Due Diligence Best Practices and Pitfalls

1. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 1 Firmex Webinar Series M&A Master Class November 17, 2011 1:00 p.m. to 2:00 p.m. Andrew J. Sherman, Esq. Jones Day 51 Louisiana Avenue, N.W. Washington, D.C. 20001-2113 202-879-3686 ajsherman@jonesday.com Art or Science? Due Diligence Best Practices and Pitfalls #firmexmc

2. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 2 About Firmex Firmex is focused on providing the best virtual data room solution for managing corporate transactions and financial compliance Who uses Firmex? •Firmex community includes over 125,000 users worldwide •Conducted over 10,000 deals in the last 18 months Why offer an M&A Master Class? •As part of our value-added service, we believe it is important to offer educational resources to our expanding community Joel Lessem CEO Firmex

3. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 3 Andrew J. Sherman Mr. Sherman is a partner in the Washington, D.C. office of Jones Day with over 2,500 lawyers worldwide. He is the author of 23 books on business growth, capital formation and the leveraging of intellectual property. His eighteenth (18th) book, Road Rules Be the Truck. Not the Squirrel. (http://www.bethetruck.com) is an inspirational book which was published in the Fall of 2008. He has appeared as a guest and a commentator on all of the major television networks as well as CNBC’s “Power Lunch,” CNN’s “Day Watch,” CNNfn’s “For Entrepreneurs Only,” USA Network’s “First Business,” and Bloomberg’s “Small Business Weekly.” He has appeared on numerous regional and local television broadcasts as well as national and local radio interviews for National Public Radio (NPR), Business News Network (BNN), Bloomberg Radio, AP Radio Network, Voice of America, Talk America Radio Network and the USA Radio Network, as a resource on capital formation, entrepreneurship and technology development. He has served as a top-rated Adjunct Professor in the Masters of Business Administration (MBA) programs at the University of Maryland for 23 years and at Georgetown University for 15 years where he teaches courses on business growth strategy. He has served as General Counsel to the Young Entrepreneurs’ Organization (YEO) since 1987. In 2003, Fortune magazine named him one of the Top Ten Minds in Entrepreneurship and in February of 2006, Inc. magazine named him one of the all-time champions and supporters of entrepreneurship.

4. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 4 What Is “Due Diligence”? • Due diligence is both an art and a science • Proper due diligence involves: – Knowing where to look – Knowing what to ask – Knowing what tools to use – Knowing who to ask – Knowing how to test premises/answers – Knowing who should ask – Knowing how to verify

5. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 5 What Is “Due Diligence”? (Cont’d) • The “Art” of Due Diligence: – Understanding how to extract key information from a person or situation – Understanding the objectives of the parties and the underlying transaction – Identifying key hurdles and risks – Identifying why information might be falsified or omitted – Targeting the proper sources for disclosure of information

6. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 6 What Is “Due Diligence”? (Cont’d) • The “Science” of Due Diligence: – Do your homework – Be prepared and well-organized – Be precise in your requests – Be persistent in your quest for the truth – Don’t accept the first answer as the final answer – Trust your gut – “if it’s too good to be true …”

8. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 8 Due Diligence and Current Events • Impact of 9/11/01 Attacks • Impact of Dot.com failures and Enron • The era of Sarbanes-Oxley • Subprime Crisis • The Madoff and Stanford scandals • Overall global recession and financial system woes Bottom Line: We are in an era where everything and everyone must be questioned and answers verified

9. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 9 Dealing With Due Diligence Surprises Walk/Run AwayWalk/Run Away Purchase Agreement Amendments and Protections (Hold backs, R+W’s, Indemnifications, Escrows, etc.) Purchase Agreement Amendments and Protections (Hold backs, R+W’s, Indemnifications, Escrows, etc.) Purchase Price Adjustments (or Terms) Purchase Price Adjustments (or Terms) IgnoreIgnore Cost R i s k

10. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 10 Due Diligence Best Practices • Work as a team, but have a clear quarterback/captain • Designate a primary point of contact for each party to the transaction • Conduct regular team meetings to compare notes and coordinate carefully • The more you know, the better questions you can ask • Be organized – set timetables and deadlines for deliverables • Use industry experts early and often • Use technological tools available to you (search engines, data rooms, etc.) • Develop penalties/consequences/remedies for non-compliance • Understand why a party may be trying to hide key facts or circumstances • Question everything – BE INQUISITIVE!

13. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 13 Overview of the Due Diligence Process • Goal: Objectively prove or disprove the investment thesis: – Can it be operated better? Synergies? – Why own this business? • Intrinsic value: Determine the intrinsic value based on cash flows – Validate/negate assumptions • Levels: 3 levels of Due Diligence – Strategic and operational – Legal and regulatory – Financial

14. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 14 Importance of Due Diligence • Ability to determine whether or not to complete the transaction • Ability to successfully negotiate the deal terms • Assess in advance the ability to successfully achieve the desired post-closing business objectives • A necessary prerequisite to a well-planned acquisition though the process can be tedious, frustrating, time-consuming and expensive Avoid Surprises!

15. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 15 Purpose of Due Diligence • Provide information to assess risks and transaction requirements • Understand the target business completely • Surface issues early on to identify deal breakers • Create a platform for a successful transaction • Note that while buyer should resist the temptation to conduct a hasty "once over" (either to save costs or to appease the seller), at the same time it should avoid "due diligence overkill," keeping in mind that due diligence is not a perfect process

16. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 16 Key Objectives of the Due Diligence Process • Allocate discovered risks between the parties • Address particular issues in representations, warranties and indemnification • Restructure original terms of the transaction based upon due diligence • Adjust the purchase price • Adjust the payment terms • Include escrows and holdbacks • Change the legal structure of the deal • Terminate the transaction • Risk Allocation Options – Indemnifications – Escrows/Holdbacks

17. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 17 Due Diligence Teams • Due Diligence Team: The purpose is to assemble a multi- disciplinary team – Attorneys – Accountants • Accountants can help give the team ammo to re-negotiate the deal – Investment bankers and advisors – Operational personnel, including technology personnel – Lenders – Don’t forget specialty consultants (tax, intellectual property etc.)

18. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 18 Common Due Diligence Mistakes Made By The Buyer • Mismatch between the documents provided by the seller and the skills of the buyer's review team. It may be the case that the seller has particularly complex financial statements or highly technical reports which must be truly understood by the buyer's due diligence team. Make sure there is a capability fit. • Poor communication and misunderstandings. The communications should be open and clear between the teams of the buyer and the seller. The process must be well orchestrated. • Lack of planning and focus in the preparation of the due diligence questionnaires and in the interviews with the seller's team. The focus must be on asking the right questions, not just a lot of questions. • Inadequate time devoted to tax and financial matters. The buyer's (and seller's) CFO and CPA must play an integral part in the due diligence process in order to gather data on past financial performance and tax reporting, unusual financial events or disturbing trends or inefficiencies. • The buyer must insist that its team will be treated like welcome guests, not enemies from the IRS!

19. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 19 Business Issues In Due Diligence • Industry - Macro Factors – Growth rates – Cyclicality – Adoption rates – Elasticity • Business Model - specific to company – Understanding its products, services, niche, "reason for being" • Growth factors – Barriers to entry – Competitors

20. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 20 Business Issues In Due Diligence (Cont’d) • Customers • Suppliers – Distribution/how, and who controls? – Pricing – Regulations – Strategic relationships – Brand recognition • Are there areas where investors/buyers can add value beyond?

21. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 21 Business Issues In Due Diligence (Cont’d) • Management/Human Resources – Appropriateness of background – Track record of success – Honesty (Background check?) – Strengths/Weaknesses/Holes – Sense of teamwork – Compensation/employment contracts – Incentives (monetary and/or equity) – Entrepreneurial v. large co. culture – Operational v. strategic – Arrangements (related party)

22. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 22 Business Issues In Due Diligence (Cont’d) • Other shareholders – Who are they? – Can you work with them? – Incentives? – Are their goals aligned with yours? • Special rights? – Financial

23. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 23 Business Issues In Due Diligence (Cont’d) • Historic review • Recasts • Projections (reliability) – Information systems • Physical Plant, Property and Equipment – Appropriateness – Leased versus owned a Replacement value – Projected capital expenditure requirements

24. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 24 Analyzing the Business Issues In Due Diligence • In conducting due diligence from a business perspective, you are likely to encounter a variety of financial problems and risk areas when analyzing the target company. These typically include: – undervaluation of inventories or weakness of backlog/customer orders or lack of loyalty – overdue tax liabilities – market trends unfavorable (margin on demand shrinkages/erosion, highly competitive, lack of growth in demand, etc.) – inadequate management information systems

25. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 25 Analyzing the Business Issues In Due Diligence (Cont'd) – incomplete financial documentation or customer information – related-party transactions (especially in small, closely held companies) – an unhealthy reliance on a few key customers or suppliers (concentration issues) – aging accounts receivable – incomplete financial documentation or customer information – unrecorded liabilities (for example, warranty claims, vacation pay, claims, sales returns and allowances) – an immediate need for significant expenditures as a result of obsolete equipment, inventory or computer systems

26. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 26 Industry/Market Review • Key problems facing the industry • Market Characteristics • Financial results of comparable companies • Importance of technology, trademarks, licenses and other intellectual property • Impact on the industry of governmental regulation • Competition

27. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 27 Financial Review • Activities that would disallow contemplated accounting treatment • Accounting Policies and Procedures • Revenue Recognition • Profit Margins/trends • Interim Operating Results • Backlog • Related Party Transactions • Debt, Cash flow and Banking Relationships • Budgets and Projections

28. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 28 Operational Review • Management: Strengths and Weaknesses • Internal Control Structure • Facilities • Compensation and employee benefits • Information systems

31. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 31 Logistics of Due Diligence • Before we understand the sources of data for the process of due diligence, it is important to understand certain logistics • The buyer's lawyer should coordinate the due diligence process so that target receives only one set of diligence requests, rather than repetitive requests from the various advisors (e.g., accountants and bankers). • Even if accountants or other specialists are also performing due diligence, the buyer's lawyers should be responsible for at least reviewing and cataloguing all items in a data room unless explicitly told to not review certain items.

32. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 32 Logistics of Due Diligence (Cont’d) • The target's lawyers should control the due diligence process at least to the extent that they receive copies of all materials that are forwarded to the buyer. Also, the target's lawyers should conduct their own due diligence review of the target, particularly if they have not historically represented the company, to ensure the accuracy of the representations and warranties and schedules.

33. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 33 Logistics of Due Diligence (Cont’d) • When distributing a due diligence request list, the buyer's lawyer may wish to also distribute the draft representations and warranties so that the target can compile information which is responsive to the diligence request and is necessary to prepare schedules to the acquisition agreement.

34. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 34 Sources Of Information • Review Public Information • Due Diligence Request Lists • Site visits/Management Meetings • Industry specific professionals • Experienced peers • Interviews: clients, vendors, competitors • Investigators • Abandoned and Failed Deals 34

37. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 37 Virtual Data Room • Print and Access Features – Enable to disable printing of documents – Enable or disable the ability to view a document – “Confidential” Options • Audit – Customized reports show date, document, time and print activity • Maximum Reach – All users are more productive and efficient – office, road or home – 24/7 availability • User Friendly – No orientation necessary

38. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 38 Virtual Data Room – Sell Side Advantages • Reduced Transaction Time – Serious bidders identified early in process – Deal closes sooner – No scheduling conflicts – No travel delays • Detail Audit Reports – Follow footsteps of each user – Easily identify documents that have not been viewed • Confidentiality – Users never bump into one another – Security protocols insure confidentiality

39. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 39 Virtual Data Room – Buy Side Advantages • Target Risk Assessment – Easy access to target information for due diligence review of company and industry • Negotiations – Centralized catalogue of documents for negotiation key issues • Post-Closing Document Integration – Documents are easily accessible to various department for review and integration

41. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 41 Due Diligence Checklists – Key Issues The buyer's acquisition team and its legal counsel gather data to answer the following a variety of key legal questions during the legal phase of due diligence: 1. What legal steps will need to be taken to effectuate the transaction (e.g., director and stockholder approval, share transfer restrictions, restrictive covenants in loan documentation)? Has the appropriate corporate authority been obtained to proceed with the agreement? What key (e.g., FCC, DOJ) third-party consents (e.g., lenders, venture capitalists, landlords, key customers) are required? 2. What antitrust problems, if any, are raised by the transaction? Will filing with the FTC be necessary under the pre-merger notification provisions of the Hart-Scott-Rodino Act?

42. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 42 Due Diligence Checklists – Key Issues 3. Will the transaction be exempt from registration under applicable federal and state securities loans under the "sale of business" doctrine? 4. What are the significant legal problems or issues now affecting the seller or that are likely to affect the seller in the foreseeable future? Are there any FCPA, DCAA, or other regulatory investigations pending or threatened? What potential adverse tax consequences to the buyer, seller, and their respective shareholders may be triggered by the transaction?

43. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 43 Due Diligence Checklists – Key Issues (Cont’d) 5. What are the potential post-closing risks and obligations of the buyer? To what extent should the seller be held liable for such potential liability? What steps, if any, can be taken to reduce these potential risks or liabilities? What will it cost to implement these steps? 6. What are the impediments to the assignability of key tangible and intangible assets of the seller company that are desired by the buyer, such as real estate, intellectual property, favorable contracts or leases, human resources, or plant and equipment? 7. What are the obligations and responsibilities of the buyer and seller under applicable environmental and hazardous waste laws, such as the Comprehensive Environmental Response Compensation and Liability Act (CERCLA)?

44. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 44 Due Diligence Checklists – Key Issues (Cont’d) 8. What are the obligations and responsibilities of the buyer and seller to the creditors of the seller (e.g., bulk transfer laws under Article 6 of the applicable state's commercial code)? 9. What are the obligations and responsibilities of the buyer and seller under applicable federal and state labor and employment laws (e.g., will the buyer be subject to successor liability under federal labor laws and as a result be obligated to recognize the presence of organized labor and therefore be obligated to negotiate existing collective bargaining agreements)? 10. To what extent will employment, consulting, confidentiality, or noncompetition agreements need to be created or modified in connection with the proposed transaction? In other words, legal due diligence will focus on the potential legal issues and problems that may serve as impediments to the transaction as well as shed light on how the documents should be structured.

45. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 45 Critical Success Factors Do: • Involve an experienced, dedicated team with clearly defined roles • Discuss potential deal breakers early and often • Insist on full access to target • Be persistent and skeptical • Plan for sufficient time to complete the project • Develop a Day 1 plan

46. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 46 Potential Problems to Avoid Don’ t: • Exclude experienced legal counsel • Agree on contract details too quickly • Rush due diligence • Assume the deal is done until it is actually closed • Be afraid to walk away from the deal before it is closed. Remember that the key objective of due diligence is not just to "confirm that the deal makes sense" but rather to determine whether the transaction should proceed at all, recognizing at all times that there may be a need to "jump ship" if the risks or potential liabilities in the transaction greatly exceed what the buyer anticipated.

48. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 48 Book Winners! • P. Freidman, SSM Health • M. Moretto Crosbie & Co • M. Kulik, Braff Group • K. Benson, Presidio Group • C. Polson, Vercap Congratulations! We will be following up shortly to get your book preference and mailing address.

49. ©COPYRIGHT 2011. ANDREW J. SHERMAN. ALL RIGHTS RESERVED 49 Thank You Next M&A Master Class is Dec 8th, 1pm Eastern Rubber Hits the Road Ensuring Success in Post-close Integration The easy part’s done – now make your investment work. Alarmed about post-close integration failure rates? How do you increase your chances of retaining key clients, partners and staff? Where can redundant processes and excess costs be cut? Learn practical tips for building successful post-merger integration program and avoid a deal disaster. www.Firmex.com/company/events Today’s Recorded Webinar, Slides, and Complementary Checklists will be made available in a follow-up email shortly.

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Due Diligence Best Practices and Pitfalls

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