The Importance of Preliminary Diligence Before Marketing the Company

As noted in our previous article, preliminary diligence is one of the most important things a business can do to improve its strategic positioning as the owners prepare for a sale. However, it can be overwhelming. This article sheds light on the preliminary diligence process and describes what kinds of information a seller should expect to collect.

Preliminary Diligence Overview

As a refresher, preliminary diligence is a joint process of the financial, tax, accounting, and legal professionals—working with management—that make up the seller's deal team. This group is tasked with gathering a massive amount of information about the company, so that they can gain an accurate understanding of the business and address any risks that they may discover. This allows the business to enter the sale from a position of strength, which, in turn, improves negotiating leverage and helps reduce the overall friction of the deal.

So, what sort of information needs to be gathered and examined?

The specifics vary based on the industry and business model of the company—but, as a general rule, any information that materially affects or has the potential to materially affect the success and performance of the business should be examined in the diligence process. The buyer will require this information anyway, so by getting an early start, the seller has time to fix issues preemptively that might otherwise crop up or be raised by the buyer during negotiations.

Specifics

While a list of each and every document that should be reviewed is beyond the purview of this article, the following is a breakdown of a few of the broad categories for the seller to focus on.

• Organizational Documents: Documents under this category will include, as applicable, things such as the articles of incorporation, by-laws, the LLC operating agreement, a list of any subsidiaries or parent companies, and the like.
• Capitalization: The company should be prepared to present proof of who owns equity and all other securities or ownership interests, including options, in the business and in what amounts.
• Finance: It is essential to locate and review income statements, balance sheets, financial projections, and other information of that nature that accurately reflect the current and historical finances of the company. These should include both monthly and yearly statements and, if applicable, be in accordance with GAAP.

Similar, yet distinct, are documents regarding outstanding unsecured and secured debt obligations (oftentimes recorded with a UCC-1 if secured) or any other information on company financing.

• Intellectual Property: Patents, patent applications, trademarks (registered and unregistered), copyrights (registered and unregistered), and licensing agreements of any of the same, and proprietary inventions and assignment agreements with employees and independent contractors should be examined and accounted for during preliminary diligence.
• Other Important Contracts: Key contracts with suppliers and customers, joint venture agreements, real property and tangible personal property leases, and any other important contracts should be gathered and assessed.
• Employees and Other Personnel: Employment contracts with management and other employees, contracts with independent contractors and consultants, current employee handbook and policies, and documentation for employee benefits and related coverage should be gathered and compiled.
• Legal Proceedings: Documentation supporting current and closed legal proceedings that involve or have previously involved the company, including cease-and-desist letters, demands, suits, arbitrations, and settlement agreements should be collected and examined.
• Insurance: Copies of current insurance policies that cover the company, management and other personnel should be gathered.
• Regulatory Compliance: Proof of the company's compliance with environmental regulations, data privacy laws, and any other requirements specific to their industry must be collected during preliminary diligence.

When it comes time for the buyer to conduct its due diligence, so long as an appropriate non-disclosure agreement is in place—subject to any overriding confidentiality obligations owed by the company to third parties—it is generally best for the seller to err on the side of over-disclosure, in conjunction with guidance from legal counsel and other advisors in determining what is the appropriate timing and scope of disclosure. As such, the seller's preliminary diligence should be as thorough as possible in order to prevent the disclosure of information that did not receive adequate review internally.

The diligence process is exhaustive (and exhausting!). However, involving a well-qualified deal team will alleviate the stress and make a complicated process seem much easier.