January 11, 2006

Virtual Data Rooms: Changing the Face (and Place) of Due Diligence

Chris Hofstad and Steve Fenlon practice in mergers and acquisitions and corporate law at Faegre & Benson. They may be reached at chofstad@faegre.com or sfenlon@faegre.com.

Merger and acquisition deals are moving faster than ever, with less and less time to wrap up due diligence before a transaction closes. As a result, more and more sellers are trading in the sometimes awkward use of physical data rooms – dominated by three-ring binders, bankers boxes and filing cabinets – for virtual data rooms, where documents can be searched and retrieved with a click of a mouse.

Virtual data rooms have done more to accelerate the pace of M&A deals than any innovation since the fax machine and the advent of e-mail. For sellers, they keep the pressure on buyers to move quickly and reduce the risk of merger discussions leaking to competitors or the media. For buyers, virtual data rooms provide access to a huge range of information quickly and efficiently. The advantages are so significant that physical data rooms may soon become little more than war stories told around the lunchroom by an older generation of dealmakers.

Data Rooms – Physical vs. Virtual

A data room is a comprehensive collection of important contracts, reports and other information regarding a company’s business, finances, history, structure, ownership, taxes, contracts, regulatory matters, litigation and benefit plans, just to name a few. When selling a company, particularly in an auction, a seller compiles a data room to provide this much-needed information to potential buyers, to help them assess the market opportunities, risks, and economic value of the target. Through a well run data room, a seller can provide organized and efficient access to information, while meeting the seller’s disclosure requirements under state and federal securities laws.

Physical Data Rooms – The Days of Old

In the old days – no more than two or three years ago! – organized sellers built their data rooms with rows and rows of three ring binders. (Less organized sellers forced buyers to stumble through boxes, file cabinets or worse.) Sellers often would house these paper collections of due diligence information in cramped, windowless conference rooms, usually located at lawyers’ offices or in nearby hotels. Buyers and their advisers would then travel to the data room to sift through the due diligence information manually, driven forward by the need to finish before the seller forced them out to make room for the next buyer, and motivated by endless supplies of coffee, doughnuts and pizza.

Virtual Data Rooms – The Wave of the Future

Today, many sellers forgo a physical data room in favor of a virtual data room on the Internet. Virtual data rooms are "built" by scanning documents into electronic files, which are then organized, indexed and posted on a secure website. The website becomes the electronic equivalent of a physical data room. A seller can build and host a virtual data room on its (or its legal counsel’s) network or it can engage a third party to do so. Potential buyers and their advisers can then "visit" a virtual data room from anywhere in the world.

Advantages and Disadvantages of Virtual Data Rooms

Advantages to Sellers

+ The biggest advantage to a virtual data room for most sellers is the ability to let multiple potential buyers view due diligence information simultaneously. In the old days, a seller had to stagger visits to its physical data room, adding weeks to a deal’s timeline. While a seller could operate several physical data rooms at once, this was a costly and logistically challenging alternative. The ability to permit simultaneous viewing in a virtual data room lets a seller accelerate the pace of an auction, while also maintaining the interest and focus of multiple buyers until one candidate emerges as the lead horse later in the race.

+ The time constraints and inefficiencies of a physical data room seldom work to a seller’s advantage to the degree many sellers believe. Giving potential buyers sufficient access to information and appropriate time to analyze it can actually assist a seller in the long run. Well informed buyers often are less inclined to drag their feet in negotiations, as they race to complete follow up due diligence behind the scenes. Buyers who enjoy thorough due diligence often include smaller holdbacks in initial offering prices, put less pressure on a seller to give broader than market representations and warranties, and are more relaxed when negotiating indemnification parameters.

+ Unlike physical data rooms, where buyers cannot be left alone, a seller does not need to host and supervise viewers of a virtual data room (or pay its lawyers to do so).

+ A virtual data room lets a seller audit, down to the page level, the information reviewed by potential buyers (including what, who, when and how long they looked at an item). This can help a seller identify areas of particular interest, sensitivity or concern and get a jump on creating a strategy to address them. This also can help a seller determine which potential buyers are the most interested in the deal, which have lost interest, and which are only feigning interest to stay in the game for strategic reasons.

+ A seller can control viewing and printing rights and vary them from buyer to buyer and from phase to phase in a deal. This lets a seller keep key information confidential until the seller is ready for disclosure and then to disclose it only to those that the seller chooses. This also can help a seller comply with regulatory concerns, such as in the antitrust area. Also, if a seller wants to cut off a specific buyer’s access, it can do so almost instantly.

+ Additionally, a virtual data room provides a record of the information disclosed. This feature is particularly useful if litigation ensues and the seller needs to prove that proper disclosure occurred, or if concerns arise over misuse of confidential information.

Advantages to Buyers

+ A virtual data room is open 24/7. Potential buyers can access the due diligence information anytime, anywhere (office, home, or Internet cafe). Subject only to the pace of the deal, potential buyers can spend whatever time is necessary to understand the items that interest them the most.

+ A virtual data room saves buyers travel time and expenses, along with the other costs associated with sending a team of lawyers and other advisers to a physical data room.

+ Buyers seldom send all of their advisers (e.g., experts in environmental, employee benefits, tax, etc.) to a physical data room because of concerns over time and cost. In contrast, a virtual data room lets all of a buyer’s advisers efficiently access information relevant to their area.

+ Most virtual data rooms have a search function that lets buyers search the entire "room" for key words or phrases. For example, a buyer can quickly target key environmental information by searching for "pesticides" or "asbestos."

+ After closing, many buyers elect to keep the virtual data room up and running as a depository for significant documents and other information frequently accessed by its personnel, including its transition team.

Disadvantages to Sellers

- Cost and security are the concerns cited most often by sellers. However, as discussed below, advances in technology may be rendering those concerns obsolete.

- If a seller permits printing of the information in a virtual data room, it loses some of the control that a virtual data room can provide. However, most sellers ultimately agree to provide photocopies, even in physical data rooms, thereby creating the same loss of control.

Disadvantages to Buyers

- Many viewers still prefer to review documents in paper form. Anecdotally, and much to the dismay of proponents of virtual data rooms, some individuals will print most of the data room’s content at the outset of their review (assuming the seller has not disabled the print function), which can be a tedious and expensive exercise. Even if the seller disables the print function initially, a seller usually reverses course if a serious buyer insists. The fact is that most viewers, other than specialists who need to review only small portions of the virtual data room, can analyze the entire data room more quickly on paper (in part by eliminating the delay in clicking from page to page and document to document).

- Security measures and segmentation in some virtual data rooms can make them cumbersome to navigate.

- The electronic format of a virtual data room makes it more difficult for a potential buyer to assess the volume of information to be reviewed and to estimate the time and personnel needed to complete that review. Most of us still find it easier to judge the scope of the task by looking at the size of a stack of boxes, rather than by knowing the number of gigabytes that a virtual data room occupies.

Other Considerations

Cost

In the infancy of virtual data rooms, costs were determined by the number of pages, number of viewers, selected security features, number of weeks available for viewing and similar factors. Today, costs have come down, and many providers essentially charge by the page. Much of the cost is in the initial scanning of documents and in building the site. Beyond that, computer server space for the site is fairly inexpensive.

It can be hard to estimate the cost of a virtual data room for a seller, as few sellers (or their advisers) can predict how many "pages" a virtual data room will hold when completed. Nonetheless, to greatly generalize, a virtual data room for a middle market deal with two to seven big boxes of documents often costs approximately $8,000 to $23,000.

This cost is incurred at the start of a deal, long before a seller knows if interested buyers will exist. Therefore, sellers can be reluctant to commit to a virtual data room. However, the cost of a virtual data room can be more than offset by less apparent cost savings over the physical version. Those savings include photocopying costs and the substantial expense of hosting and supervising the physical data room.


Security

Other than cost, security typically is a seller’s biggest concern. A data room holds a seller’s most confidential information. To address this concern, virtual data room providers have developed a variety of security features, such as:

  • displaying documents, or sensitive pages, in "read only" format to prevent printing;
  • putting watermarks on printed documents to let a seller trace any printed version back to the individual who printed it;
  • requiring that viewers enter and re-enter passwords and usernames regularly;
  • click-through confidentiality and non-use agreements; and
  • electronic "tokens" that display a continuously rolling access code (viewers access the virtual data room by entering the rolling code currently displayed on the token, along with a confidential personal identification number).

Virtual Data Rooms – The Future is Here
Sellers need to move their deals quickly, and buyers need easy and efficient access to information. While compelling advantages and disadvantages exist with regard to virtual data rooms, the accelerating pace of deals means that they are here to stay.

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