The Due Diligence Stage
There is no gentle way to say it: Due diligence is hell.
By this point, you've come a long way. Yet, there is still a distance to go in this process, and the due diligence stage can be one of the longest phases—and the most grueling.
If you are fortunate, you may be one of the few who sees this time blaze by in a few weeks, and you could be moving on to a whole new phase before you realize it. In other cases, this period can be drawn out for many months or even a year or more. Hopefully, you'll land somewhere less than that.
If you thought due diligence for fundraising was a pain, or if you thought it was a lot of work shopping your business around finding a great potential buyer and negotiating the terms, then get ready for that pain and work on a whole new level.
For those who have gone through the process of getting a mortgage to buy a house, it isn't too different in workload and theory. At first, you are consumed with finding the right home to buy. Once you think you've nailed that, you have all of the back-and-forth negotiations. Then, you finally get an offer accepted.
But instead of being able to finally breathe and relax, the real work is just beginning. Due diligence is necessary to validate and prove everything required and be certain that the value of the collateral is there. This can lead to last-minute glitches, delays, and renegotiations. Before the closing happens, there can be a lot of sleepless nights and stress.
This experience can be quite a shock for those not anticipating it. It is far more stressful than you imagine. Expect it to be really hard. Anything less will feel really good.
Beat the grueling toll this could have on you mentally and physically by preparing yourself in advance. Make sure the team members involved are also clued in and prepared for what to expect and that they can deal with it well.
Putting Together the Deal Room
Your deal room can make or break the deal, and it will certainly greatly affect how quickly you can close the deal (or not close it). It also has the ability to substantially affect the terms and price of the deal.
Physical versus Virtual Deal Rooms
For the most part, physical deal rooms (also known as data rooms) have become redundant. The status quo used to be a dedicated physical room for physical document storage, with restricted access (only for those with permission to view them).
Of course, physical rooms full of physical paper just aren't practical any more. It certainly isn't efficient. The exception may be for government-involved deals, where extra security is paramount.
Today, virtual deal rooms (VDRs) are much more common and expected, especially with the globalization of business.
Here are the benefits of VDRs:
- Saving enormous amounts of pollution and trees
- More efficient and profitable to use, saving time and money
- Greater speed in uploading requested documents and pushing the deal forward
- Clarity in collaboration, with Q&A and note-leaving ability
- Easy searching and location of documents
- Ease of cross-referencing and linking data
- Clear tracking of all information and records of who has viewed what
- Secure storage of data in the cloud, with no paper to be lost or stolen
Deal Room Software
A wide range of deal room software is currently available. Some of the popular options include Merrill, Intralinks, Venue, ShareFile, Mixado, Digify, Firmex, DealVDR, ShareVault, and DealRoom. These are not recommendations or endorsements—this is simply a sampling of options to explore.
Instead of using dedicated deal room providers, you can always place the documents into a folder and share them via Google Drive or Dropbox.
If you want to explore deal room software options, look for these things in M&A deal room software:
- High-level cybersecurity
- The option to revoke access and permissions at any time
- Ability to track views and who accessed what and when
- View-only permissions
- Differing levels of access for different roles
- No long contracts
Who Should Have Access to Your VDR?
When you create your virtual deal room, you need to consider who has access to it. There are a lot of people who shouldn't be able to access it. You probably don't want your entire staff, clients, customers, the press, the general public, or any parties not involved in the deal to be able to access your VDR. People you might want to grant permission to your VDR may include the following:
- Executive management
- Investment bankers
- Deal leads and committee members
- Post-closing integration leads
- Team members responsible for loading data to the deal room
What Information Should Be Uploaded to Your Deal Room?
A lot of people are uncertain of what information to provide in their deal room. Although the nature of your deal might influence some of the specifics, it is important to consider all of the potentially relevant options. Identifying, preparing, and uploading the information can be a lot of work, but the effort is necessary and pays off in the end. Following are the categories of information that you should consider:
- 1.01 Certificate of incorporation (or equivalent) and all amendments and restatements
- 1.02 By-laws (or equivalent), as currently in effect
- 1.03 List of all business names used by or registered for use by the Company
- 1.04 List of any and all subsidiaries and affiliates of the Company and jurisdiction of formation
- 1.05 List of all jurisdictions in which the Company owns or leases (either as lessor or lessee) assets or has done so since incorporation
- 1.06 List of all jurisdictions in which the Company is qualified as a foreign entity, has applied for such qualification, or has substantial contacts
- 1.07 Minutes, including minutes of meetings of the board of directors, board committees, or the shareholders (or any equivalents); written consents of any of the foregoing in lieu of a meeting; and all materials distributed to the board, board committees, and the shareholders (or any equivalents) at any meeting
- 1.08 List of any business acquisitions or dispositions made by the Company
- 1.09 List of all persons who have been or who currently are officers or directors (or equivalent)
- Capitalization and Securityholders
- 2.01 List of Company securities authorized and outstanding that indicates the holders, amounts, and classes or series of such securities and copies of securities transfer books and stock ledgers
- 2.02 Agreements to issue and/or register securities
- 2.03 Agreements relating to voting of securities, preemptive rights, restrictions on transfers, rights of first refusal, and any other grants of rights in respect of the Company's securities
- 2.04 All warrants, options, or other agreements relating to rights to acquire securities of the Company or requiring the issuance and/or registration of such securities
- 2.05 All plans and grant or award documents for any stock option, stock bonus, stock purchase, or other equity-based compensatory programs for employees, consultants, advisors, and/or directors (or equivalent)
- 2.06 Any agreements with “finders” or that purport to obligate the Company to compensate any person or entity in connection with a financing transaction
- 2.07 Private placement memoranda, investment letters, questionnaires, and other documents relating to any offering of securities of the Company
- 2.08 Copies, front and back, of all stock certificates and stock powers
- 2.09 List of any copies of closing binders of each and every prior equity financing (including debt convertible into equity)
- Financial Statements and Audits
- 3.01 Financial statements for the last three years
- 3.02 Schedule of liabilities (contingent or otherwise) not reflected in the most recent financial statements
- 3.03 List of any change in accountants and/or auditors since incorporation
- 3.04 Copies of audit letters from counsel to auditors since incorporation
- 4.01 List of all domestic and foreign jurisdictions in which the Company remits sales, use, income, franchise, property, or other taxes
- 4.02 Tax returns (federal, state, and local) of the Company since incorporation
- 4.03 Reports filed and material correspondence with any and all tax authorities, including the IRS, since incorporation
- Employees, Salaries, and Labor Disputes
- 5.01 All collective bargaining agreements, employment agreements, offer letters, consulting agreements, severance agreements, noncompete or non-solicit agreements, change-in-control agreements and intellectual property transfer agreements, nondisclosure or confidentiality agreements to which the Company is a party, and list of any of the foregoing agreements currently contemplated or about to be entered into by the Company
- 5.02 Summary of labor disputes, requests for arbitration, organizational proceedings, grievance proceedings, and similar matters and history of recent union negotiations
- 5.03 List of all employees indicating each employee's division, title, function, industry experience, and earnings and whether each such person is an officer and/or director (or equivalent) of the Company
- 5.04 List of all employees terminated since incorporation and the reason for such termination; indicate whether each such employee has signed a release (and provide a copy of signed release)
- 5.05 Termination procedures, policies, and a sample termination letter
- Employment Policies and Employee Benefits
- 6.01 All personnel manuals, employee handbooks, and documents relating to employment policies and procedures
- 6.02 Any affirmative action plan(s)
- 6.03 Policies and practices regarding compensation for all employees not earning a straight salary (i.e., bonuses, commissions, overtime, premium pay, shift differentials, and so on)
- 6.04 Policies for fringe benefits, perquisites, holidays, vacation, and severance pay
- 6.05 Incentive, bonus, deferred compensation, profit-sharing, and nonqualified pension plans
- 6.06 Employee health and welfare plans, whether insured or self-insured, including most recent summary plan description for each
- 6.07 All Form 5500 Series annual financial reports and summary annual reports (including all supporting schedules and audit reports) for each employee-benefit plan described in 6.06 and 6.08
- 6.08 Each tax-qualified retirement plan and any related trusts or insurance contracts (as amended to date) and most recent summary plan description for each
- 6.09 Most recent IRS determination letter for each tax-qualified benefit plan
- Financial Commitments
- 7.01 All indentures, loan, and note agreements (whether demand, term, installment, or other) and line of credit arrangements, whether bank loans, industrial revenue bonds, mortgages, or other, and whether secured or unsecured, and all documents evidencing other material financing arrangements, including sale and leaseback arrangements, installment purchases, letters of credit, capital and leveraged leases, and receivables securitizations
- 7.02 Summaries of compliance with the instruments described in 7.01 (including indication of whether defaults are presently anticipated for future periods) and all communications with lenders
- 7.03 Guarantees for the benefit of or by the Company
- 7.04 List of loans to or from securityholders, employees, officers, directors (or equivalent), or any of their immediate family members
- 7.05 Contractual obligations relating to termination of employment
- 7.06 List of all outstanding indebtedness of the Company detailing amount and effective interest rates of such indebtedness
- 7.07 Schedule of all liens and encumbrances to which the property and assets of the Company are subject
- 8.01 List of all material consents required to be obtained by or on behalf of the Company to complete the proposed transaction, specifying the name of the entity or individual from whom consent is required, the agreements under which required, and the reason why such consent is required
- Permits and Licenses; Compliance
- 9.01 All material permits and licenses (including, without limitation, environmental permits and licenses) needed by the Company
- 9.02 Description of any regulatory and compliance issues the Company has faced, currently faces, or anticipates facing (including, without limitation, FDA, HIPAA)
- 9.03 Information related to potential regulatory or product liability claims or actions that the Company may face
- 9.04 If applicable, written policies and guidelines regarding protection of personal health information and related privacy policies
- 10.01 All insurance contracts, including director-and-officer liability (or equivalent), automobile, general liability, environmental liability, key person (whether or not owned by the Company), and products liability; list of and summaries of insurance claims, disputes with insurance companies, or denials of insurance coverage that are currently pending or have occurred since incorporation; list of insurance claims paid against occurrence policies
- 10.02 Workers' compensation documentation
- 10.03 Vendor liability endorsements
- 10.04 List of any time the Company has ever been declined for a policy or of any time an insurance company has declined to provide a key person policy requested by or on behalf of the Company (whether the policy was to be owned by the Company or not)
- 11.01 List of and status of pending and threatened claims, litigation, administrative, or other proceedings and governmental investigations involving the Company or, to the extent that they relate to performance of corporate duties (whether for the Company or any third party), any of the directors (or equivalent) or officers or relating to any product manufactured or distributed by the Company and list of counsel presently and previously handling such matters
- 11.02 List of outstanding judgments or decrees against the Company and, to the extent that they relate to performance of corporate duties, any of the directors (or equivalent) or officers
- 11.03 List of all consent decrees, settlement agreements, injunctions, and similar matters involving the Company and, to the extent that they relate to performance of corporate duties (whether for the Company or any third party), any of the directors (or equivalent) or officers
- 11.04 List of all pending and threatened claims, litigation, administrative, or other proceedings and governmental investigations involving any key person (defined to mean any founder, officer, or director or key employee of the Company) during the last five years
- 11.05 List of any and all bankruptcies and license revocations or suspensions or censures or prohibitions on involvement in the sale or trading of securities or commodities in which any key person has been involved if in effect during the last five years
- Intellectual Property
- 12.01 Patents, trademarks, service marks, copyrights, trade names, trade secrets, and other intangible assets owned or used by the Company (including domestic or foreign applications, registrations, licenses, and assignments)
- 12.02 Opinions relating to patents (including right to use, patentability, blocking patents, infringement, and validity) and opinions relating to trademarks (including registrability, infringement, and validity) and opinions relating to other intellectual property
- 12.03 List of all software programs owned by the Company that are (a) used internally by the Company in its business operations or (b) made available by the Company for use by customers
- 12.04 List of all software programs owned by third parties that are (a) used internally by the Company in its business operations (other than non-custom, mass-marketed software products licensed under a “shrink-wrap” agreement) or (b) made available by the Company for use by customers, indicating in each case the owner of and nature of the Company's right to use such intellectual property
- 12.05 License agreements relating to intellectual property under which the Company is licensor or licensee (including “shrink-wrap” software products to the extent related to the products developed by the Company) and list of any obligations to pay or rights to receive royalties
- 12.06 Documentation alleging infringement of third-party intellectual property by the Company or relating to alleged or actual third-party infringement of the Company's intellectual property
- 12.07 Secrecy, confidentiality, nondisclosure, and assignment of inventions agreements with employees, consultants, or independent contractors and list of any employees, consultants, or independent contractors not covered by such agreements
- 12.08 Written policies and guidelines distributed to employees regarding protection of proprietary items, technical data, marketing data, or confidential information used by the Company in its business operations
- 12.09 Documentation relating to third-party development and testing of the Company's products, services, and proprietary products and information
- 12.10 List of any open source or community source code incorporated into any of the Company's software products or products under development
- 12.11 List of all liens and encumbrances on the Company's intellectual property
- Property, Plant, and Equipment
- 13.01 List of all real property currently and formerly owned by the Company
- 13.02 List of all real property currently and formerly leased to or by the Company
- 13.03 All leases and subleases regarding real property and material amounts of personal property leased to or by the Company
- 13.04 All material agreements encumbering real or personal property of the Company, including, without limitation, mortgages, deeds of trust, and security agreements
- 13.05 All material equipment leases involving the Company, including capitalized or financing leases
- Environmental Matters
- 14.01 All notices of violation or enforcement activity relating to any domestic or foreign environmental laws received since incorporation or otherwise unresolved at present
- 14.02 All “potentially responsible party” notices, Section 104(e) (i.e., 42 U.S.C. §9604(e)) requests, or other documents relating to possible liability under CERCLA, on-site or off-site
- Other Contracts
- 15.01 All contracts, agreements, or arrangements restricting the nature or geographic scope of the Company's business
- 15.02 All contracts, agreements, or arrangements between the Company and any officer, director (or equivalent), securityholder, or any of their immediate family members
- 15.03 All contracts, agreements, or arrangements between the Company and management or key personnel
- 15.04 All secrecy, confidentiality, and nondisclosure agreements between the Company and employees or third parties and list of any employees not covered by such agreements
- 15.05 All indemnification contracts, agreements, or arrangements for officers and directors (or equivalent)
- 15.06 All contracts, agreements, or arrangements between the Company and any of its subsidiaries or affiliates
- 15.07 All commission, brokerage, and agency contracts, agreements, or arrangements to which the Company is a party
- 15.08 All joint venture, partnership, corporate alliance, collaboration, and similar contracts, agreements, or arrangements to which the Company is a party
- 15.09 All executed closing documents relating to any merger, acquisition, or disposition by the Company (whether consummated or not)
- 15.10 All marketing contracts, agreements, or arrangements, including sales agent, representative, dealer, distributor, consignment, consultant, pricing, and advertising agreements, to which the Company is a party
- 15.11 All material supply, requirements, purchase, or sales contracts, agreements, or arrangements to which the Company is a party
- 15.12 All material licensing and royalty contracts, agreements, or arrangements to which the Company is a party
- 15.13 All government contracts, agreements, or arrangements to which the Company is a party
- 15.14 All contracts, agreements, or arrangements relating to the Company's securities to which the Company is a party, including, without limitation, subordination agreements, standstill agreements, stock option plans, forms of stock option agreements, and agreements pursuant to which the Company has agreed to issue or to register securities
- 15.15 All contracts relating to the operation of the Company's website
- 15.16 All other contracts, agreements, or arrangements that provide for the aggregate payment or receipt by the Company of $10,000 or more
- 15.17 All other material contracts, agreements, or arrangements
- 16.01 All other documents and information that are significant with respect to any portion of the Company's business or that should be considered and reviewed by prospective investors in the Company
When Should All of This Data Be Uploaded to the Deal Room?
One of the biggest pitfalls in M&A is not having the data ready and available immediately. Once you get this far, you don't want the buyer to walk away. Don't blow it by not being ready.
If you are going down this path, you are either going to sell or merge the company, go public, or raise another big round of funding. In any of these scenarios, you are going to need a deal room, so make the investment and take the time to create one.
And get started early. By the time you hit due diligence, everything you need should be there, barring any documents that may need to be updated during a drawn-out period of due diligence.
If you aren't prepared, then you are going to look amateurish at best. At worst, you will look like you are hiding something. Neither of these perceptions is going to be attractive to buyers, especially when you are trying to get the highest possible price for your company.
Getting a head start on loading your deal room also means, quite simply, avoiding more pitfalls and mistakes that often crop up in due diligence.
While creating a deal room, it is common to discover that documents are missing or contracts and legal work that are missing signatures. You may find you need additional documentation. You'll also gain more of a buyer's perspective through this process and see potential gaps and areas for improvement that the buyer will notice. Finding this out yourself and taking the time to get things right before showing your information to buyers can make a huge difference in how smoothly due diligence progresses.
Validating Your Claims
Don't make claims that you can't back up.
It is relatively easy to create a great marketing and sales pitch. You can make all kinds of promises to investors to raise seed money. You can overpromise in ads to make sales and hope too many people won't complain or ask for a refund. You can also commission and create a fantastic pitchbook and exit presentation.
There may be some creative and artistic license when flaunting how great your company is, the strategic fit, and what's possible by merging your companies. However, anything to do with your financials, sales, asset values, partnerships, and product is going to be under scrutiny. All this has to be proven and documented.
The disclosure schedule will lay out exactly what data need to be provided to back up your claims, pitch, warranties, and representations. It will also lay out what you won't be required to prove.
If the potential buyer starts seeing critical information that is not lining up with your promises, you will be under even more scrutiny.
This is why due diligence and deal rooms are necessary.
The Dos and Don'ts During Meetings
Your due diligence process is probably going to be full of meetings.
Have an agenda for each meeting. This will ensure you are prepared. You need to time the meeting well to keep everyone from getting bored (or keep you from accidentally oversharing). You'll be making progress, rather than just burning time. Attendees will know what to expect, talk about, or take action on.
Listen twice as much as you speak. Build good rapport and hold engaging meetings that move the needle. Always keep in mind that you'll learn a lot more and grow your power in the negotiations considerably faster if you listen more than you talk. Resist the urge to speak as much as possible. Pause and take a few deep breaths before you have to speak.
You'll find listening much easier if you strive for objectivity and refuse to let emotions get the best of you. Being passionate and charismatic about your business and its strengths and vision is great. However, when you're in active meetings with the other side, you don't want to let any other emotions show. If you aren't careful, they will show through your body language (both during in-person and video meetings). They'll show in your voice and words over the phone. These are tells that professional negotiators on the other side will be looking for, and your emotions will be used against you—which is another great reason to have professionals in your corner to shield you.
Again, don't overpromise, make decisions, offer guarantees, or speak out without your lawyers, consultants, and board members. You are paying them to protect you. They are there to help you achieve the best possible outcome. They may even be the ones with the decision-making authority.
Managing the Flow of Information
Managing the flow of information is vital during due diligence.
Leaks of information or claims of a deal before one is struck can be incredibly destructive. They may break legal agreements. They might even be seen as fraud or at least attempts at stock and market manipulation. Both leaks and false information provided to the news or proclaimed to buyers could prove very expensive and may even cost you your role.
Leaks can affect the deal in a variety of ways. They can happen at many levels and for different reasons, or even by accident—and on both sides.
It's wise to throttle any information provided. There are sharks that will get into talks just to get inside data and tie you up. Typically, it is best to have your deal room fully loaded. You also want to be overprepared so that you don't slow down the deal. But that doesn't mean you have to provide complete access to every document and detail at once. You may open up more throughout the process as requested, without slowing things down, while preserving the integrity of your data and business as much as possible.
Using your VDR software, you can achieve this by creating different levels and areas of access. You can keep a tight grip on information by controlling access to sensitive documentation, throttling it, and tracking who has accessed it.
This book discusses the right time to share any potential thoughts of a merger or acquisition with different levels of your team and shareholders. Any other time is dangerous.
What to Look for in the Potential Buyer
You should be looking for several key factors in your potential buyer during the due diligence phase. You'll want to consider potential indicators of a good buyer and deal, as opposed to indicators of trouble or unscrupulous players trying to engage you and tie you up. The following sections help identify some of the things you should be looking for.
What Information Is The Buyer Asking For?
One of the factors you'll want to consider is the nature of the information your potential buyer wants. What information is the buyer asking for through disclosure schedules and other requests? What information is the buyer really trying to dig into? Is it in alignment with the buyer's stated goals and thesis for acquiring your company?
What Data Are the Buyer Looking At and When?
Using your deal room tools, you can see exactly who has accessed which documents, when, and how often. Does this activity line up with what the buyer is saying? Are the right people from the organization looking at the right documents and asking the right questions and in a logical order? Does all this align with the stated vision and intent? Are you seeing any quirky trends that could be red flags? Are people who should be looking at data relevant to a potential business merger involved? Or is someone just going through all of your IP and customer lists and neglecting data that would be more applicable to actually closing the deal on financially intelligent terms?
You'll also want to make sure your potential buyer is authentically interested in the deal. Is everything the buyer is digging into becoming an excuse to ask for more information, to delay things, or to renegotiate the terms yet again? Or does it feel more like the buyer really wants to do the deal?
Efficiency and Honesty
A VDR with great tracking features gives great insight into the buyers you are courting. Are they working efficiently and transparently? Are they working through the schedules and data in an organized, swift, and thorough fashion? Or are they all over the place, claiming they can't find information you know they already accessed? The answers to these questions will tell you a lot about their integrity and even more about what they are going to be like to work with after the deal closes.