Reverse Due Diligence

By Miriam V. Gold

Congratulations!  You have decided to sell your business.  Before you go out and find a buyer, you need to do your homework.  Doing so will not only make the sales process go quicker and more smoothly, it might well result in more profitability for you.  Selling a business is often more difficult for an owner than operating one.  In this article, I will discuss some of the major areas of Reverse Due Diligence.

• What is Reverse Due Diligence?  Isn’t the Buyer going to conduct Due Diligence?  Why should I?

The buyer will certainly conduct Due Diligence.  He will want to know as much as possible about what he is buying.  Sometimes buyers end up knowing more about the business than the seller, putting the seller at a disadvantage during negotiations. Simply put, Reverse Due Diligence is the process of understanding all of the elements of the business that either provide – or may provide -- value to the business or subtract – or may subtract -- value from it.  Identification of the value enhancing, or value destroying, aspects of your business will help you to (a) price your business optimally,  (b) target the types of buyers that will best meet your objectives for the sale, (c) fix problems or manage issues before involvement of a buyer, (d) eliminate a buyer’s ability to renegotiate the price late in process, when you are already committed, because he has discovered an “issue”,  (d) structure the deal with your tax adviser to maximize your profitability and (e) create a level of trust between you and the buyer that will facilitate the sale.

Reverse Due Diligence, like the due diligence that will be undertaken by the buyer, is a team activity.  The particular nature of your business will determine the members of the team.  For example, a business whose value is predominately intellectual property will need intellectual property experts as team members.  Any chemical deal will need environmental expertise.  Any transaction will need tax advice.  The earlier a team is formed the more likely the issues that arise will be addressed in a timely way.  For important areas, make sure to use experts.  In the long run, they will be cost effective because they will quickly cull the wheat from the chaff.

Any agreements (shareholders agreement, operating agreement, partnership agreement and the like) that might deal with a sale of the business need to be consulted.  Who needs to agree? What are each seller’s rights and obligations to the other sellers? What will be the ultimate disposition of the proceeds?    Even in the absence of such an agreement, relationship issues need to be considered.  Ensuring that everyone on the selling side has the same vision of what selling the business means is sometimes especially challenging in a family owned business, even when it appears that only one member of the family is actively involved in the operations.  Had grown children intended to join the business?  Does Uncle Joe need to continue to work?  Are you intending to retire, or do you want to maintain some ongoing relationship with the company?  Is timing important?  Are you going to want a buyer that will display loyalty to your employees and the community, and will be a good steward for the business into the future?  Often, entrepreneurs who have built a business do not want to sell to someone who will not continue to treat employees in the same fashion.  Understand where you are willing to compromise and where you will not.  Ensure that everyone on the selling side who can impact the transaction, whether with legal rights or not, has a shared vision of the end state of the deal.

Once you fully understand all of the objectives of your transaction, and have prioritized those objectives, you should affirmatively try to attract the type of buyer that best meets your goals for the sale.  Strategic buyers and financial buyers have very different motivations, and often buy and operate businesses quite differently.  Small buyers may also have different plans and needs than bigger buyers. Private buyers are of course different from public buyers.  Knowing exactly what you are selling, and the relative value of each of the components in the transaction, will ensure you are positioning your business optimally for the type of buyers you want to attract.

• How will you structure your transaction? Stock deal? Asset Deal?

How your deal is structured can impact the proceeds you receive from that transaction.  Tax and liability issues are often, but not always, the driving considerations in structuring a transaction.  Assignability provisions and change in control provisions for significant contracts will also have to be considered.  Most deals can be structured as either a stock or an asset deal, but the form will impact the benefit to each of the parties.  In a stock transaction, the business entity itself is transferred, with all of its assets and liabilities, whereas in an asset deal, the buyer is able to select only those assets and liabilities it wants to assume, subject to some exceptions.  In the sale of a closely held business, the ability of the buyer to select out assets and liabilities may be more theoretical than real, as the seller likely will want to transfer the entire enterprise, however that is accomplished.  The analysis suggested in this article will help your advisors determine the best  arrangement for the transaction.  The final determination of the structure will likely be negotiated between the seller and the buyer, who will have different perspectives.  The parties will have to determine which structure provides the most benefit in the aggregate, and then based on the structure, calculate or adjust the purchase price.

Not all assets of a business are of equal value to all buyers.  Some buyers may see more value in some of the assets than the seller does.  You might also find that some buyers don’t want certain assets (for example, a headquarters building or a contract for payroll administration) and might even value the business higher without them.  In this section I will discuss some of the likely assets in the sale of a chemical business.  While in a stock deal, as opposed to an asset deal, the whole entity is being sold, the same analysis is still of great importance.

• Intellectual Property

Intellectual property generally consists of patents, trade secrets, copyrights, trademarks and trade names.  Unless your company name or product names have some cache in the industry, you are typically selling patented and unpatented technology, either on the composition of your products or the process for making those products.  For trade secrets, one of the most important considerations is ensuring that the trade secret is in fact “secret”.  Verify that you have confidentiality agreements, and with respect to IP developed by third parties under contract to you, verify that you have agreements that demonstrate the IP was made as a “Work for Hire” and has been assigned to the business.  Make sure you own what you think you own.  Sometimes owners discover that some of the IP used in the business is licensed in.  In those cases, for important technology, you need to be sure that you have the right to transfer the license to a buyer of the assets, and with respect to stock deals, that there are no issues with change of control provisions.   To the extent you are selling only part of your business, think about how some of the technology that relates to several different product lines may be divided in the transactions.  For patents, understand whether or not some of your technology may be infringed by third parties, or whether or not you may be infringing the right of third parties.   This type of information may have found its way into call reports, correspondence files or lab files.  Make sure your maintenance fees are paid. 

The same issues exist about ownership and liens with respect to real estate as with respect to other assets.  Make sure you have good and transferable title to your real estate.  Any issues with title and any liens should be addressed before the business is marketed.  Recognize that buyers may be more particular these days about real estate, both because of concerns with environmental issues, and to keep hard assets off of their balance sheets.   (See discussion on environmental issues in the next newsletter).  Generally, manufacturing plants raise the highest level of environmental concern, then warehouses, laboratories and office space.  Newer facilities are generally less of an issue than older facilities.  Cleanliness is important.  Just like showing a home for sale, a clean plant makes a far better impression than a dirty run down one.  Dirty plants invite more inspection.

Is the real estate in question just suited to the current use?  Should the buyer not be interested, are there other buyers for this particular asset?  Is the asset worth more as part of the contemplated transaction than apart from the transaction?  If the real estate is leased, can the lease be assigned to the buyer, or are there opportunities to terminate the lease early, at what fee, or to sublet the property? 

• Inventories

The quality and quantity of the inventories are both important.  What is your percentage of obsolete or nonconforming inventory?  Does it make sense to rework or discard such inventories before sale, or is it better to expect the buyer take this on?  Having too much defective inventory on hand could suggest to the buyer either a problem with the manufacturing process, suppliers or internal controls.  How much inventory do you have?  As a percent of sales?  You should look at this not only in the aggregate, but also on a product level, to ensure that the business can meet its order flow without tying up too much money in working capital.  Some buyers might even want extra inventories to carry them through any change in manufacturing sites.  Think about this in connection with the real estate issues discussed above.  (See also discussion in the next newsletter on product regulatory issues).

• Accounts Receivable

Are your credit terms customary for your industry and your geography? Do you collect receivables in a timely fashion?  What percentage of your receivables is aged, and how aged?  In an economic downturn, such as now, will your customers be likely to go into bankruptcy?  Have you thought about managing potential preferences in such a case?  This was a major concern not so long ago as the textile industry was going off shore.  Other industries could find themselves in a similar situation.  Consider whether making the effort to tighten up your collections will be worth it in the greater scheme of things.

Employees are always impacted by a sale, and employees have a disproportionate ability to impact the sale.  There will be some employees of the seller whose continued employment will be significant to the ongoing vitality of the business, a small portion of whom where perhaps retention might even be a condition precedent to the closing of the transaction.  There will be some who will be essential to operate the business during the transition and to help integrate the business after the sale.  There will be some whos e j obs will be terminated as a result of consolidation after the sale.  Financial buyers will likely have less of the latter than strategic buyers.  While the complete classification of employees into one of the foregoing categories cannot be made until later in the process, you should think about what you can do to ensure that the employees you need to retain stay committed to the business during what can be an unsettling time for many.  Do you have severance policies in place?  Would you consider retention bonuses for significant players?  While those issues will be worked out with the buyer, the costs should be considered by the seller when valuing the business.  Consider also the shifting of loyalties that inevitably occurs in a sale, from the seller to the buyer, who will be the new employer.

Some employees may have contracts.  Review those carefully. You may have a Union at one or more facilities.  You will need to determine your obligations with respect to labor contract in a sale transaction.  Notice provisions?  Bargaining over effects?  And so on.  Don’t forget that there can also be federal (such as the WARN Act) or state laws that need to be consulted.  Employees will be not only concerned with whether or not they will retain their positions, they will want to know about their benefits.  The mechanics of how that will be handled will need to be addressed.

All contracts need to be reviewed to ensure they are current and to determine whether they are assignable in connection with the contemplated transaction, and for stock deals, whether there are any change of control provisions.  During a diligence exercise we find that some contracts have long expired or that the written terms of the contract no longer reflect the practice between the parties.  To the extent a contract is critical to the business, you might want to consider negotiating an update or extension.  What is a critical contract depends on the business itself.  It could be a contract with important customers, large suppliers or suppliers of unique products.  It could be a supply contract that provides a price advantage not available on the open market.  It could be a license for technology essential for the seller’s processes or products.  If there are critical contracts that are nonassignable by their terms, you have the time to consider how best to address the situation.  Sometimes your buyer might be able to persuade the third party to deal with it.  Sometimes there might be an alternative you can identify. 

Important relationships might not be subject to a contract. How will you be able to persuade your buyer that those relationships will be transferred to him with the business?  This is especially important where the third party is a considerable portion of the customer or supplier base of the seller.  Understand the motivations those parties have to conduct business on the same basis they have historically.

• Other Issues—to be continued

In next quarter’s newsletter, we will continue our discussion of Reverse Due Diligence.  We will look at liabilities, such as environmental and litigation, and other miscellaneous issues.