October 25, 2022
In business acquisitions, a thorough legal review is a critical component of comprehensive due diligence. Review efforts should not just focus on commercial due diligence such as financials, strategy, human resources, customer concentration, supplier relationships, etc. A detailed legal review will open windows into how a business has been managed and what opportunities and risks will be awaiting a buyer post-closing.
Legal due diligence focuses on overall deal structure, legal compliance, and risks associated with compliance negligence. It involves a wholistic view of the diligence process that takes both the business and legal aspects of the company into account. Legal due diligence can unearth important issues during a transaction’s negotiation process, such as the need to allocate risk (through pre- or post-closing covenants or indemnification provisions) based on what has been discovered or even the need to adjust the transaction’s purchase price. Due to the varied and widespread nature of legal due diligence, it is common to have separate legal counsel conduct diligence on specialized aspects of the business such as tax, intellectual property, employee benefits, and real estate.
Engaging a good attorney or attorneys to perform legal diligence is important but not enough by itself. Both buyer and seller must stay closely involved to understand and manage the process.
A key outcome of the legal due diligence process are the disclosures that are required in connection with any representations and warranties made in the transaction’s definitive (purchase/sale) agreement. If it turns out (after the transaction closes) that a disclosure was missed, misrepresented, or that any of the representations or warranties are otherwise untrue as a result, the other party may be unhappy and could even bring a claim in court. It therefore pays to be thorough.
Let’s turn to some key topics on which to focus when conducting legal diligence. Note that the following is NOT meant to be a comprehensive list. Legal counsel should always be consulted when compiling the complete list of topics that will be relevant to a specific situation.
This category provides the basic information regarding a company and how it is governed, who owns it, who runs it, how it operates, and what the rights are between its equity holders. Be on the lookout for (1) any basic deficiencies in corporate set up (for example, more shares issued than properly authorized), (2) any transfer restrictions, preemptive rights, rights of first refusal, or option/warrant rights on the equity, and (3) the type or number of votes or consent required to approve the transaction, etc. Examples of documents to request:
• An organizational structure chart showing the company and all of its related owners and subsidiaries
• Organizational documents (certificates of incorporation, bylaws, stockholder agreements, voting agreements, buy-sell agreements, etc.)
• Minute books containing minutes of meetings of the directors or managers as well as the members or stockholders (or other equivalent of equity holders)
• Good standing certificates from every jurisdiction where the company operates
• List of the current officers and directors, stockholders, shareholders, partners, managers, or members
• List of where the company’s assets are located, its main office location, all of its leased or owned real property, and a list of all of its employees and independent contractors
Material agreements should give a good feel for basic economics of a company’s business operations and relationships with its customers and suppliers. Some key relationships may need to be handled with care in the course of a sale/acquisition in order to maintain them going forward. Be on the lookout for (1) change of control and assignment provisions which could prohibit contracts being moved to a new owner, (2) notice provisions, termination, and event of default provisions that could be triggered as a result of the transaction, and (3) non-compete or non-solicitation provisions and other relationship specific provisions like exclusivity or most-favored-nation clauses, etc. Fully-executed copies of documents are always preferred as those provide evidence of the binding nature of the contracts. Examples of documents to request:
• A list of the top customers and suppliers by amounts received/paid
• Copies of all standard form contracts that are used in the business
• Any joint venture or similar agreements
• Any contract that relates to a material capital expenditure, asset disposition, or acquisition of another business
• Any rental or operating lease agreements
• Any warranty or guarantee documents
• Any licensing, non-compete, or other similar agreements that set forth continuous future obligations
• A description of any related-party transactions and copies of relevant documentation for those relationships
• A description of all oral/verbal agreements and arrangements
Getting a good handle on the financial landscape and health of a company is one of the more straightforward aspects of the diligence process and is typically already extensively done early on in the pre-transaction timeline. Be on the lookout for (1) concerning levels of debt or overleveraging, (2) events of default that may be triggered as a result of the transaction, and (3) working capital needs, etc. Examples of documents to request:
• Copies of financial statements for the current year and recent past years
• All loan agreements and other documents relating to outstanding indebtedness of the company or any indebtedness secured by any asset or interests of the company
• All loan or other agreements between the company and any of its present or former shareholders, managers, or officers
• A list of any personal guarantees provided by any shareholder, officer, director, or manager of the company
• Copies of any UCC filing statements filed with respect to any assets of the company
• A list of the company’s available and drawn lines of credit and outstanding debt
A review of outstanding claims against a company and any prior claims will provide an idea of the company’s current exposure (both economically and reputationally) and potential exposure in the future that may hamper the success of the business. Be on the lookout for (1) any pattern among claims in which the company is a defendant, (2) the status of each outstanding claim, and (3) whether past claims have been settled or litigated, etc. Examples of documents to request:
• A summary of all outstanding or threatened litigation, claims, administrative, or regulatory proceedings or any governmental investigations or inquiries affecting or arising in relation to the business or operations of the company
• A list of all judgments, consent decrees, orders, rulings, settlement agreements, and any other orders or agreements to which the company or any of its officers, directors, key employees, or shareholder(s) is a party or is bound
• Copies of all reports, notices, or correspondence relating to any alleged violation of local, state, or federal law or infringement by the company or any of its officers, directors, key employees, or shareholder(s)
• Copies of all assessments, letters, findings, or reports created by or on behalf of the company that relate to the company’s compliance with applicable law in any jurisdiction, including laws that relate to health, safety, advertising, consumer protection, fraud, trade practices, and other laws applicable to the business
Reviewing employment materials allows for assessment of a company’s current employment practices and policies and can provide insight into the company’s management of its human capital. Be on the lookout for (1) employee misclassification or immigration issues, (2) current employee benefits and potential obligations related to them after the transaction closes, and (3) existing claims made by employees against the company, etc. Examples of documents to request:
• A list of all employees including name, date of hire, title, function, salary or hourly wage, and commission if applicable
• Any management or employee incentive plans
• All employment agreements as well as contracts with independent contractors and consultants
• Noncompetition agreements or severance agreements with any current or former employees
• Any collective bargaining agreements
• A copy of any policy, handbook, or other written communication outlining expectations or arrangements between employees and the company
Identifying the intellectual property in a business enables you to identify the importance and materiality of such intellectual property to the company. Some companies have a competitive advantage in their industry solely due to the nature of their intellectual property and related trade secrets. Be on the lookout for (1) any patents or trademarks, (2) revenue generated by products or services that incorporate the intellectual property, and (3) who owns the intellectual property used in the business, etc. Examples of documents to request:
• A list of all patents, trademarks, copyrights, trade secrets, domain names, or other intellectual property (whether registered or not) owned or used by the company
• A list and copy of all licenses of intellectual property that the company is a party to, either as licensee or licensor
• A list of the following: (a) all civil actions in which the intellectual property of the company has been involved or in which the company has been alleged to infringe another party’s intellectual property, (b) all proceedings in the United States Patent and Trademark Office or other administrative proceedings concerning intellectual property in which the company has been a party, and (c) each threat, claim, objection, protest, or inquiry received by or made by the company concerning the use or registration of any intellectual property
• A copy of all inventions, assignment, and confidentiality and/or nondisclosure agreements to which the company and/or its employees are a party
• Any intellectual property license agreements, both outbound (where the company licenses its IP to third parties) and inbound (where the company licenses IP from third parties)
Almost every company has at least one leasehold or ownership interest in a piece of real property. In some cases, the real property assets may require additional scrutiny if the business involves hazardous materials, industrial waste, and other similar substances or by-products that could raise environmental law issues. It may be useful to conduct an in-person inspection of the property as well, if possible. Be on the lookout for (1) deficiencies in title of the real property owned, (2) assignment or change of control provisions in lease agreements, and (3) liabilities related to environmental issues, etc. Examples of documents to request:
• Copies of all deeds and other documents or instruments related to title, including legal descriptions, title commitments, title policies, copies of underlying title documents, including easements and restrictions
• Copies of all leases, subleases, licenses, or other occupancy agreements (whether affiliated or non-affiliated) and all amendments and agreements
• Copies of any environmental reports, assessments, and investigations conducted with regard to the company’s properties
• Copies of any environmental permits, consents, approvals, authorizations, registrations, licenses, or qualifications necessary for any business operations conducted by the company or for any property owned or formerly owned, leased, or otherwise operated
• Copies of environmental, health, and safety compliance verification reports (compliance audits) and quality assurance documents
All of these items will need to be reviewed and addressed slightly differently in a stock versus asset transaction. However, once the transaction has closed, it is much harder to transfer liability back to a seller for something that wasn’t specifically spelled out in the definitive agreement.
The purpose of due diligence is not necessarily to find red flags. Rather, it is to draw conclusions on patterns of well-executed or poorly-executed details. These patterns help buyers structure the definitive agreement around important issues as well as prepare a post-acquisition game plan to manage certain risks. These patterns can also guide a buyer towards a “walk-away” decision.
Proper legal due diligence often spotlights deficiencies for which the buyer will need to either develop a pre-closing or post-closing plan for addressing.
Conducting diligence searches and weighing the importance of the results can be a time-consuming and expensive process. It cannot be rushed and should not be skipped. Plan accordingly and leave time to deal with surprises. Not completely understanding or ignoring potential risks is not a smart strategy.
If you are the seller, you should consider a certain level of pre-sale diligence as it really pays off by adding a level of certainty to the closing process. A good transaction advisor will systematically disclose all of this evidence (framing unfavorable information as an opportunity) in marketing materials, financial reporting, and other data-sharing events in order to limit the time, expense, and impact of undisclosed information on the time period between LOI execution and closing. Surprises in due diligence are the leading causes of downward re-trading and outright failure to close and should be avoided at all costs. Performing a pre-sale legal check-up – with your transaction advisor quarterbacking the effort – is a pro-level move that reduces uncertainty in the sale process.
If any of this resonates with you, we encourage you to take our M&A Discovery Questionnaire and talk with us to see if your business makes the cut as one who can still command a great exit in this M&A environment. We will be in touch quickly to discuss the results. Click here to take the assessment.
Gilbert & Pardue Transaction Advisors (GaP) is a Houston-based business advisory firm serving lower middle market and middle market business owners from coast to coast through representation for Mergers & Acquisitions (M&A).
Matt Gilbert and Bret Pardue established GaP to provide owners of lower middle market and middle market businesses – those businesses generally enjoying annual revenue of $10-$80 million – with the quality of M&A representation and value-enhancement services previously only available to upper middle and large businesses. GaP brings highly experienced executives, sophisticated financial and marketing products, proven-effective processes, and fully-integrated expertise to every engagement. No other M&A firm serving the lower middle and middle markets provides the quality of representation and transactional expertise that we do.