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Due Diligence
When buying or selling any asset including a business, you will normally
carry out a due diligence investigation. When entering into any business
agreement, you may wish to perform a due diligence investigation to confirm
that the other party is capable of doing when it represents, for example,
that a prospective joint venture partner has the personnel with the ability
to perform its part of the bargain. Due diligence is an investigation
to ascertain that what is being presented is accurate. For example, in
purchasing a used automobile, due diligence may consist of paying a mechanic
to inspect it for major, common problems. When selling a high-priced asset,
due diligence usually is limited to verifying that the purchaser has the
financing to meet his obligations and is otherwise capable of following
through with the purchase. Often due diligence requires the hiring of
experts - lawyers, accountants, environmental engineers, management specialists,
sales specialists, regulatory specialists - to conduct various aspects
of a due diligence investigation.
In addition to performing due diligence before buying or selling an asset
or entering into a significant business arrangement, due diligence is
often done to avoid liability under the securities laws. When offering
investment securities for sale, those offering the investment for sale
are vouching for the truth of the description of the investment. You are
subject to great liability for any misstatements in the offer or sale
of security investments. The law does impose upon you an affirmative duty
to ascertain the truth of what you are saying about the investment. Thus,
you have an affirmative duty to conduct a thorough due diligence investigation
of the business you are selling an opportunity to invest in. If later
the business does not do well and the value of the investment goes down,
then you could defend against certain claims of fraud by showing that
you engaged in a thorough due diligence investigation of the business
and the investigation could not have been reasonably able to discover
the facts that ultimately led to the business's difficulties. These securities-defending
due diligence investigations are most often done before the initial public
offering of a business's securities, usually involve larger businesses,
are done mostly by lawyers and accountants and cost hundreds of thousands
of dollars. The areas investigated are basically the same as the investigation
done when purchasing a privately held business described below.
The most common due diligence investigation performed consciously as a
formal due diligence investigation is that done before purchasing a business.
You the investor want to confirm that the seller's representations about
the business are true. You will need to investigate every aspect of the
business. This investigation differs from the securities-defending due
diligence investigation in that you can use greater judgment in foregoing
parts of the investigation in order to save money and because you are
confident a particular aspect of the investigation will not reveal anything
unknown. You will, however, be taking a risk that you the purchaser alone
will bear. You cannot take such risks in securities defending due diligence
investigations since you have an obligation to the investors that the
facts of the business are as stated. Similarly, in purchasing a business
as part of a coalition, you will have to talk with your partners before
taking such risks. In general, due diligence is more important when purchasing
high-value, new, or high-technology businesses.
The due diligence investigation conducted in purchasing a business will
include an investigation and review of the following areas and documents:
1. The company's organizational records including:
a. Articles of organization and amendments
b. Secondary governance documents such as by-laws
c. Proceedings of shareholders, directors, partners, etc.
d. Records and ledgers reflecting equity interests
e. Qualification to do business in foreign jurisdictions/states
f. Good standing certificates
g. Tax status
h. Equity interest in other entities, subsidiaries
2. The company's financial records including:
a. Debt instruments
b. Security interests
c. Investments
3. The company's property ownership records including:
a. Real property records to include encumbrances, title reports, local
ordinances reflecting restrictions on use of real estate
b. Equipment and other personal property records
4. The company's litigation records including assessments of potential
litigation
5. The company's environmental matters including records and risks of
cleanup expenses and environmental litigation (usually done by an environmental
engineer).
6. The company's licenses, permits and regulations governing them.
7. The company's management including:
a. Employment contracts
b. Consulting contracts
c. Salaries/Salary Revisions
d. Employee or Related Party Transactions
8. The company's employee matters including:
a. Organizational structure
b. Benefit plans
c. Equal employment opportunities
d. Occupational Safety and Health Matters
9. The company's intellectual property including:
a. Schedule of intellectual property
b. Intellectual property filings
c. Intellectual property licenses
10. The company's business practices including:
a. Sales and distribution procedures
b. Product liability procedures
c. Standard form purchase orders and sales orders
d. Sales representatives
e. Product warranty procedures
f. Significant contracts
11. The company's production and sales including:
a. Products and quality
b. Production methods and processes
c. Engineering and Research
d. Controls
e. Facilities
f. Industrial relations
g. Verification of accounts receivable
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