Any purchase of an equity interest in a private company in the United States requires the buyer to perform at least some due diligence on the company and the individuals who own the company. Perhaps the most basic information the buyer needs to determine is who owns the company.
Much company information is available from public sources, for example, whether a corporation is in good standing in the jurisdiction where it is registered or incorporated and who are its current officers and directors. In many countries, such as China, the identity of the owners of a company are part of the registration records maintained by the government, and these are available for inspection. In California, however, registration and periodic filings required for companies incorporated in California do not include ownership information. The identities of the owners of a non-public company, and the amount of capital they invested in the company, are therefore strictly private. This means that when performing due diligence on a non-public California corporation or limited liability company (LLC), information regarding ownership must be obtained from the company itself. Documents which record ownership for a corporation include board resolutions authorizing share issuances, share certificates, and stock ledgers. For LLCs, typically, the only document showing ownership is an LLC agreement or operating agreement.
Care should be taken to identify interests in the equity of the company that is not strictly ownership interests and therefore not identified in these documents. For example, an employee may have been granted the right to purchase equity in the company at some future date or upon the occurrence of some future event, and this right may only be documented in an employment contract.
Due Diligence Obstacles
Relying on the company to provide ownership information presents two basic problems. One is the common problem where corporate records are incomplete or poorly maintained. This may require the creation of new documents that properly record the company’s ownership. The other problem, which is always present no matter how good the company’s records are, is the buyer’s inability to check the accuracy of the company’s records against any public or objective source. One solution to this problem is to require the company and its owners to make representations and warranties in the share purchase agreement regarding the ownership of the company and the accuracy of the documents provided.
With this example, we can see why the due diligence process must be closely coordinated with the share purchase agreement drafting process. In order to protect the buyer, information requested and received in the course of due diligence must be correlated with specific representations and warranties in the purchase agreement. This way, the buyer can be protected in the event ownership or other vital information is discovered to be inaccurate after the closing of the share purchase.