustments or earn-outs that affect the target business?

• Escrow: Are there any funds in escrow? What are the funds earmarked for? What are the
conditions of release?

• Survival of representations and warranties and indemnification: Has the survival period of the
representations and warranties run out? Have any indemnification claims been made? Does
the target business anticipate future indemnification claims?

• Unusual provisions: Look for any provisions that could impact the transaction or future operation
of the target business. For example, counsel should note if there is a non-compete obligation
currently in effect or if the target business has taken responsibility for any ongoing liabilities of
the other party.

• Final executed copy: Is there a final executed copy of the agreement? If not provided in the
diligence materials, does one exist?
• Finance documents. These include loan agreements, hedging agreements, guarantees, and
promissory notes. Common issues that counsel should consider are:

• Parties: Who are the parties to the agreement?

• Basic terms: What debt is outstanding? What are the interest rates? When do the loans mature?
Are there any mandatory prepayment obligations or prepayment penalties?

• Contingent obligations: It is important to note any contingent obligations such as, guarantees.
It is also important to note if any debt is guaranteed by third parties (for example, a parent
company guaranty).

• Restrictive covenants: Look for any restrictive covenants that impact the transaction or future
operation of the target business.

• Change of control: Is there a change of control provision? Does this transaction constitute a
change of control?

• Liens: Are there any liens on the target business or its assets? Has the stock of the target
company been pledged?

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• Final executed copy: Is there a final executed copy of the agreement? If not provided in the
diligence materials, does one exist?
• Litigation. Commons issues that counsel should consider are:

• Pending claims: How many claims are currently pending? What is the estimate of damages?
What is the current status of each claim? What is the likelihood of success on the merits?

• Litigation history: Were there any large claims paid out in the past? Any class actions? What
kind of claims is the target business a party to?

• Litigation trends: What are the common types of litigation? What is the average amount of
damages? Are most claims settled or litigated?

This list does not include specialist areas such as tax, employee benefits, or intellectual property
materials and is not intended to be exhaustive (see Specialist Review).

Specialist Review
A portion of the due diligence review is conducted by legal specialists (such as real estate, intellectual
property, and environmental lawyers) and outside consultants (such as accountants and insurance
consultants). Often, a junior corporate attorney is responsible for distributing materials to the specialists
and communicating instructions from the client. Sometimes a document that appears to be a corporate
document will need specialist input. For example, a supply contract may have significant provisions
relating to the intellectual property of the target company. In this case, the contract will likely need
review by a corporate and an intellectual property attorney. The junior corporate attorney on a
transaction may spend a large portion of time facilitating the specialist due diligence review.

Due Diligence Considerations for Private Equity Buyers

A private equity buyer may have a different view on certain due diligence issues. Private
equity buyers are often more risk averse because they are trying to make a relatively quick
profit on a highly leveraged acquisition. Generally a buyer who is currently operating in the
industry (known as a strategic buyer) is better equipped to absorb an operational loss or
messy litigation. As a result, private equity buyers often conduct more extensive due
diligence reviews than other types of buyers and may seek greater contractual protections.

As opposed to a strategic buyer, a private equity buyer may not have certain operational
capabilities. For example, if a private equity buyer buys a target business that does not
have its own payroll department or IT systems, the private equity buyer will have to procure
those services. A strategic buyer would likely have those services already in place for its

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existing business. As a result, a private equity buyer may need to focus on operational due
diligence.

For more information, see Practice Notes, Due Diligence for Private Equity Transactions
and Buyouts: Overview.

Impact on the Transaction

Due diligence is a necessary part of any significant acquisition. The due diligence findings can impact
the transaction in the following ways:

• Purchase price. If a due diligence finding affects the valuation of the target company, the buyer
may adjust the purchase price. For example, if counsel discovers a $10 million liability that was
previously unknown, the buyer may reduce their offer by that amount.
• Representations and warranties. A buyer often uses the representations and warranties as
protection against unknown liabilities. If counsel discovers that certain permits are very important
to the operation of the business, the buyer will likely insist on a full representation and warranty
that the target business is in compliance with all permits. If this representation and warranty turns
out to be false, the buyer can seek indemnification post-closing.
• Indemnification. If counsel discovers a liability that the buyer is unwilling to acquire, the seller
may agree to indemnify the buyer for that specific liability. For example, the seller may indemnify
the buyer for any costs or expenses incurred in connection with a particular litigation.
• Disclosure schedules. The buyer uses its due diligence review to verify the disclosure schedules.
Ideally the buyer should have an opportunity to investigate anything that the seller lists on the
disclosure schedules. If the disclosure schedules are inconsistent with the buyer’s due diligence
findings, the buyer may negotiate to add or remove certain disclosures (see Practice Note,
Disclosure Schedules: Mergers and Acquisitions).
• Deal termination. In extreme situations, due diligence findings may cause a party to terminate the
transaction (known as deal breakers). There may be certain issues which either drastically affect
the value of the target business or otherwise impact the buyer’s desire to make the acquisition. For
example, if a buyer is acquiring a company primarily for its supply channels and then discovers
that none of the supply contracts are binding, the buyer may choose to terminate the deal. It is
important to identify any deal breakers early so that counsel can focus on these issues and
communicate any findings to the client as soon as possible.
• Pre-closing covenants. The due diligence findings may raise issues that the buyer wants the
seller to correct before the closing. For example, if there are title defects in assets the buyer is

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acquiring, it may require the seller to correct these defects before closing.

How Due Diligence Impacts Buyer’s Knowledge

Sometimes a seller will try to use a buyer’s due diligence review to preclude the buyer’s
recovery for breaches of representations and warranties. For example:

• If the buyer and seller are litigating the seller’s breach of a representation and
warranty and the buyer learned of the breach during its due diligence review, the
seller may argue that the buyer is precluded from recovery because it closed with
knowledge of the breach. It is unsettled whether a court will agree with this argument.
• The seller may try to insert a provision into the transaction agreement which states
that the buyer is precluded from indemnification if the buyer knew of a breach before
closing (known as an anti-sandbagging provision). However, the buyer may object
to this provision and argue for a pro-sandbagging provision reserving the right to
bring indemnification claims against the seller for breach even if the buyer knew about
the breach before the closing and proceeded to close the transaction.
• The seller may try to define buyer’s knowledge as everything that was disclosed in the
data room. The buyer may object to this definition.

Recording and Communicating the Findings

Importance of Communication
Due diligence is often conducted by very junior attorneys so constant communication is necessary. It
often takes a very experienced attorney to identify significant issues. It is important to raise any issues
with senior members of the team promptly because the due diligence findings may impact the
negotiation of the transaction documents or the purchase price. If the client has identified any deal
breakers or issues to focus on, counsel should communicate any findings as soon as possible. It is
good practice to have regular status meetings with the internal due diligence team and to give periodic
informal reports (for example, through an email or telephone call) to the client.

Due Diligence Summaries

It is important when reviewing due diligence to keep careful notes of the findings. Often attorneys
create a written record summarizing the key terms and conditions of each document. Counsel needs to
understand the scope of the due diligence review so that it can determine the level of detail it needs to
record. Different firms have different forms of due diligence summaries and counsel should confirm the

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preferred style. Due diligence summaries maintain a record of what the due diligence has reviewed and
will help recall important issues. Counsel is often asked to report on the due diligence findings days or
weeks after the team has reviewed the materials. Without a proper record the team may be unable to
properly report its findings. Sometimes due diligence summaries are shared with the client, but often
the summaries are only used as an internal record. For sample templates of due diligence summaries,
see Standard Documents:

• Due Diligence Summary Template: Merger and Acquisition Agreements.

• Due Diligence Summary Template: Organizational Documents.
• Due Diligence Summary Template: Agreements.

Due Diligence Report

The ultimate product of a due diligence review is the due diligence report (also known as a due
diligence memorandum). Due diligence reports range from an oral presentation to a lengthy document
with very detailed findings. Counsel should ask the client what type of report they prefer at the start of
the due diligence process. Generally, the length and level of detail in the report will correspond with the
scope of the due diligence review. Like the due diligence review, it is often a junior corporate attorney’s
job to coordinate the preparation of the report. Although each specialist usually writes up their own
findings, counsel needs to fit all of the pieces together into a coherent product. If the report is lengthy, it
is helpful to provide an executive summary highlighting the significant findings and issues. The due
diligence report should be clear and concise so that the client can assess any issues quickly. Drafting
the due diligence report is a time consuming process because it involves drafting the corporate sections
and refining and reformatting the specialist portions.

Third-Party Reliance on the Due Diligence Report

Sometimes, such as when the buyer finances the acquisition, it is asked to share the due
diligence report with a third party (for example, the financing bank or members of the
buying syndicate). Some firms permit the client to share the report, provided that the third
party executes a non-reliance letter. Although most non-reliance letters state that sharing
the report does not serve as a waiver of attorney-client privilege, it is unsettled whether
such a statement actually preserves privilege. While it is common in Europe and gaining
popularity in the US, counsel should find out from the client whether it plans to share the
report with any third parties, whether any third parties expect to rely on the reports, and
then consult with the deal team to determine the appropriate course of action. If the client
shares the report, counsel should remind the client that the third party may review the
report with a different objective and that the information in the report may reveal
sensitivities about the target company that the buyer may want to keep confidential.

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Assignment and Change of Control

Anti-assignment Provisions
In general, all rights under an agreement can be assigned and all duties delegated unless
prohibited by law or public policy. However, the parties to an agreement can limit the
general permissibility of assignment and delegation by explicitly agreeing to restrictions in
the agreement (known as an anti-assignment provision).

If a transaction is structured as an asset acquisition, forward merger, or a forward triangular

merger, third party consents are required for those target company contracts which contain
an anti-assignment provision. Typically anti-assignment provisions are not triggered in
stock acquisitions or reverse triangular mergers unless the contracts contain change of
control provisions. In 2013, the Delaware Court of Chancery confirmed that reverse
triangular mergers would not constitute an assignment by operation of law (see Legal
Update, Delaware Court of Chancery Holds that Reverse Triangular Mergers Do Not
Trigger “Assignment by Operation of Law” Provisions). However, not all states take this
approach. In SQL Solutions, Inc. v. Oracle Corp., a California district court held that a
reverse triangular merger can result in an assignment by operation of law (see SQL
Solutions, Inc. v. Oracle Corp., 1991 WL 626458 (N.D. Cal. Dec. 18, 1991)).

Change of Control Provisions

A change of control provision gives the other party certain rights (such as consent,
payment, or termination) in connection with a sale transaction. Not all change of control
provisions are triggered by the same action. A change of control may be triggered by a
change of ownership, sale of assets, or change in board members. Change of control
provisions are not always clearly labeled. It may be called a change of control provision or
it may be embedded in an assignment or termination section.

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