More than 20 years ago, I was General Counsel of a small software company. The CEO – a successful serial entrepreneur – was always looking for opportunities to acquire, or establish strategic relationships with, other companies. The CEO was creative in identifying opportunities, yet highly attuned to potential problems. He told me, “If you think it smells bad now, wait until you dig into it.“ I was recently reminded of his warning.
A client (“Client”) had signed a letter of intent to acquire a much smaller company (“Target”) and asked that I represent Client in the transaction. I sent a Due Diligence Request List to Target, and with its reply I had my first clues that Target might have some problems. Target’s initial responses were superficial and incomplete. I did not know whether the company was being evasive or was merely naive. Either way, it appeared that Target lacked a lawyer’s guidance.
I sent several e-mails specifying, point by point, exactly what we needed. In some instances, Target supplied detailed information – but the more information we received, the worse Target looked. For example:
- Target provided an incomplete stock ledger, share certificates (which the Bylaws required) had not been created, and Board meeting minutes did not specify the consideration for which shares had been issued.
- Target’s personnel included full-time independent contractors who should have been classified as employees and for whom taxes and other amounts should have been withheld.
- Target did not have agreements with those independent contractors, so the company did not own the work product the contractors had created.
- Target projected healthy cash flow during the coming year from existing clients, but there was a written agreement in place for only one of them.
Based on the partial information we had already received, I advised Client that the transaction was risky and that Target’s potential liabilities might even exceed the amount Client was planning to invest. Ultimately, Target was not able to clean up the problems, so Client elected to stop the transaction.
There are two audiences who would benefit from paying close attention to this story:
- Potential acquirers should use the “smells bad” test. Companies rarely look better once you see the details.
- Potential targets that do not have an attorney should retain one right away. It will take much more time to fix problems and complete due diligence than you imagine, and the costs of a failed acquisition are extraordinarily high.
Dana H. Shultz, Attorney at Law +1 510 547-0545 dana [at] danashultz [dot] com
This blog does not provide legal advice and does not create an attorney-client relationship. If you need legal advice, please contact a lawyer directly.