Due Diligence: A Smart Spin in Risk Allocation, Part 2.5 of 3

10/04/2011 02:51 pm ET | Updated Dec 04, 2011
  • Jim Thomas Lawyer for business/Steward for Colorado

I finished the 1990 Bob Cook Memorial Mount Evans Hill Climb on the wheel of that year's winner, Olympic road cycling gold medalist Alexi Grewal. The "hill" climbs 7000 feet in altitude in only 27 miles from Idaho Springs to 14,130 feet near the summit of Mount Evans, the mountain that dominates the Denver skyline. I was thinking about my accomplishment, and its relation to risk allocation in the buying and selling of businesses, recently as I watched the finish of the USA Pro Cycling Challenge, the first professional road stage race in Colorado since the Coors Classic ended in 1988.

Professional stage racing returns to Colorado with the USA Pro Cycling Challenge.

I'll get to your puzzled look in a minute. In the last two posts, I've said risk allocation is as important as valuation, and introduced the role played by warranties and representations in business sale risk transaction. I planned those as the first two of a three-post series that would culminate with indemnification as the ultimate risk allocation device, but on the finishing straightaway of Sunday's stage, I realized a flaw in my logic.

The best possible risk allocation comes from verifying facts so that enforcement of the contract is never necessary. "Trust, but verify" as President Reagan advised. In mergers and acquisitions, due diligence is an overused and misunderstood idea. Some folks say they have to "do" diligence, as if it was an item in an M&A checklist, instead of an integral part of the process. (It's also a song, but that's another story.)


A break-away that did not last.

Diligence, when done properly, is the job of both buyer and seller. Diligence should challenge the assumptions of a business transaction, from strategic goals and organizational fit, to facts about financial performance and the existence, or nonexistence, of liabilities. A seller conducts diligence on itself in order to cure (when possible) or explain (when not) matters that might otherwise get the seller sued. When post-closing performance by a buyer is a critical (for example, when a big chunk of the purchase price is paid in a note or in buyer stock), then the seller also has to check out the buyer.

The buyer's examination of the seller, what people think when they hear "due diligence," begins with a lengthy list of requested information as the buyer starts checking facts and checking under rocks. What it finds matters. It is much easier, and certainly less expensive, for a buyer to renegotiate a deal, or even walk away, than it is to enforce the buyer's risk allocation rights after closing.


You, like Levi Leipheimer, will play it smart for the ultimate win

So, where does my Mount Evans story fit in? It's true that I crossed that finish line right behind Grewal; however, if in good due diligence fashion you checked my registration, you would see that my racing classification started the race 30 minutes before him. The seller who reports a certain level of profits, but doesn't tell the buyer that the business pays substantially below-market rent under a lease that ends with the sale, is guilty of more than glory-days boasting. The buyer who uncovers that fact before paying an artificially high purchase price can smartly avoid risk by restructuring or passing on that deal instead of suing the seller afterward.