The Importance of Due Diligence in M&A Transactionsby Scott Edward Walker on March 21st, 2016
I’ve been handling a number of M&A transactions over the past few months from the buy-side, and one mistake I’m repeatedly seeing is the failure of the acquirer to perform an adequate due-diligence investigation of the target. As I discuss in this video from a few years back (starting at the 0:24 mark), I first learned of the importance of due diligence as a young lawyer at a major law firm in New York City. Indeed, this lesson stuck with me – and it applies regardless of the size of the acquisition.
SONY’S ACQUISITION OF CBS RECORDS
The first significant deal to which I was assigned as a junior corporate associate was representing Sony in connection with its acquisition of CBS Records for $2 billion. At the time, it was one of the largest M&A transactions in the world, and we had a due diligence team of 25-30 lawyers from every department at the firm (corporate, real estate, tax, litigation, etc.). The corporate diligence team, of which I was member, was made-up of six junior associates and one mid-level associate who was the captain. All of us spent 16+ hours a day for about three weeks reviewing contracts at the offices of CBS Records. Our job was two-fold: (i) to summarize the terms of every contract and (ii) to flag any significant issues (which was then folded into a formal “red-flag” memo to the client).
In the course of our review of CBS Records’ contracts with high-profile musicians (such as Michael Jackson, Bruce Springsteen and others), we discovered a “change-of-control” provision, which permitted the respective musician to terminate his contract if CBS Records were acquired or merged with another company. Obviously, this was a very important provision because the value of CBS Records would be substantially diminished if those musicians did not come along with the acquisition. We, of course, flagged this issue for Sony, and CBS Records was required to negotiate with those musicians and to obtain their written consent as a condition to closing.
SMALL TECH TRANSACTIONS
Fast forward to today, and I am obviously not handling multi-billion dollar, cross-border mergers and acquisitions at my boutique law firm. Nevertheless, even in small tech acquisitions, I cannot emphasize enough the importance of diligencing the target. Yes, the scope and budget for due diligence will depend on the purchase price, but for founders to ignore this issue and hope for the best is not a prudent acquisition strategy.
Below is an email I recently sent to a client who is acquiring a small SaaS company; paragraph #4 flags the diligence issue.
[Client Name] — Attached is an initial draft of the purchase agreement. Please note that:
1) My comments and questions are set forth in bold and bracketed language.
2) As I previously advised, the heart of the agreement is the representations and warranties (commonly referred to as “reps”), which are designed (i) to protect [Acquirer] in the event a problem arises post-closing and (ii) to flesh-out any significant risks.
3) Closely related to the reps are the Schedules. If a rep is not accurate as of the date of the agreement, then [Target] must list the particular exception/reason on a Schedule (or he would be in breach post-closing). For example, in Section 3.12, [Target] is repping that: “There are no Proceedings pending against the Company relating to the Business…” If that were inaccurate, the rep would need to be revised to read: “Except as set forth on Schedule 3.12, there are no …” Certain Schedules also expressly require the disclosure of key information, such as a list of material contracts.
4) An important aspect of any acquisition is the due diligence investigation. Indeed, as I wrote in this article on buying businesses (see http://bit.ly/5ec44u):
“Do Your Diligence. A comprehensive due-diligence investigation is critical to the success of any acquisition. The fundamental purpose of due diligence is to validate assumptions with respect to valuation and to identify risks. Accordingly, there are typically three separate investigations: operational/strategic, financial and legal. Clearly, the scope of the investigations must be tailored to the particular transaction; however, it cannot be emphasized enough that most deals fail due to inadequate diligence — resulting in the buyer (i) overpaying for the target, (ii) assuming significant unknown liabilities and/or (iii) experiencing major integration problems.”
Obviously, this is a relatively small transaction; however, it is still imperative that, at a minimum, you conduct financial due diligence (to validate the numbers [Target] has provided to you) and IP diligence to confirm the ownership and functionality of the software. The Schedules will also flesh-out particular issues that warrant additional diligence.
5) We can discuss the draft and the foregoing on Monday. Thank you.