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Due Diligence Checklist

What is Due Diligence
Diligence is often performed by the potential buyer or investor on the business of the potential seller. Due Diligence could be considered an exhaustive review of all business documents and records in an effort to assess the health and viability of the business in question.
 
Due Diligence is permitted by the seller once one or more prospective buyers or investors have been identified. The identification of potential buyers is a role that is played by professional as Investment Banker or Investment Attorney. Due Diligence is often only permitted once the prospective buyers have signed a Non-Disclosure Agreement (NDA). The due diligence data room often contains copies of the most confidential data a company possesses.

The process of creating a Due Diligence Data Room will primarily be under the direction of a Legal Counsel at times assisted by attorneys. The lawyer/attorney you select to assist during the transaction and will provide you with an exhaustive list of all the documents which should be included in your due diligence data room (here is an example Due Diligence Checklist). The documents in the Due Diligence data room are often arranged by topic. Below is an overview of each Due Diligence data room category.

Financial Due Diligence.
The finance area is the most common section of the due diligence data room. This section contains not only the last two to three years historical financial records but also financial forecasts for the current year. Many companies would also include a 2-3 year financial forecast in the data room. Be careful not to forecast sales that are not realistic as terms of the sale may be tied to the successful achievement of the sellers forecasted revenue projections. These are called “earn outs”.

The due diligence check list contained on this web site is a good starting point for compiling the financial records that will be required for review by the prospective buyer/investor. The financial due diligence data contained in the due diligence data room is critical in the determination as to the value of the ongoing business. Any and all “other income” should be documented.

All tangible and intangible assets should have a corresponding legal due diligence.

Legal Due Diligence
The Legal Due Diligence section of the data room is frequently the largest section. It contains all the business legal documents as well as copies of all annual meeting minutes. The Legal Due Diligence should also contain a detailed explanation on ownership and owners of the company. Additionally, copies of all contracts and agreements should be in this section of the due diligence data room. If you company has intellectual property or patents, copies of all employee and company documents related to ownership of corporate intellectual property should be included in the legal due diligence data room.

Much of the content of the Legal due diligence data room section will be defined by the law firm that is assisting in reviewing the legal documents associated with the sale of the company. It is important that the legal due diligence section include any and all past legal documents that could reoccur as become issues in future. If you fail to disclose a relevant legal issue you could be at risk of a future law suit. All law suits by or against the company are listed along with their probable impact in future revenues.

Operational Due Diligence
The operational due diligence section of the data room should contain well documented overviews of the processes associated to the operation of the business. Business relationships, suppliers and distribution channels should also be clearly documented. The buyer/investor will be looking for areas of risk such as a single supplier that could affect ongoing success. Another area of concern would be an unbalanced sales distribution network where one channel has a disproportionate amount of channel sales.

The seller should also include a summary of their business plan in the due diligence data room with emphasis on the next 1-3 year business plan and how improved efficiencies, additional products, expanded distribution will increase revenue and net profit. This business plan should also be referenced in the financial due diligence section.

Another important data point for the due diligence data room is web traffic and the size of not only the customer database but also the size of potential customers in the email marketing database.

The prospective buyer may look for ways to eliminate expenses once the transaction is complete. The desire will be to identify changes that will result in an increase in EBITDA. Prospective buyers will also be interested in international operations and associated agreements.
 

IT and Intellectual Due Diligence
The IT Due Diligence data room area should include a detailed listing of all IT systems used in the normal business processes. If the company is a Software Development company or has developed any software for internal all of these programs should be documented in detail. Any use of third party software of software contracts should also be documented. Any use of “open source” software should also be included in the IT due diligence data room.

Any patents or trademarks should be included in this section of the due diligence data room. The company’s internet presence should be documented including information on ecommerce, web hosting and online customer records.

Procedure and overview documents should cover such topics as, security, backup procedures, controls, and auditing. Remember, the one of the objectives of the due diligence data room is to present enough information to remove any and all concerns a prospective buyer might have. Unanswered questions translate to undefined risk which translates to lower offers. A buyer that believes he has a COMPLETE understanding of all facets of a prospective business will have lower risk concerns and thus be more willing to submit an offer that is at the top end of his valuation model.
 

Personnel Due Diligence
Documents contained in the Personnel Due Diligence data room area should include an Org Chart of all management, a Bio/Resume for each executive, a resume on each critical employee (key developers, designers, programmers, etc.), wages and salary contracts for all executives and key employees. This section should also contain any and all HR, benefits, and compensation contracts and policies.

The Personnel Due Diligence area of the data room is often where issues arise that could potentially result in deal not closing. Some examples of “deal breakers” might include, unresolved sexual harassment issues, key management who might leave if salary and benefit programs are altered. Undocumented oral agreements on future perks or stock options that will be distributed after the acquisition.

Buyers will likely look for positions or division that could be eliminated to reduce operating costs. Care should be made to document and understand the value of each key person/department to ensure ongoing success of the business.

A Due Diligence Data Room is the place where your company places copies of the financial, legal and business documents that define the history and future of the company for prospective investors to review prior to submitting a formal offer.
 
A due diligence data room is accessed by potential buyers or investors after being approved by the seller and after having signed an Non Disclosure Agreement (NDA). The investment banker representing the seller is responsible for identifying viable buyers/investor, securing signed NDA’s and scheduling access to the due diligence data room information.

There are two types of Due Diligence Data Rooms: Traditional Due Diligence Data Rooms and Virtual Due Diligence Data Rooms.

Pro’s and Con’s of both of these types of data rooms exists and an evaluation should be done for creation of Data Room.


Greatest Risk for the Seller
The most important decision a Seller can make is selecting a good advisor to assist in navigating through the process. The worst thing a seller can do is focus too much time and energy on the construction of a due diligence data room and the selling process and by doing so, neglect the business resulting in poor sales and earnings during the process. The performance of your company during the sales process if the MOST IMPORTANT OBJECTIVE. The creation of the due diligence data room should be done with your general oversight but conducted by individuals not need to manage the day to day business. For this reason many have turned to a service provider to create the due diligence data room or an “easy to use” software solution that allows you to create a virtual due diligence data room with very little effort.

If your company is small or just getting started with very little history of sales, then you might be able to construct a due diligence data room on your own without impacting day to day sales performance. If you are hoping to sell your company or secure additional investment in excess of $1,000,000 you should definitely not risk constructing a due diligence data room by yourself. The small amount you pay to have your advisor or investment banker or a third party due diligence data room service provider create a professional due diligence data room for you will be more than be recovered at the end of the transaction.


The Seller’s Key Objective of the Due Diligence Data Room
The main objective of the due diligence data room for the seller is to:
Remove any concern the potential buyer or investor has in the viability and profitability of the company
Disclose all data required or requested by the buyer/investor to close the sale quickly
Present business records with emphasis on growth and future value to maximize the offer amount
Expose any “skeletons” up front in the most positive way possible before final valuation offers to minimize any potential downward trend in the offers
A Seller uses the due diligence data room to draw attention to the best attributes of the business to try to INCREASE the buyer’s/investor’s valuation of the business. A well constructed due diligence data room can increase the final valuation offer by several percentage points.

The Buyer’s/Investor’s Key Objective of the Due Diligence Data Room
The main objective of the due diligence data room for the potential buyer/investor is to:
Use financial data to arrive at Valuation Model
Determine any operational costs when can be reduced or eliminated
Identify and business data or trends that could be used to justify a lowering of the valuation offer
Identify any "skeletons" that will risk achieving future revenue or earnings projections
A Buyer/Investor uses the data in the due diligence data room to validate their valuation model and to identify anything that could risk future earnings thus providing a reason to LOWER his valuation offer.

In summary, the proper creation of a due diligence data room can be time consuming and potentially risk the day to day operation of the business if created by existing management. To maximize the benefit of a due diligence data room the owner should research and secure a software solution to utilize a virtual due diligence data room and hire an affordable third party to construct this due diligence data room.

List of detailed due diligence checklist which has been compiled from many years of M&A projects.
 
While this list is one of the most extensive and comprehensive due diligence checklists available for free on the internet, you should consult your lawyer and investment banker as they will likely have a few additional suggestions.

Due Diligence Checklist:  Table of Contents
General Company Data
Financial Information
Corporate Agreements
Legal Documents
Intellectual Property Rights and Product Information
Insurance Coverage
Litigation History and Documents
Employees & Human Resources (HR)
Environmental Matters
Tax Filings and Documents
Marketing and Customer Information
Internal Controls & Information Systems
Sales Operational Information
Support Services & Product Pricing

I. GENERAL COMPANY DATA
A list of each direct or indirect subsidiary of the Company.
 
Capitalization of the Company showing the number of authorized shares of each class or series of capital stock, the number of issued and outstanding shares of such stock, and the record owners of such shares.
Certificate [or articles] of incorporation and Constitution/bylaws of the Company, or articles of organization and operating agreement in effect.
Minutes of meetings of the Company’s stockholders or members, board of directors, or any committee thereof, for the last 3 years.
All agreements among stockholders or members of the Company relating to management, ownership, or control of the Company.
All documents entered into with respect to or related to any prior financings or equity issuances of the Company, including, but not limited to, Stock Purchase Agreements, Stockholders Agreements and Registration Rights Agreements.
All correspondence and agreements between or among the Company and the directors or officers of the Company relating to indemnity, employment, loans, or advances.
Stock books, stock transfer ledgers, and other stock records of the Company.
A list of options, purchase rights, and warrants issued by the Company specifying the name of the holder, the number of options, rights or warrants issued, the date granted, the option or purchase price, and the position of the holder with the Company, together with copies of option, right or warrant agreements.
An address list/bulleted speicifications of the locations of all land, buildings, and other improvements either leased or owned by the Company.
All material governmental permits, licenses or authorizations, and related correspondence, of the Company.
Other than customer contracts, any agreements with any federal, state, or local regulatory authorities to which the Company is a party.


II. FINANCIAL INFORMATION
Audited financial statements for each of the Company for the last three fiscal years, with the auditor’s opinion and all footnotes.
Un-audited financial statements for each of the Company for the most recent month or quarter end.
Comparision of last two (2) years forecasted budgets compared to actual performance.
Copies of the financial packages delivered to management and the Board of Directors of the Company during the past three (3) years.
Detail of capital expenditures for the last three (3) calendar years.
Receivables aging schedule.
All correspondence between the Company and the Company’s auditors for the last three (3) years.
The Company’s forecast projections for performance for the next three years.

III. CORPORATE AGREEMENTS
All agreements or documents relating to or evidencing borrowings (other than accounts payable incurred in the ordinary course) of the Company or any Subsidiary, whether secured or unsecured, including credit agreements, other senior debt agreements and instruments, surplus or other subordinated debt agreements and instruments, hedging or derivative agreements, guarantees and letters of credit.

Bank letters or agreements confirming any other lines of credit in favor of the Company or any Subsidiary.
All documents and agreements evidencing other financing arrangements to which the Company or any Subsidiary is a party or under which the Company or any Subsidiary is otherwise obligated, including sale and leaseback arrangements, capitalized leases, real estate and other installment purchases, make-whole agreements (or covenants) and guarantees.
 All acquisition agreements and related documents and schedules regarding the Company’s acquisition of its Subsidiaries.
 All documents relating to any material acquisition or disposition of assets by the Company or any Subsidiary in the last ten years (whether or not the Company or any Subsidiary retains the related property or assets).
 All material agreements encumbering real or personal property owned by the Company or any Subsidiary, including all mortgages, deeds of trust, and security agreements.
 All real estate contracts of the Company and each Subsidiary.
Deeds and title policies relating to any real property owned by the Company or any Subsidiary.
 All leases of real or material personal property (including computer leasing agreements) to which the Company or any Subsidiary is lessee or lessor or to which the Company or any Subsidiary proposes to become a lessee or lessor.
 All joint venture, partnership, or other management, operating, or consulting agreements relating to the Company or any Subsidiary.
All franchise, conditional sales contracts and consignment agreements to which the Company or any Subsidiary is a party.
 All agreements between the Company and its 20 largest customers, and a form (or forms) of any agreement typically used by the Company in provided goods or services to its customers, together with copies or descriptions of significant variations from such form (or forms) in the case of particular customers. All material customer purchaser orders.
 To the extent not duplicative, all agreements related to the distribution by the Company or its Subsidiaries of products in the ordinary course of business.
 All contracts under which the Company (or any of its Subsidiaries) has agreed to refrain from competing with any other person or entity or otherwise to refrain from engaging in any particular business activity (whether in a particular geographic area or otherwise).
 All contracts between the Company (or any of its Subsidiaries) and any affiliate. A written description of any oral agreement between the Company (or any of its Subsidiaries) and any affiliate.
 Any agreement providing for participation in the Company’s equity, other than options, rights or warrants.
 A list of any agreements to which the Company or any Subsidiary is a party that cannot be disclosed due to any non-disclosure covenant or agreement. relating to the Company or any Subsidiary, not otherwise described above, to which the Company or any Subsidiary is a party.
All material contracts
A list of the Company’s 20 largest customers and vendors, determined by annual revenues and expenditures, respectively.
Other than customer contracts, any agreements with any federal, state, or local regulatory authorities to which the Company is a party.

IV. LEGAL DOCUMENTS
A list of each direct or indirect subsidiary of the Company.
 
Capitalization of the Company showing the number of authorized shares of each class or series of capital stock, the number of issued and outstanding shares of such stock, and the record owners of such shares.
Certificate or articles of incorporation and bylaws of the Company, or articles of organization and operating agreement in effect.
 Minutes of meetings of the Company’s stockholders or members, board of directors, or any committee thereof, for the last 3 years.
 All agreements among stockholders or members of the Company relating to management, ownership, or control of the Company.
 All documents entered into with respect to or related to any prior financings or equity issuances of the Company, including, but not limited to, Stock Purchase Agreements, Stockholders Agreements and Registration Rights Agreements.
All correspondence and agreements between or among the Company and the directors or officers of the Company relating to indemnity, employment, loans, or advances.
Stock books, stock transfer ledgers, and other stock records of the Company.
A list of options, purchase rights, and warrants issued by the Company specifying the name of the holder, the number of options, rights or warrants issued, the date granted, the option or purchase price, and the position of the holder with the Company, together with copies of option, right or warrant agreements.
 An address list/bulleted speicifications of the locations of all land, buildings, and other improvements either leased or owned by the Company.
 All material governmental permits, licenses or authorizations, and related correspondence, of the Company.
 Other than customer contracts, any agreements with any federal, state, or local regulatory authorities to which the Company is a party.

V. INTELLECTUAL PROPERTY RIGHTS & PRODUCT INFORMATION
Schedule of all trademarks, service marks, trade names, copyrights and patents that relate to the products, services, operations or names of the Company.
 For each product presently or previously marketed, or presently being developed, by the Company or its Subsidiaries:
a) the name of each individual who performed work on the product, its documentation, and/or its enhancements and modifications;
b) the status of each such individual when the work on the product was performed and whether such individual signed an agreement with the Company assigning all rights in such work to the Company;
c) any and all information concerning the development of the product, including whether the product is based, in whole or in part, on any other product, public domain, open source or otherwise; and
d) any reviews or critiques of the product.
 All agreements concerning confidentiality, nondisclosure and assignment of inventions with employees, contractors, visitors or other parties.
Date of first use of all unregistered trademarks, and date on which copies of any material copyright first released to the public.
All documents concerning registration of trademarks and service marks, including registration certificates, applications, correspondence and searches, and the results of any trademark or service mark searches conducted by the Company.
 All documents concerning registration of patents, patent applications, and the results of any patent searches conducted by the Company.
 All R & D agreements, including agreements with independent contractors who participated in development of any product.
 All agreements and documents concerning assignment, purchase, sale or license of proprietary rights, royalties or maintenance, including patents, copyrights, trade secrets, and trademarks.
 Manual or other written documents detailing the procedures for maintaining the secrecy of trade secrets.
 Copies of all “End User License Agreements” associated with any products delivered.
 Copies of all escrow agreements or descriptions of escrow agreements relating to any computer source code.
 Blank form of end user agreements.
Documents relating to claims or disputes concerning products, services or proprietary rights owned or used by the Company.
 
Product literature distributed to the public over the last 2 years.
 Product maintenance logs and error reports for the last 12 months.
 A schedule of any exclusive rights granted by the Company.
 All agreements with computer on-line service providers and internet access providers relating to services or data provided by or to the Company.
 Copies of all agreements with third parties relating to the development of company products and software.

VI. INSURANCE COVERAGE
Description of each property, general liability, automobile, worker’s compensation, and umbrella liability insurance policy issued to the Company, specifying:
Name of insurance carrier(s)
Annual Premium
Coverage
Claims within the last 3 years
Self-insured retention, co-payment, or deductible
Whether the policies are “occurrence” or “claims made” policies.

VII. Litigation HISTORY & AGREEMENTS
A list of any litigation or judgments settled within the last 5 years in which the company was involved either directly or indirectly.
 A list of all pending or threatened litigation or administrative proceedings, inquiries, or investigations, including copies of petitions or complaints.
 A list of names and addresses of all legal counsel who are currently acting on behalf of the Company.
 A list of all consent decrees, judgments, injunctions, other decrees, orders, settlement agreements, arbitrations, and arbitration findings to which the Company is subject or bound

VIII. EMPLOYEES AND HUMAN RESOURCE
All management employment contracts, “golden parachute agreements,” severance agreements, consulting agreements, “stay” agreements, and agreements not to compete to which the Company is a party.
 All labor contracts, collective bargaining agreements, union agreements, and any consents, waivers or amendments.
 An organizational chart which lists the name and title of each divisional Vice President and Director. Include the number of direct reports by functional area under each Manager.
 A list of the executive employees of the Company, and employees of the Company whose total annual compensation is in excess of $100,000, including the dollar amount of each such employee’s total annual compensation.
 With respect to each employee benefit plan:
 a) copies of such Employee Benefit Plan and any related trust, insurance policy, annuity contract, or other funding vehicle;
 b) the most recent favorable determination letter or tax exemption letter issued by the Internal Revenue Service (“IRS”);
 c) all applications for IRS determination or tax-exemption with respect to which a favorable determination letter has not yet been received;
d) the most recent summary plan description and any subsequent summaries of material modifications;
 e) the three most recently filed Forms 5500, including all attached schedules;
 f) a description of the funding status and non-funded liability of each Employee Benefit Plan, including but not limited to executive compensation, severance pay, and retiree medical plans; and
g) all actuarial and financial reports prepared during the last three years with respect to such Employee Benefit Plans.
 
A summary of liability for termination payments to employees.
Copies of all bonus, severance, employee option and employee equity participation plans or agreements.
 Details of all other employee plans and arrangements that do not constitute Employee Benefit Plans.
 List of employees including both active and inactive employees employed by the company for the last three years.
 A description of any order or decree to which any senior executive of the Company is subject that does or could impact the business or the Company as currently conducted or contemplated to be conducted in the future.
 Discuss number of employees and average tenure.

IX. ENVIRONMENTAL MATTERS
A list of all environmental permits under which any facilities owned or leased by the Company operate.
 All written reports made in the last five years regarding any environmental testing or environmental matters affecting the operations or properties of the Company.
 All written estimates prepared in the last five years concerning future expenditures for environmental programs relating to the operations or properties of the Company.
 All notices and demands of environmental authorities relating to the operations or properties of the Company.
 All records regarding compliance history with environmental permits including air, water, waste, and sewer permits under federal, state, and local rules and regulations.
 Locations of any on-site hazardous waste disposal sites.
 Locations of any underground tanks and lines including those no longer used, specifying any history of spillage or leakage.

X. TAX FILINGS & RECORDS
All Unioun/federal, state, local, and other tax returns and reports filed by or on behalf of the Company for the last three fiscal years and for all open years.
 All information related to any audit of any return or report filed by or on behalf of the Company for the last five fiscal years or related to any pending audits or administrative or judicial disputes relating to taxes for any open periods.
 All tax allocation, sharing, or preparation agreements involving the Company
 Agreements which waive or extend the period for assessment or collection of any federal, state, local or other taxes.
 All ruling requests filed with the IT authorities relating to the Company.
 Any tax elections which may have a material effect on the Company.

XI. CUSTOMER AND MARKETING INFORMATION
Total customer counts by major product year for each of the last 3 years.2. Listing of any customer that constituted more than 1% of total sales during the last three years.
 Total number of web site visitors by month for the last 2 years
 Total number of product evaluation requests by month for the last 2 years.
 Discuss primary sales channels including Internet and reseller, as it pertains to the following:
 
For each of the Company’s products, discuss target customer and marketing strategy. How are sales efforts organized?
     a) Internet sales as a percentage of total sales, currently and over time
     b) Resellers as a percentage of total sales, currently and over time
     c) Number of resellers
     d) Structure of reseller agreements
     e) Resellers by geography
 
Describe how new business is generated and the process of entering into arrangements with the customer.
 Absent any significant sales expenditures, how does the Company drive:
Discuss the importance of individual customer relationships in the business; how are purchase orders processed (i.e., via the web/fax/mail)?
 Regarding market share, discuss the size of both the international and domestic market segments for which the company’s products are sold.
    a) Brand awareness
    b) Product upgrades
    c) New product introductions
 
List the company’s top competitors, their market share and how the company differentiates itself from each of these competitors including competitor products, market focus and pricing.
How does the Company’s customer base differ from its competitors?
 Who are the Company’s primary competitors?
 Does the Company have any strategic alliances or business relationships with other industry participants? How are they structured.

XII. INTERNAL CONTROLS and INFORMATION SYSTEMS
Generally describe the information systems used by the Company and how they compare with industry standards and the Company’s direct competition.
 Complete List of all Hardware and Software used to manage the business
Quantify the dollar investment made by the Company over the past three years with regard to its technology.
Describe the Company’s accounting and financial controls and MIS functions.
What MIS and technology expenditures will be needed in the future?
Generally describe the IT physical security as well as Internet IT security.
Determine how many security breaches the company has had as a result of hackers within the last 24 months and the extend of information lost or compromised.
 Identify What remote locations have secured or non-secured internet access to servers which contain corporate information.
 Identify which employees have “administrative” or “super-user” access to critical company files and databases. How many of those employees were terminated within the last 24 months.
 What is the backup procedure to secure critical business electronic records and databases.
 Are any records secured in an offsite or third party location?
 Does the company have a disaster recovery plan?

XIII. SALES OPERATIONAL INFORMATION
Breakdown of sales by channel (distributors, direct, e-commerce) by month for the last 3 years.
 Listing of top 20 resellers or distributors and revenue by reseller for the last 3 years.
 Written statement of annual revenue derived from new customers verses existing customers as well as revenue from new product sales verses recurring maintenance contracts for the last 3 years.
 If any revenue was a result of international sales include a written statement detailing the amount of annual revenue by country for the top 10 countries placing orders for each of the last 3 years.
 Provide information related to the Company’s planned new product releases (i.e., expected timing of release, related product and service margins and markets targeted).
 Discuss any new business the Company might have been awarded and comment on any business which may have been recently lost.
 Are there particular areas of the Industry that the Company would identify as significant growth opportunities?
 Discuss the Company’s major partnerships, if any, and how these help drive revenue growth.

XIV. SUPPORT SERVICES AND PRODUCT PRICING
Discuss the economics behind (1) Product fees, (1) license fees and (2) maintenance fees, (3) other revenue producing fees.
 Discuss current margins and growth in margins for (a) Products and (b) maintenance services.
 What pricing advantages does the Company have versus its competitors?
 Discuss the Company’s pricing strategy and contract terms.
 Describe the Company’s proprietary products, systems and technologies with specific reference to economics underlying the offering.
 How are upgrades delivered to the customer?
a) Are customers charged for upgrades or is this tied to a maintenance contract?
b) Are upgrades made available via the web, on a CD or both?
 
Does the Company perform any product customization? If so, discuss the economics behind this offering.
 Describe the Company’s support function. Is this 24/7?

 

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