By Jeremiah E. Aneji Esq. MIDRP
Corporate Merger and Acquisition are viable tools of corporate expansion and stability. It has also aided the survival of several businesses by providing the much-needed resources and manpower to weather tough and unpredictable business terrains.
For a merger or an acquisition to attain its desired results, several factors are to be put in place and thoroughly examined with the aid and services of professionals so as to ensure the end processes inures to the benefits of all the parties/players involved. Where a merger or an acquisition led to a deterioration of fortune or final collapse of the merging entities, as we have witnessed severally, it would be said to have become counterproductive and purpose defeated.
To start with, before considering an offer/proposal for a merger or contemplating a take-over(acquisition), one must first carry out due diligence on the proposing entities or the entity sought to be acquired. This would also include a cursory look into the major players in the entities so as to ensure they are carried along the process to avoid any legal or future impediment that could have been easily avoidable with some hindsight.
In Merger and Acquisition, due diligence cannot be overrated as it forms the basis upon which players in the process can make an informed decision on the viability of the project in question. It is key to the entire process and can influence the outcome/performance of the merging project, during and after the post- merger. Due diligence lays the foundation upon which all such scheme of arrangement and compromise are drawn from, hence its utmost relevance to the whole process.
Haven elucidated on the role of due diligence in the merger and acquisition process, we shall in the course of this work, be drawing up a checklist which are key to making an informed decision in a merger and acquisition project, particularly in the context of the Nigerian Corporate Regulatory framework.
In tackling this subject, we shall consider the following:
- Defining the Concept of Due Diligence
- When to commence due diligence in a Merger and Acquisition Scheme.
- What to be on the Lookout for In Exercising Due Diligence.
- THE CONCEPT OF DUE DILIGENCE
Due diligence is a broadly used term across multiple disciplines, particularly in the legal and corporate realms. In the context of business, it refers to the investigation performed by an interested party, including venture capital and private equity firms, into a merger or acquisition target or to vet companies for potential investments.¹
As already mentioned in the introductory part of this work, The due diligence period is also a time for acquirers to learn more about a target company’s products, prospects, value and how it will mesh with their companies or portfolios. Failure to perform adequate due diligence may result in an overvaluation, missed opportunities for synergies and integration difficulties. It allows an acquirer to identify and assess risks, liabilities and business problems in the target company before finalizing the transaction, potentially avoiding losses and bad press later on.
- WHEN TO COMMENCE DUE DILIGENCE IN A MERGER AND ACQUISITION SCHEME.
Due diligence is often introduced via a Letter of Intent (LOI). An LOI is a document outlining the intent of both parties, rules of the negotiation period and the basics of the final deal. While the letter of intent signals that a buyer is serious about a potential purchase, it is often not legally binding. Instead, negotiations are conducted in good faith. The exception is when parties include terms that specify, or could be construed as specifying, that the companies are legally bound.²
The Letter of Intent (LOI) in M&A is a written, non-binding document which outlines an agreement in principle for the buyer to purchase the seller’s business, stating the proposed price and terms. The mutually signed LOI is required before the buyer proceeds with the “due diligence” phase of acquisition³
- WHAT TO LOOK OUT FOR IN CONDUCTING DUE DILIGENCE.
In conducting due diligence of the nature on a Merger and Acquisition project, the services of professionals are often invalidated ranging from corporate solicitors, financial advisors, experts, assets valuers, auditors. On this part of the work, we shall acknowledge and place reliance on the work of Richard D. Harrroch & David A. Lipkin on 20 Key Due Diligence Activities in a merger and acquisition transaction⁴ which had been made adapted to the Nigerian Context. The common questions to be answered in clear certainties are categorized in the order below:
- Diligence On Financial Matters – In a proposed merger or acquisition project, the target company often advance its financial prospects as becomes a major factor in its bargaining power. The buyer will be concerned with all of the target company’s historical financial statements and related financial metrics, as well as the reasonableness of the target’s projections of its future performance. (citation) In doing this the following inquiry would become necessary:
- What do the company’s annual, quarterly, and (if available) monthly financial statements for the last three years reveal about its financial performance and condition?
- Are the company’s financial statements audited, and if so for how long?
- Do the financial statements and related notes set forth all liabilities of the company, both current and contingent?
- Are the margins for the business growing or deteriorating?
- Are the company’s projections for the future and underlying assumptions reasonable and believable?
- How do the company’s projections for the current year compare to the board-approved budget for the same period?
- What normalized working capital will be necessary to continue running the business?
- What capital expenditures and other investments will need to be made to continue growing the business, and what are the company’s current capital commitments?
- What is the condition of assets and liens thereon?
- What indebtedness is outstanding or guaranteed by the company, what are its terms, and when does it have to be repaid?
- Are there any unusual revenue recognition issues for the company or the industry in which it operates?
- Are the capital and operating budgets appropriate, or have necessary capital expenditures been deferred?
- Does the company have sufficient financial resources to both continue operating in the ordinary course and cover its transaction expenses between the time of diligence and the anticipated closing date of the acquisition?
- Technology/Intellectual Property – The buyer will be very interested in the extent and quality of the target company’s technology and intellectual property. This due diligence will often focus on the following areas of inquiry:
- What domestic and foreign patents (and patents pending) do the company have?
- Has the company taken appropriate steps to protect its intellectual property (including confidentiality and invention assignment agreements with current and former employees and consultants)? Are there any material exceptions from such assignments (rights preserved by employees and consultants)?
- What registered and common law trademarks and service marks does the company have?
- What copyrighted products and materials are used, controlled, or owned by the company?
- Does the company’s business depend on the maintenance of any trade secrets, and if so what steps has the company taken to preserve their secrecy?
- Is the company infringing on (or has the company infringed on) the intellectual property rights of any third party, and are any third parties infringing on (or have third parties infringed on) the company’s intellectual property rights?
- Is the company involved in any intellectual property litigation or other disputes(patent litigation can be very expensive), or received any offers to license or demand letters from third parties?
- What technology in-licenses does the company have and how critical are they to the company’s business?
- Has the company granted any exclusive technology licenses to third parties?
- Has the company historically incorporated open-source software into its products, and if so does the company have any open source software issues?
- What software is critical to the company’s operations, and does the company have appropriate licenses for that software (and does the company’s usage of that software comply with use limitations or other restrictions)?
- Is the company a party to any source or object code escrow arrangements?
- What indemnities has the company provided to (or obtained from) third parties with respect to possible intellectual property disputes or problems?
- Are there any other liens or encumbrances on the company’s intellectual property?
- Customers/Sales – The buyer will want to fully understand the target company’s customer base including the level of concentration of the largest customers as well as the sales pipeline. Topics of inquiry or concern will include the following:
- Who are the top 20 customers and what revenues are generated from each of them?
- What customer concentration issues/risks are there?
- Will there be any issues in keeping customers after the acquisition(including issues relating to the identity of the buyer)?
- How satisfied are the customers with their relationship with the company? (Customer calls will often be appropriate.)
- Are there any warranty issues with current or former customers?
- What are the sales terms/policies, and have there been any unusual levels of returns/exchanges/refunds?
- How are salespeople compensated/motivated, and what effect will the transaction have on the financial incentives offered to employees?
- What seasonality in revenue and working capital requirements does the company typically experience?
- Material Contracts – One of the most time-consuming (but critical)components of a due diligence inquiry is the review of all material contracts and commitments of the target company. The categories of contracts that are important to review and understand include the following:
- Guarantees, loans, and credit agreements
- Customer and supplier contracts
- Agreements of partnership or joint venture; limited liability company or operating agreements
- Contracts involving payments over a material dollar threshold.
- Settlement agreements
- Equipment leases
- Indemnification agreements
- Employment agreements
- Agreements imposing any restriction on the right or ability of the company (or a buyer) to compete in any line of business or in any geographic region with any other person (Covenant in Restraint of Trade).
- Real estate leases/purchase agreements, deed of assignments, sales agreements etc.
- License agreements
- Powers of attorney
- Franchise agreements
- Distribution, dealer, sales agency, or advertising agreements.
- Non-competition agreements.
- Union contracts and collective bargaining agreements.
- Contracts the termination of which would result in a material adverse effect on the Company
5. Employee/Management Issues – The buyer will want to review a number of matters in order to understand the quality of the target company’s management and employee base, including:
- Management organization chart and biographical information
- Summary of any labor disputes
- Information concerning any previous, pending, or threatened labor stoppage. d. Employment and consulting agreements, loan agreements, and documents relating to other transactions with officers, directors, key employees, and related parties
- Schedule of compensation paid to officers, directors, and key employees for the three most recent fiscal years showing separately salary, bonuses, and non-cash compensation (e.g., use of cars, property, etc.).
- Summary of employee benefits and copies of any pension, profit sharing, deferred compensation, and retirement plans.
- Compliance with the pension requirement under the Pension Reform Act.
- Compliance with the Nigerian Social Investment Trust Funds(NSITF) for employers.
- Plans relating to severance or termination pay, vacation, sick leave, loans, or other extensions of credit, loan guarantees, relocation assistance, educational assistance, tuition payments, employee benefits, workers’ compensation, executive compensation, or fringe benefits
- What agreements/incentive arrangements are in place with key employees to be retained by the buyer? Will these be sufficient to retain key employees?
- Litigation – This should be undertaken by a legal expert. It should take an overview of any litigation (pending, threatened, or settled), arbitration, or regulatory proceedings involving the target company is typically undertaken. This review will include the following:
- Filed or pending litigation, together with all complaints and other pleadings.
- Litigation settled and the terms of settlement
- Claims threatened against the company
- Consent decrees, injunctions, judgments, or orders against the company.
- Insurance covering any claims, together with notices to insurance carriers
- Matters in arbitration.
- Pending or threatened governmental proceedings against the company
- Tax Matters – This should be handled by a legal or corporate tax consultant. Tax due diligence may or may not be critical, depending on the historical operations of the target company, but even for companies that have not incurred historical income tax liabilities, an understanding of any tax carryforwards and their potential benefit to the buyer may be important. Tax due diligence will often incorporate a review of the following:
- Federal, state, local, and foreign income sales and other tax returns filed in the last five years.
- Personal Income Tax Remittance for Employees under the Nigerian PAYE system.
- Copies of any correspondence or notice from any foreign, federal, state, or local taxing authority regarding any filed tax return (or any failure to file).
- Tax Holidays and Waiver Agreements under the Companies IncomeTaxAct, the Finance Act, 2021, Pioneers incentives, Investment Incentives etc that lowers or height the tax obligations of the target company.
- Arears of penalties arising from taxes
- Correspondence with taxing authorities regarding key tax items
- Settlement documents with the Federal Inland Revenue Service or the state revenue collection agencies and other government taxing authorities
- Antitrust and Regulatory Issues – The parties must watch out for the implication of the recently passed Federal Competition and Consumer Protection Act (FCCPA) as it relates to restrictions on scheme with intent to stiffen competition. To attain this one must ask the following questions
- If the buyer is a competitor of the target company, understanding and working around any limitations imposed by the company on the scope or timing of diligence disclosures
- Analyzing scope of any antitrust issues under the FCCPA.
- If the company is in a regulated industry that requires approval of an acquisition from a regulator, understanding the issues involved in pursuing and obtaining approval (Corporate Affairs Commission, The Security and Exchange Commission and the Regulator of the specific sector like the Central Bank of Nigeria for banks, the National Communications Commission (NCC) for the Telecommunication Industry).
- Confirming if the company has been involved in prior antitrust or regulatory inquiries or investigations
- General Corporate Matters – Counsel for the buyer will invariably undertake a careful review of the organizational documents and general corporate records (including capitalization) of the target company, including:
- Letter of Good standing from the Corporate Affairs Commission (CAC) where necessary.
- Memorandum of Association and Articles of Association (MERMART).
- List of subsidiaries if any and their respective Memorandum of Association and Articles of Association (MERMART).
- The Directors and Shareholders of the Company (Status Report)
- Indirect Holder of Significant Interest in the company.
- Creditors of the company. g. Lists of all security holders (common, preferred, options, warrants)
- Stock option agreements and plans, including both standard documents and any deviations therefrom.
- Governmental Regulations, Filings, and Compliance with Laws – The buyer will be interested in understanding the extent to which the target company is subject to and has complied with regulatory requirements, including by reviewing the following:
- Documents showing any certification of compliance with, or any deficiency with respect to, regulatory standards of the company(Where into drugs FDI, Standard Organization of Nigeria(SON), National Agency For Food and Drug Administration and Control (NAFDAC))
- Material governmental permits and licenses required to carry out the business or operations of the company or its subsidiaries currently in force
- Information regarding any of the company’s permits or licenses that have been canceled or terminated
11. Property. A review of all property owned by the target company or otherwise used in the business is an essential part of any due diligence investigation, with such review including deed of assignments and other relevant materials
Due diligence is key to enable parties weigh their options in any merger and acquisition-related project. The services of experts are needed to ensure all the boxes are checked and that concerns raised are addressed at the earliest possible time. The Duration of the due diligence does not in any compare to the advantages of making informed decisions on any prospective merger so as to avoid the avoidable pitfalls and foreseeable liabilities.
This article is for information purpose, it may, or may not reflect the current position of the law and is therefore not intended to provide legal advice or guidance on litigation or provide commentary on any pending case or legislation.
1 Due Diligence Explained: Advantages, Types and Processes: Megan O’Brien Megan O’Brien: https://www.netsuite.com/portal/resource/articles/financial-management/due-diligence.shtml Accessed on the 5/1/2023.
4 Richard D. Harrroch & David A. Lipkin on 20 Key Due Diligence Activities in a merger and Acquisition Transaction: https://www.academia.edu/resource/work/40988261 accessed on the 5/01/23