Legal Due Diligence

Legal Due Diligence

Before entering into a business transaction, it is essential that the parties learn more about each other to avoid unnecessary risks and ensure fair terms.  This investigative process is known as due diligence.

What Is Legal Due Diligence?

Legal due diligence is a review and analysis of relevant information about a party and his or her business. It is a necessary part of any transaction but is especially important in the context of a merger, acquisition, investment in a business, or when entering into a licensing deal. The goal is to allow the parties to make well-informed decisions about whether and/or how to move forward with the deal. Typically, the buyer/investor investigates the seller, but legal due diligence is valuable to both parties. The process enables them to assess potential risks by examining the other side’s assets, liabilities, operations, legal documents, and business relationships.

When Does Legal Due Diligence Occur?

Legal due diligence can occur before or after the conclusion of a transaction. However, if it occurs afterward, the agreement should be conditional upon successful completion of the diligence review, to the satisfaction of the buyer. This protects the buyer in the event a dealbreaker may be uncovered in the process.

Why Is Legal Due Diligence Important?

The purpose is to avoid any surprises or hidden liabilities in the future. By investigating the business’s assets, agreements, books and records, the buyer can better assess the risks and liabilities associated with the transaction, and mitigate potential problems. It also helps the buyer understand the business’s reputation, industry and market position. Where risks are uncovered, the goal is to determine how to exclude or minimize them in the agreement or, if they are dealbreakers, end discussions before money is paid.

What Is Involved in the Legal Due Diligence Process?

Generally, the first step is for the potential buyer to sign a non-disclosure agreement. The seller will require the agreement in order to protect the confidentiality of information being given to the potential buyer and prevent the buyer from revealing the existence or substance of any discussions. Such disclosure could have an adverse effect on the seller’s business or relationships.

A legal due diligence questionnaire or checklist is typically prepared by the buyer’s attorney. Through the checklist, the buyer or buyer’s attorney will request various documents relevant to the financial worth and operations of the business. In addition, the buyer may wish to speak with key management, customers, tenants, vendors, etc., as permitted by the non-disclosure agreement.

The scope of the legal due diligence process may vary depending on a number of factors, including the type of business involved, the size and type of transaction, and the buyer’s goals in entering into the transaction (i.e., how the buyer will use the assets). The legal 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 certain period of time to review and analyze it. The buyer’s attorney will compile the results of the legal due diligence into a report or executive summary, along with an assessment of the risks and recommendations for how to proceed with the transaction. These recommendations will either terminate discussions or guide further negotiations. For example, if significant problems are found, the buyer could request that the seller provide representations and warranties in the agreement or indemnify the buyer in the event of a future lawsuit. The purchase price or other terms may also be negotiated to compensate the buyer for undertaking risk.

What Is a Legal Due Diligence Checklist?

The level of legal due diligence varies, but there is certain information that is generally requested. Typically, the following are included in a diligence questionnaire or checklist:

  • Corporate structure: Articles/Certificate of incorporation, by-laws, corporate meeting minutes, shareholder/operating agreements, restructuring documents.
  • Financials: Tax returns, balance sheet, cash flow statements, sales and returns records, accounts receivables, accounts payable, pricing, salaries.
  • Contracts/legal documents: Loan and credit agreements, leases, employment agreements, contracts with customers and vendors, partnership/joint venture agreements, insurance policies.
  • Intellectual property rights: Licensing agreements, intellectual property registrations (copyright, patent, trademark, domain names), trade secrets, litigation.
  • Legal compliance-related documents: OSHA, environmental, zoning, securities filings, licenses, permits.

This is not an exhaustive list, as each transaction is unique.

Legal due diligence is necessary to avoid costly mistakes. The parties should have experienced advisors to assist with legal due diligence, as well as negotiate an agreement that is beneficial to their interests.