One of the best things about a career in law is the opportunity to work with extremely gifted and experienced attorneys. I have had the great fortune to learn from many such individuals, but none have been as influential in my life over the years as George P. Shenas here in San Diego.

Although I left George’s firm in 2009 in order to pursue a start-up venture as co-founder, our relationship endured… so that I now have the pleasure of collaborating with him on occasion as co-counsel on certain corporate matters. We recently worked together on an M&A transaction which did not close, but that collaboration inspired me to post this three-part video series capturing an in-depth conversation we had on the importance of due diligence. I trust it will be of interest to any readers contemplating the sale of their company or the acquisition of another company.

For more informative videos that feature other guests, please visit GPS INC

- Marcus Klebe

Part 1 Information as Currency – Why a Seller Short-changes Due Diligence at its own Peril

George P. Shenas, Esq. hosts Marcus H. Klebe, Esq.

George asks Marcus about the importance of due diligence in M&A transactions, and Marcus begins by defining “due diligence” and then explaining how undertaking a systematic review of one’s own enterprise gives a seller leverage during subsequent negotiations. Marcus and George encourage the full and honest disclosure of facts, even unfavorable ones, as part of the process – the key is placing all facts in their proper context, and painting a comprehensive picture of the enterprise that will hold up under close scrutiny and yet secure the highest possible purchase price. Marcus emphasizes the need to maintain the buyer’s confidence throughout the due diligence process, because trust is an essential component to speedy and mutually-favorable negotiations. George and Marcus agree that any financial or other projections relayed by the seller at the outset of the M&A negotiations must be met, or preferably exceeded, during the weeks and months leading up to closing in order to avoid the risk of significant price erosion.

Part 2 Managing the M&A Process before the Process Manages You – Assembling the Data Room

George P. Shenas, Esq. hosts Marcus H. Klebe, Esq.

George engages Marcus in a detailed discussion of the use of virtual and physical data rooms to facilitate sophisticated M&A transactions. Marcus describes the nuts and bolts of the M&A due diligence process, specifically describing the way our law firm organizes information and manages disclosure of that information to the seller. George asks Marcus to explain why it might be in a company’s interest to compile the same information before even engaging in formal merger discussions with a third party. To illustrate better the practical application of due diligence principles, Marcus, speaking from experience, gives several concrete examples involving three different subject areas: intellectual property, material contracts, and financial data. By the time a seller gets to the stage of actually negotiating the purchase agreement, the parties have largely formalized their relative positions; accordingly, a savvy seller can stake out a much more favorable position as the formal document begins to take shape by understanding these due diligence principles and working with legal counsel from the very beginning. George emphasizes that a company’s financial data should be presented in a way that comports with industry-wide best practices, including compliance with accounting standards that are defensible when scrutinized by a buyer and their advisors.

Part 3 The Law Firm’s Critical M&A Role in Reducing the Seller’s Exposure to Liability

George P. Shenas, Esq. hosts Marcus H. Klebe, Esq.

George asks Marcus to describe, in concrete terms, the way that facts and circumstances which are revealed as a part of the due diligence process make their way into the definitive purchase agreement. Marcus explains the representation and warranties section of the purchase agreement, starting with a definition of “representation and warranties,” generally. George and Marcus discuss the practical ways that our law firm tries to reduce the overall exposure to liability on the part of the seller either on the closing date or after the transaction has fully consummated, including the use of qualifiers to the representations and warranties or the use of survival periods. The discussion concludes with advice gleaned from many successful M&A transactions: playing ‘hide and seek’ during the due diligence process doesn’t work – an honest, transparent and complete representation of the company’s condition, one which nevertheless aggressively presents the seller’s point of view, best preserves enterprise value and resists post-closing disputes. Good legal counsel is therefore critical to obtaining the right purchase price from the seller’s perspective.

John M., Anakam

John B., XCO Development

Bruce D., Growth Dynamics

Based on an informal (and admittedly very unscientific) survey I conducted with colleagues throughout the greater San Diego area and other cities, I estimate that, regardless of whether you are talking products or services, the ‘Great Recession’ has reduced net revenues anywhere from 10-40% for most companies.  Even to the extent that losses have been stemmed and companies remain profitable, a vast majority of companies have been forced to cut deeply into expenses and reduce overhead.  When experts talk about a “jobless recovery” they are referring to the fact that companies are not even considering replacing all the laid off employees, let alone growing payroll past historical highs, in the near future.  And it’s not just employees who are suffering – independent contractors, including outside counsel (!), are finding severely constricted demand for their services.

My sense is that the situation has largely stabilized at the current level and will remain so through 2010, but significant financial shocks are on the horizon.  While time constraints won’t let me discuss every reason underlying my suspicions, I do want to highlight the systemic risk posed by awful commercial mortgage lending practices in the United States.  The carnage that poor residential mortgage lending practices have wrought on Wall Street (eventually resulting in the federal bailout), will be replicated by the equally poor commercial mortgage lending practices on the part of regional banks.  Regional banks were fortuitously shut out of the residential mortgage market, but disastrously sought to replicate Wall Street’s short-term profits in a market where they do predominate, namely commercial mortgages, beginning a year or two after Wall Street started down this path initially.  As an aside, I will be posting more later on my own experiences with so-called Mortgage Backed Securities transactions.

Just consider the rising vacancy rates at your local indoor or outdoor mall, and then consider the mountains of debt that are being serviced by lease payment streams.  Already commercial borrowers are simply walking away from underwater properties in ever-growing numbers, leaving banks holding the bag.  These shocks will make it even harder for ordinary businesses to obtain loans or draw on lines of credit, financing of the sort which is instrumental to growth (and sometimes survival).  It doesn’t take an MBA to understand the risks, just an appreciation for numbers and statistics.

While my informal survey is interesting, I rely on experts to explain what is really happening, as well as what to expect.  I use this knowledge to shape the advice I ultimately give my clients, because corporate law can’t be practiced successfully in a bubble or ivory tower – I always seek to understand my clients’ specific objectives and reality-test the possible outcomes.  Part of the reality-testing process is conveying a true sense of the big picture.  One of the best sources of hard data I have found that is continuously updated is a blog called Calculated Risk which also puts the data into context and produces helpful graphs.

For example, a recent update shows the domestic “Capacity Utilization Rate for Total Industry” as of January 2010 at 72.6% — still far below normal and far below the pre-recession levels of 80.5% in November 2007.  This is the highest level for industrial production since Dec 2008, but production is still 10.1% below the pre-recession levels at the end of 2007.  Since there is plenty of slack in industrial production, this means that even if economic growth eventually pushes up production, capital investment and plant improvements (which accelerate growth in a virtuous cycle) won’t immediately follow.  The same update shows the domestic “Housing Market Index” (where any number under 50 indicates that more builders view sales conditions as poor than good) at 17 in February, an increase from 15 in January, whereby the record low was 8 set in January 2009.  This kind of data implies a long period of builder depression and underlines the fact that Southern California can’t rely on housing or construction to lead a recovery. 

This is all part of the abundant empirical evidence that San Diego has a long way to go to recover from the ‘Great Recession,’ and companies should continue to hope for the best and plan for the worst.

-        Marcus Klebe

Ivy G., HID Global Corporation

Please return often to this “News & Discussion” section of the website, as I will be offering not only general commentary on important legal developments, but also observations on business, the state of the economy and executive decision-making. I emphasize honesty and communication in my law practice, which is why this section endeavors to reveal significant aspects of my thought process and beliefs. Since I also believe that dialogue is an integral part of effective communication, I welcome comments from members of the business community and other attorneys, no matter where they might find themselves geographically.

If readers find the commentary thought-provoking and of some benefit to them, then I will have achieved two of my key objectives in creating this section.

- Marcus Klebe