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    In the game of buying and selling businesses, information is king. In order to evaluate a potential acquisition correctly and to avoid entering into an inauspicious deal, the buyer must thoroughly investigate the target business. This process is generally referred to as “due diligence”.

    A careful and thorough due diligence investigation should be part of every acquisition. The nature and scope of a due diligence investigation will depend on the structure of the proposed acquisition (asset sale or stock sale), the financial condition of the seller, whether the seller will continue to operate a business after the transaction, and the value of the transaction. Set forth below is a list of ten important issues that a buyer must confront and evaluate as part of its due diligence prior to purchasing the business. The following list is intended to be a starting point in a buyer’s investigation and is not intended to be all-inclusive; rather, it is simply a guide to help a buyer make an informed decision. Once the issues are properly analyzed, a buyer may better ascertain whether the business should be acquired and whether the proposed purchase price is appropriate.

    (1) Assess the “True Value” of the Target’s Assets to Your Business: First, ask yourself whether the business has something your business currently needs, and evaluate whether you can acquire the same or similar assets in a less costly manner. Assuming that you are still inclined to acquire the asset, consider whether you have the ability to protect the asset in a meaningful way. If the asset is manufacturing property and equipment, for example, the inquiry may be more practical and straightforward. However, if the asset is intellectual property (such as a patented manufacturing process or unprotectable recipes), the asset could potentially decline in value and evaluation may be more involved.

    The buyer should ask the seller to prepare a list of all the assets that the buyer will be acquiring as part of the acquisition. The list should include all real, personal and intangible property and the list of physical assets. The buyer should ensure that the seller actually possesses title to the assets it intends to sell. Buyers (and sellers, too) are sometimes surprised to discover that the seller only leases or licenses critical assets from third-parties, and therefore cannot sell them outright. In these situations the results can vary widely, and the buyer should re¬ evaluate the entire deal. Sometimes the true owner is an active part of the business and is cooperative, but often the owner is a third-party who wants something in exchange for his/her consent to the sale.

    Finally, the character of the assets and the actual assets should be evaluated. A “bulk transfer” of certain assets from inventory, for instance, often triggers a notice to creditors and can significantly delay the closing. Also, the assets should be checked against the seller’s depreciation schedule to verify that the principal assets have been identified. With a manufacturing, distribution or retail business, the buyer needs to make arrangements to take a physical inventory immediately prior to the closing. The final asset list should be attached as an exhibit to any sale agreement.

    (2) Employment and Labor Matters: Experienced businesspeople often state that a business’ most valuable “asset” is its employees. In a small acquisition, the buyer should request a list of all of the Seller’s employees, which includes each employee’s name, position/title, date of hire, and compensation. The buyer should also review copies of all agreements, contracts or commitments relating to each employee. The buyer should verify that the employment agreement has properly transferred to the employer all intellectual property created by the employees while they were working in the business. If not, the buyer must ensure that buyer obtains an assignment of these rights prior to the close of the sale.

    If there are certain key employees who are essential to the success of the business, the buyer may want to make the execution of a new employment agreement with these employees a condition precedent to closing. In such situations, sophisticated buyers go to great effort to align these employees’ interests with those of the buyer. This may entail holding back a portion of the purchase price to ensure that certain employees remain to smoothly transition the business to the new owners, or by structuring employee bonuses based upon future performance of the business.

    Owner-employees, after selling their business to the buyer, sometimes want to retire or pursue other ventures, either immediately after the sale or at some point thereafter. Since the owner-employee typically has special knowledge of the inner-workings of the business, the owner-employee would be a formidable competitor if the buyer’s new business were forced to compete against him or her. As a result, buyers often insist on obtaining a non-competition agreement from the owner-employee, which is generally an enforceable restriction in California in this context. Non-competition agreements should be carefully crafted and are often heavily negotiated to include or exclude certain types of businesses and geographical areas, and frequently place limits on soliciting vendors and employees. The buyer should start to formulate a list of proposed restrictions during the due diligence process, based upon the nature of the business being purchased and the business’ susceptibility to certain types of competition.

    (3) Financial Statements: The buyer should carefully review the seller’s most recent interim balance sheet and income statement, as well as the annual financial statements for at least the last three years. The buyer should also request the most recent accounts receivables aging report and the accounts payable ledger, particularly if the buyer is purchasing or collecting the receivables or assuming any of the payables as part of the proposed transaction. Remember to read all notes that are a part of the financial statements and ask a good accountant for guidance.

    (4) Basic Corporate Documents: The buyer should ask buyer’s counsel to review a seller’s basic corporate documents, including its articles of incorporation, by-laws and meeting minutes for the past several years. These documents reveal the rights and powers of the shareholders, directors and officers, and can often impact the operation of the business and the legal structure required to acquire the seller’s business. The meeting minutes may reveal problems and potential issues that were not disclosed by the seller, and give an insight into how frequently the seller’s officers and directors have come and gone.

    (5) Loans and Credit Facilities: The buyer should inquire as to the status of all outstanding loans, liens, mortgages, lines of credit, and other credit facilities, and whether each is in compliance with all loan covenants. Further, the buyer should request information as to the status of any credit accounts used by the seller and essential to the operation of the business.

    (6) Governmental Licenses, Permits and Filings: The buyer should determine whether the operation of the business requires any special licenses or permits. If so, the buyer should confirm that these licenses and permits can be transferred to the buyer as part of the sale. If not, the transaction may need to be restructured and/or conditioned upon the buyer’s receipt of the required permit or license.

    (7) Leases and Licenses: The buyer must obtain and analyze all existing real estate leases and personal property leases or licenses for terms that might be triggered by the purchase and sale. Lease agreements, for instance, routinely provide that a change in ownership automatically requires prior consent of the lessor, and the process of obtaining this consent often delays the closing and requires that payment or additional security be provided to the landlord. Be sure to request copies of leases and licenses early in the due diligence process.

    (8) Contingent Liabilities and Potential Claims: In addition to the liabilities shown on the financial statements, it is essential to identify and address all contingent liabilities and potential claims (“off balance sheet liabilities”). The buyer should ask the seller to disclose any litigation involving the seller, as well as any and all contingent liabilities or potential claims.

    Environmental: Liability for the cleanup of hazardous waste has been a hot topic for many years, particularly because liability can be imposed without actual knowledge of the environmental condition. Still, many buyers fail to adequately investigate the existence of hazardous substances at the seller’s place of business. The buyer should confirm that there are no pending or foreseeable environmental liabilities that will be imposed on the buyer as a result of the sale.

    (10) Customer Lists, Vendor Agreements and Pending Orders: Customer lists are usually proprietary and sellers often are unwilling to release the identity of their customers until the closing. However, the buyer should review pending customer orders and outstanding purchase orders to determine the business’ upcoming commitments. The buyer should also confirm that the seller’s principal customers and vendors will continue to do business with the buyer after the closing. In addition to requesting the foregoing information from the seller, the buyer may want to acquire additional information through the use of corporate search firms, credit bureaus, investigators and other consultants. Another invaluable tool is simply running an Internet search such as Google and combing through the results. You never know what you might find.

    The due diligence process may seem overwhelming, but is well worth the effort, as it will provide the buyer with invaluable clarity as to whether the business he or she is purchasing is a sound investment.

    by Jonathan B. Wolf, Esq. 

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