Perfunctory Due Diligence Foils Buyer's Fraud Claim over Company Purchase

Posted on January 6, 2010 by Angela France

In reading the Virginia Lawyers Weekly Important Decisions of 2009, a Norfolk District Court case stood out as a reminder of the importance of a thorough due diligence examination by buyers in acquisitions of small and medium sized businesses and allocating risks in the purchase agreement. The buyer in the Norfolk case was an accountant and performed his own due diligence before his purchase of a Chesapeake accounting firm.  It is apparent from the reading of the decision, however, that the buyer did not discover all material information necessary to fully understand the target company before signing on the dotted line. Such due diligence failure and the absence of risk-shifting provisions in the purchase agreement cost him a substantial sum in the end.

The accountant in White v. Nicholas L. Potocska P.C. claimed that the Seller made misrepresentations during the negotiation of the deal which resulted in the loss of one of the firm’s largest clients after closing. Unfortunately for the buyer, his fraud claims against the Seller did not even survive to reach a jury. The Judge summarily dismissed the Buyer’s claims against the Seller based upon the accountant’s curtailment of his due diligence investigation prior to the discovery of material facts. The Court opined that the failure of the buyer to uncover certain items did not suggest fraud by the seller.

This case highlights the risks inherent in the due diligence process. In Virginia, the buyer is responsible for “every piece of paper” available to him in due diligence – even the needle in the haystack. It is interesting to note that the accountant in this case was described as “one of the most diligent prospective buyers” by a business broker who worked with him.  Perhaps the issues in this case had less to do with the accountant's "thoroughness" and more to do with the proper allocation of risks in the acquisition transaction documents.  As we often see, sometimes it isn’t practical or cost efficient to discover all potential issues in a limited amount of time.

So, how can a buyer reduce risk in an acquisition absent a lengthy, exhaustive due diligence investigation? The purchase agreement can be crafted to shift certain due diligence risks to the seller, and make clear that all parties are relying on the seller’s statements. Moreover, if client retention is a part of the purchase price to be paid to the seller, the parties can incorporate an earn-out into the purchase price formula based upon company’s revenue after the closing.

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Efficiently Managing Due Diligence in Acquisition Transactions

Posted on November 18, 2009 by Angela France

Are you or your company considering the acquisition of another business? If so, you will want to discover and analyze all material information necessary to fully understand the target company before signing on the dotted line.

Due diligence is one of the most risk-fraught elements of the transaction; however, it rarely receives the attention it deserves in acquisitions involving small privately held companies most often because of budgetary constraints.  You don’t need to skimp on this phase, though – the proper implementation and execution of a well conceived due diligence review can control costs and expenses, reduce risk, and maximize the value of your investment.

A due diligence review reveals more than just potential “deal killers” in the target, it provides information that will be useful for valuing the stock or assets of the target and defining representations and warranties in the final sales agreement. Otherwise, how will you confirm that the business is what it appears to be and is worth the asking price?

The key to effectively and efficiently managing the due diligence phase of an acquisition is to include the following organizational elements into the review process:

  • Prepare a Player’s List: Prepare a spreadsheet of contact information for each responsible person involved at the target company as well as your own team (i.e., address, telephone numbers, facsimile numbers and email addresses).
  • Organize a Due Diligence Checklist: Prepare and organize a comprehensive Due Diligence Checklist with items grouped together in categories and columns for the names of the responsible team members, notes and status of each items.
  • Assemble a Due Diligence Team: Assign a key staff member(s) to gather certain categories of documents. For example, make your accountant responsible for gathering and reviewing relevant financial documents and tax returns of the target company; chief operations manager responsible for gathering customer contracts; human resource manager responsible for gathering employee contracts and benefit information; etc.
  • Structure the Due Diligence Process: Develop key phases for specific tasks, such as, the gathering documents, including on-site and off-site review; conducting research on target’s organization, liens, and litigation; researching the target’s industry, competition, long-term prospects; meeting with key management of the target company; document review; etc.
  • Develop Milestones: Set reasonable deadlines for the review process with check points along the way to ensure complete and proper implementation of the due diligence process.

Due diligence should be approached as a business process in order to maximize the monetary benefits of the deal. Achieving success and efficiency in this phase of the transaction can be as simple as organization plus disciplined implementation.

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