Performing Due Diligence on Subject Companies During Reverse Mergers
Posted by Securities Attorney Laura Anthony | April 4, 2011 Tags: , , , , , , , ,

Due diligence is a critical component of structuring any business transaction. In a reverse merger scenario there are two sides to the due diligence equation. There is the due diligence performed by the private company merging with the public shell (“Public Shell”) and there is the performance by the shell company of due diligence on the private company (“Private Company”).

Successful Reverse Mergers

In order to successfully complete a reverse merger it is essential for the Public Shell to perform appropriate financial, legal, corporate, market, and management due diligence on the private company merging with the Public Shell. At the most basic level the Public Shell needs to satisfy itself that the Private Company has all information completed and ready to file its Super 8-K within 4 days of completing the merger, including having audited financial statements prepared by a PCAOB licensed auditor.

As far as due diligence is concerned, particularly from a functionality standpoint, understanding management’s reasons for going public, as well as knowing the extent of their knowledge regarding public company operations, is critical to success and timeliness. Investors typically do not invest in the horse, but rather the jockey.

Reporting Requirements

Post merger, the once private company will need to file quarterly, annual and periodic reports pursuant to the Securities Exchange Act of 1934, as amended, and must have the internal controls in place to ensure compliance with these reporting requirements. Hence, determining beforehand the qualifications of management is invaluable to ensuring a successful post merger operation.

Due Diligence Questions

Essential questions to be answered during the personal interview phase are set forth in the reporting requirements enumerated in Items 401 through 404 of Regulation S-K. From a fundamental business perspective, these Items will help current and future shareholders determine:

1. Is management competent?
2. How many years of experience in the industry do they possess?
3. Has management been successful in running the operation to date?
4. Does management understand the difference between running a private company verses the rigorous legal, investor relations and accounting demands of a public company?
5. Are there any legal roadblocks to future offerings or extremely detrimental disclosure items (i.e. bad boy provisions)?

Furthermore, the shell company’s due diligence should gain insight as to the ability of the private company, through management and/or hired professionals, to address and remain compliant with: Sarbanes Oxley, GAAP, Exchange Act reporting requirements, including yearly 10-K’s, quarterly 10-Q’s and periodic 8-K’s, Investor Relations, internal controls, Annual Report filings and annual meeting, as well as other basics concerning the general daily operational factors of a public company.

Review Corporate Books and Records

At the corporate level of the due diligence process the public shell needs to review basic corporate records to determine that the Private Company is in legal corporate good standing and has maintained adequate books and records.

Legal due diligence encompasses such things as ensuring loans by insiders have been documented, extensions on outstanding obligations have been memorialized and documented, title to ownership of assets (including intellectual property and real estate) is in the corporate name and if not, proper linking documents (such as a lease agreement or assignment) have been prepared and executed. Does the Private Company rely on a distribution network? Make sure it’s in writing. In short, legal due diligence involves crossing the T’s and dotting the I’s and is part and parcel with the auditor’s job.

Identifying Potential Legal Issues

In addition to the personal matters there also exist the typical concerns of pending or anticipated litigation issues. These issues include, but are not limited to, product liability; hazardous waste; real estate liens; employment discrimination suits; other environmental concerns and other legal issues that could have a “material” negative impact in the future.

As stated, where relevant to the particular private company, environmental issues are an extremely important legal due diligence point. Environmental laws and the gaining power of the Environmental Protection Agency make this a critical factor. Failure to ensure that appropriate Phase I and Phase II environmental reports are in order could lead to expensive future cleanup and litigation costs. Furthermore, it is suggested that any potential future liability be signed off on by the appropriate agency or authority.

Now to the most important due diligence matter: financial due diligence. If the target entity does not have or cannot obtain completed audited financial statements, prepared by a PCAOB qualified auditor in accordance with GAAP, there exists no rationale to move forward with the merger.

Audited Financial Statements

Financial due diligence is the key element in the due diligence process. The Public Shell Company should be meticulous in reviewing the financials, margins, inventory and equipment lists of the private company going public. In addition there may be patents, intellectual property and employee compensation agreements that need to be reviewed. The Public Shell should be comfortable with the footnotes as well as the line item financial statements.

Unforeseen Merger Issues

It must be understood that there are always going to be some sort of issues. However, the Public Shell Company’s objective is to address significant material issues via the due diligence process. By doing so the Shell Company enhances the probability of a successful reverse merger.

In summary, the due diligence process is designed to uncover material facts that may adversely impact the transaction. The process is not designed to destroy the deal but moreso to address key issues in order to strengthen the transaction and protect shareholders. Inversely, properly completed due diligence on the Public Shell Company to be acquired ensures that the merging Private Company reaps the benefits of a viable public entity by which to grow and enhance shareholder value.

Comprehensive, detailed and meticulous due diligence creates a foundation of integrity, authenticity and transparency on which a strong, operating public company can be built. The due diligence process can be time consuming, but it is most easily completed when all parties involved operate reasonably and professional cooperation is maintained throughout the due diligence process.

The Author

Attorney Laura Anthony
Founding Partner, Legal & Compliance, LLC
Securities, Reverse Mergers, Corporate Transactions

Securities attorney Laura Anthony provides ongoing corporate counsel to small and mid-size public Companies as well as private Companies intending to go public on the Over the Counter Bulletin Board (OTCBB), now known as the OTCQB. For more than a decade Ms. Anthony has dedicated her securities law practice towards being “the big firm alternative.” Clients receive fast and efficient cutting-edge legal service without the inherent delays and unnecessary expense of “partner-heavy” securities law firms.

Ms. Anthony’s focus includes but is not limited to compliance with the reporting requirements of the Securities Exchange Act of 1934, as amended, (“Exchange Act”) including Forms 10-Q, 10-K and 8-K and the proxy requirements of Section 14. In addition, Ms. Anthony prepares private placement memorandums, registration statements under both the Exchange Act and Securities Act of 1933, as amended (“Securities Act”). Moreover, Ms. Anthony represents both target and acquiring companies in reverse and forward mergers, including preparation of deal documents such as Merger Agreements, Stock Purchase Agreements, Asset Purchase Agreements and Reorganization Agreements. Ms. Anthony prepares the necessary documentation and assists in completing the requirements of the Exchange Act, state law and FINRA for corporate changes such as name changes, reverse and forward splits and change of domicile.

Contact Legal & Compliance, LLC for a free initial consultation or second opinion on an existing matter.

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