Legal Due Diligence

Before entering into a business transaction, it is crucial for parties to get to know each other better to avoid unnecessary risks and ensure fair conditions. This investigative process is called legal due diligence.

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What is Legal Due Diligence?

Legal due diligence involves the examination and analysis of relevant information concerning a party and its business. It is a necessary step in any transaction, but particularly crucial in mergers, acquisitions, investments in a business, or when entering into a licensing agreement. The goal is to enable parties to make informed decisions about the relevance and manner of proceeding with the transaction. Typically, the buyer or investor examines the seller, but legal due diligence is beneficial for both parties. This process assesses potential risks by examining assets, liabilities, operations, legal documents, and business relationships of the other party.

 

When Does Legal Due Diligence Occur?

Legal due diligence can take place before or after the conclusion of a transaction. However, if conducted afterward, the agreement must be conditioned upon successful completion of the due diligence to the satisfaction of the buyer. This protects the buyer in case any deal-breaking issues are discovered during the process.

 

Why is Legal Due Diligence Important?

The aim is to avoid surprises or hidden liabilities in the future. By reviewing assets, agreements, books, and records of the company, the buyer can better assess risks and liabilities associated with the transaction and mitigate potential issues. It also helps the buyer understand the company's reputation, industry, and market position. When risks are identified, the goal is to determine how to exclude or minimize them in the agreement or, if deal-breaking, to cease negotiations before spending money.

 

What Does the Legal Due Diligence Process Involve?

Typically, the initial step involves the potential buyer signing a non-disclosure agreement. The seller requires this agreement to protect the confidentiality of information provided to the potential buyer and prevent disclosure of the existence or substance of any discussions, which could negatively impact the seller's business or relationships.

 

A due diligence checklist or questionnaire is usually prepared by the buyer's attorney. Using this checklist, the buyer or their attorney requests various documents related to the financial value and operations of the business. Additionally, the buyer may wish to speak with key management members, customers, tenants, suppliers, etc., as allowed by the non-disclosure agreement.

 

The extent of the legal due diligence process can vary based on several factors, including the type of business involved, the size and type of transaction, and the buyer's objectives in entering the transaction (i.e., how the buyer will use the assets). The due diligence process may require financial, technical, and other experts in addition to attorneys to review relevant documents.

 

Once all information is received, the buyer will have a period to review and analyze it. The buyer's attorney will compile the results of the legal due diligence into a report or executive summary, accompanied by a risk assessment and recommendations on how to proceed with the transaction. These recommendations will either terminate discussions or guide future negotiations. For example, if significant issues are discovered, the buyer may request the seller to provide representations and warranties in the agreement or indemnify the buyer against future lawsuits. Purchase price or other terms may also be negotiated to compensate the buyer for assuming risks.

 

What is a Legal Due Diligence Checklist?

 

The level of legal due diligence varies, but certain information is typically requested. Typically, the following items are included in a due diligence checklist:

• Company Structure: Articles/certificates of incorporation, bylaws, corporate meeting minutes, shareholder/partnership agreements, restructuring documents.

• Financials: Tax returns, balance sheet, cash flow statements, sales and returns records, accounts receivable, accounts payable, pricing, salaries.

• Contracts/Legal Documents: Loan and credit agreements, leases, employment contracts, contracts with customers and suppliers, partnership/joint venture agreements, insurance policies.

• Intellectual Property Rights: License agreements, intellectual property registrations (copyright, patent, trademark, domain names), trade secrets, litigation.

• Legal Compliance Documents: OSHA, environmental, zoning, securities filings, licenses, permits.

 

This list is not exhaustive as each transaction is unique.

Legal due diligence is essential to avoid costly mistakes. Parties should engage experienced advisors to assist with legal due diligence and negotiate an agreement that benefits their interests.

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