One of the key aspects to enable a successful business acquisition is conducting legal due diligence, which is the process of examining the target business’s documents and information to identify potential risks.
Nearly half of business transactions fail due to issues found during the due diligence process. For this reason, as a seller, it is key to ensure all your documents and financials are accurate and in place to facilitate the transaction. As a buyer, you want to conduct a comprehensive due diligence process to verify the value of the business you will acquire.
Here, we’re going to discuss the role due diligence plays in M&A, its importance, and how to conduct it. Additionally, we will provide a checklist to ensure you have everything you need before buying a business.
What is legal due diligence in M&A?
In the context of M&A, the legal due diligence process is an in-depth inspection of the target business made to identify the company’s underlying risks and analyze its legal standing.
When doing due diligence, the purchasing party audits the multiple profiles of the company, including the financial, commercial, operative, and legal. By having a complete perspective of the business, the buyer can understand its true condition and make any adjustments to the price or other purchase terms.
Legal due diligence is typically conducted by an external M&A law firm appointed by the buyer, which will analyze key legal aspects of the the target business, including regulatory compliance, corporate documents, agreements, and outstanding litigation issues.
What is the importance of legal due diligence?
The purpose of due diligence is to reveal and minimize the impact of hidden liabilities. After this examination, the purchasing party will be able to make an informed decision and decide whether to withdraw from the deal or move forward, structuring a business purchase agreement that protects its interests.
In Mergers and Acquisitions or when making an investment, conducting due diligence is of the utmost importance for the following reasons:
- To verify the accuracy of the information by getting a complete and unbiased view of the business status and performance.
- To have clearer expectations regarding the worth of the company and the investment potential
- To determine whether the target company is under any risk, such as administrative fines, lawsuits, or a breach of legal requirements.
- To understand the role of existing commercial contracts in the company operations.
- To have more accurate pricing and be able to negotiate the purchase agreement’s representations and warranties, as well as closing conditions and indemnification provisions.
- To make required rectifications before closing the deal or identify measures to be applied after the integration.
- To understand any legal obstacles that impede a successful closing, such as any consent that must be obtained.
The legal due diligence process
Once the buyer and seller have initiated serious discussions for the business transaction, the buyer’s lawyer drafts the letter of intent, which is a document that sets the preliminary terms of the transaction, including the period for conducting due diligence.
The letter of intent should also include a confidentiality clause, which will prohibit the buyer from disclosing any sensitive information that is revealed during the transaction.
After signing the non-disclosure agreement, the buying party will request to the seller a list of documents for review. These documents are uploaded to a data room, which is a secure online space where the confidential documents are going to be stored and made available for the potential buyer.
The due diligence process occurs in the following way:
During this stage, the purchasing party defines the scope and objective of the inspection to outline the process to be taken. It sets a timeframe and the key elements to analyze.
An adviser should establish how much the client already knows about the target business and ask what are the buyer’s areas of concern.
Before stepping into this phase, the due diligence advisor will determine:
- A due diligence budget
- The scope of the process
- The specifications of the report
- A timeframe and schedule for due diligence
The buyer requests specific documents for review and a list of questions to be answered by the seller. This information is uploaded to the data room, and the buyer’s team prioritizes what information to review first, according to the complexity it implies to review them.
In the investigation phase, the attorneys and a team of qualified experts will review key documents, such as:
- Organizational documents
- Pending and potential lawsuits
- Intellectual property
For this, the team will prepare a due diligence checklist according to the needs of the transaction for the seller to send the requested documents. Nowadays, the data room is often virtual, and the seller decides who can access the data site.
Some of the typically required documents include information about real property, liens, contracts, leases, and more.
When reviewing the information, the buyer side will primarily ensure all the requested documents were provided and that the questions were satisfactorily answered.
The following are the areas to be assessed:
- Corporate information: Identify the company’s shareholders, operating agreements, and details on ownership interests or stock transfer records.
- Regulatory compliance: Ensure the business has the required licenses and permits, that it is tax compliant, and also follows the labor, environmental, and safety laws.
- Contracts: Determine what are the key agreements in which the company is involved, whether they are transferrable, and if they represent any liability. These include leases, commercial contracts, and employment agreements.
- Litigation: Research for any past or pending lawsuits, enforcement procedures, or disputes to understand the company’s culture and reputation.
Once the investigation is complete, all the findings will be compiled into a report that will cover the corporate, commercial, financial, legal, operational, and other areas of the business.
Backed by clear documentation, the report will include an in-depth summary of the findings, determine the value of the transaction, and expose potential issues.
The report also provides an analysis that defines what are the next steps or recommendations on whether to proceed with the transaction.
Either verbally or written, the results of due diligence will describe the reviewed documents, the most important discoveries, and recommendations.
Buy-side due diligence
In a business transaction, the most interested party in conducting due diligence is the buy side, since it is the one who wants to ensure the acquisition is a profitable investment.
Due diligence provides an accurate view of the business and helps the buyer make an informed decision before compromising his investment by entering into a binding agreement.
Sell-side due diligence
Even when it may not be a priority for a business seller, this party can also benefit from due diligence. As a seller, this process can help you identify the true value of your business and the aspects that could be deal-breakers.
Before adding investors or potential buyers to the picture, a business seller can conduct due diligence on the company to reveal underlying issues to be fixed before putting it on sale.
For example, by identifying the contracts the business is into, the seller can ask for the consent of the third parties to be reassigned. The seller can create a strategy to approach these issues and gain leverage before the acquisition starts.
How long does the legal due diligence process take?
The length of the due diligence process varies according to multiple factors. For small business acquisitions, the average duration of due diligence is two months.
The following are some of the factors that impact on the duration of the due diligence process:
- Deal structure: This process can vary depending on whether the business sale is structured as an asset sale or stock sale. In the latter, the process is going to require a more in-depth inspection, while in an asset sale, the audit may only demand to focus on specific assets.
- Industry: The industry of the target business impacts what licenses and regulations are needed.
- Size of the business: The bigger the business, the more complex the deal will be. The company will have more contracts and legal documents to be reviewed, which is why the due diligence process may take longer.
M&A Legal due diligence checklist
To verify the target company’s good standing, the following are some documents you should thoroughly review:
Organization and ownership
- Organizational documents, such as articles of organization, articles of incorporation, or bylaws
- Certificate of good standing
- Minute book
- List of officers and directors
- Organization chart
- List of current shareholders and their respective amount of ownership, dates of issuance, and type of consideration
- List of subsidiaries and other entities in which the company has an equity interest
- Operating agreements, corporate bylaws, or shareholders agreements
- Recapitalization or restructuring document
- Number of authorized shares for each class or series of stock
- Properties owned by the company
- Jurisdictions where the company is authorized to conduct business
- Last three years’ list of all pending, past, and current legal actions against the company
- Work health, safety, or environmental legal proceedings
- Issues under government investigation
- Governmental proceedings against the company
- Are there any liens or securities that may affect the transaction?
- Claims from customers, suppliers, and third-party entities
- Regulatory actions
- Analysis of potential antitrust issues
- Any consent decrees, injunctions, judgments, settlements, or other orders
- List of licenses, permits, and authorizations
- Compliance with FDA, CPSC, OSHA, and FLSA regulations, if applicable.
- Schedule of permit and license renewals and associated fees
- Automobile registrations
- No state of insolvency or bankruptcy
- Details on workplace safety and health programs
- List of hazardous substances
- Federal, state, local, and foreign income tax returns for the last three years
- Employment tax filings for the last three years
- Audit adjustments proposed by the IRS
- Copies of documents concerning any tax litigation proceedings
- Copies of the latest tax audits or revenue agency reports
- Service contracts
- Client contracts
- Contracts with suppliers
- Lease agreements
- Licensing or franchise agreements
- Insurance contracts
- Debt financing documents
- Loan agreements, bank financing agreements, or lines of credits to which the company is a party
- Copies of employee handbooks
- Files containing employee relations matters
- Employees’ non-disclosure, non-solicitation, and non-compete agreements
- Payroll documents
- Employment agreements
- Patents of the company
- Trademarks of the company
- Copyrighted products and materials
- Trade secrets
- Active websites and social media accounts
- General descriptions around proprietary know-how, trade secrets, technology, and processes
Legal due diligence questionnaire
In addition to reviewing the mentioned documents, the buyer can ask the following questions to the seller:
- Why do you want to sell the business?
- What are the assets included in the transaction?
- Are you willing to help during the transition?
- What is the organizational structure of your company?
- Is the company formally registered?
- Who are the company’s shareholders? What percentage of the company does each shareholder own?
- Who are the key members of your organization and what are their roles?
- Who are your board members?
- Can you show me the company’s most recent annual reports and minutes from board meetings?
- Are there any restrictions on transferring company equity?
- What is the dividend policy? How can it be changed?
- Are there any contracts that are necessary to run the business?
- What is the contract’s termination policy? Can the contracts be assigned?
- Does the business have any existing partnerships with other entities?
- In which locations does the company do business?
- Does the company need any permits or licenses to run the business?
- Has the company or any of its stockholders been involved in any litigation?
- What are your compliance programs and policies?
- Are there any loans, mortgages, or outstanding debts?
- What are the company’s intellectual property assets?
- How does the company protect its IP?
- What websites and domains do you currently own?
- What are the currently active software licenses?
- What are the company’s real estate assets?
- Do you own or have any leases on equipment?
- What are the company’s insurance policies?
- What are the safety and health regulations that the company needs to comply with?
- Can you show me the company’s federal, state, and local tax returns for the past three years?
- Are there any tax liabilities?
- Are there any pending tax audits or investigations?
- How many employees do you have?
- What are the terms of your current employment agreements? Are there any non-disclosure, non-compete, or severance agreements?
- What are the benefit plans, including pension, stock options, and retirement?
- Is there an employee handbook or manual?
- What is the turnover rate of the last three years?
Safe transactions and smooth acquisitions with Motiva Business Law’s due diligence services
Buying a business is a complex operation that requires paying attention to detail and following a strategic process that aligns with your personal and professional objectives.
Our due diligence services are an indispensable asset for ensuring a seamless business acquisition and safeguarding your interests. With our meticulous and thorough approach, we uncover potential risks, liabilities, and opportunities that may impact the transaction, allowing you to make well-informed decisions.
Our M&A attorneys will assist you during the transaction by:
- Guiding you throughout the business acquisition and helping you structure the deal
- Writing the letter of intent and outlining the preliminary terms of the transaction in your favor.
- Conducting due diligence and identifying underlying risks
- Helping you understand the true value of the target business and have clear expectations of its performance
- Negotiate the most favorable terms and write a purchase agreement that addresses the risks that were found
- Ensuring regulatory compliance and a proper transfer of contracts and licenses
Our expertise not only streamlines the due diligence process but also provides you with the necessary insights to mitigate risks and negotiate more effectively. By our side, you can navigate the complexities of M&A transactions with confidence, knowing that your interests are well-protected every step of the way.
Schedule a consultation at (630) 517-5529