Understanding the Due Diligence Process Today Helps Position Businesses for Successful Transactions Tomorrow

John Bentas
Counsel, Corporate Department
Published: New Hampshire Business Review
August 13, 2010

Whether it is a debt financing, capital infusion or the sale of your business, at some point, some level of inspection of your business operations, practices, records, relationships and financial information – commonly called “due diligence” – is required of a business owner.

A little preparation now will not only save you a lot of aggravation later, but it also can make you look pretty good with your new bank or investors too. Moreover, it may make a difference in terms of the proposed transaction, or even being able to engage in the transaction at all.

Instead of starting from scratch when a transaction is imminent, here are some things that can give you a head start on the process.

  • Organization: Believe it or not, the due-diligence process can stretch back to your first day of business or formation.Things to consider are: Did you file the correct forms with the state to organize your entity (such as a corporation or limited liability company)? Have you paid and filed your annual requirements? Have you properly adopted organizational documents to govern your business affairs (for example, bylaws or an operating agreement)? Are you “qualified” or “registered” to do business in the appropriate states? Have you complied with any necessary corporate formalities (such as holding annual meetings of directors and shareholders)? While some of these things can seem like a small concern in running a business, they mean quite a bit to a bank or third-party investor.
  • Capital structure: It is not unusual for the records of a small-business owner to have some deficiencies as to the ownership of the business.Like most small businesses, the beginning stages of a company are made up of many sources of funds – friends, family, acquaintances and “angel investors” – in each case, perhaps without the involvement of legal counsel. It is possible that people have “given” money to your business without any documentation as to whether it was a loan, a capital investment or some hybrid of the two. Getting a handle on who provided money to your business, what the nature of that financial infusion was and whether it is properly documented will be key concerns for any person conducting due diligence. Clarity is essential.
  • Material contracts: Even today, many business relationships are not evidenced by written agreements. In a due-diligence situation, oral agreements or performance-based contracts can be areas of significant concern. Depending on the arrangements, they could even have the unintended effect of lowering the value of your business if the terms are unclear or not readily predictable. Not all contracts must be reduced to writing, but the material terms and conditions should be memorialized for your business’s most important contracts (such as with major customers, property leases and material suppliers).
  • Employee items: Employees can be the lifeblood of your business, so it is important to keep good records for a prospective investor or lender who wants to become involved the business.There are numerous “good practices” regarding maintaining personnel files, employee non-disclosure and non-compete agreements, disclosures in employee handbooks and documenting benefits plans and compensation levels which are beyond the scope of this article. There are also a myriad of laws, rules and administrative agencies that can have an impact on your business as it relates to employees (including subcontractors).
  • Tax and financials: In a due-diligence phase, tax and financial analyses can be subject to scrutiny on levels and in ways you may not normally conduct for an ongoing business. Furthermore, lenders or investors may have different perspectives or formulas for your tax and financial information that a person running a business may not expect to be of significance. In this regard, not only is an experienced counsel important, but a certified public accountant is crucial as well.
  • Environmental, intellectual property, product liability: Depending on its business, a company could have legal issues relative to the environment, intellectual property (such as software, trademarks or licensing of technology, etc.) or product liability (among other areas). Taking some time with knowledgeable counsel to help him or her understand your business prior to due diligence can not only expedite that process and make it more robust, but it may also permit the identification of legal issues to help you run a more compliant and (hopefully) efficient business.

The due-diligence process is very important to protect your business from potential future liability, and the appropriate amount of time and energy should be devoted to make it complete and accurate.