Legal due diligence for a corporate investment or acquisition starts with a series of document and information requests to management of the target business. The investor’s legal counsel then reviews the documents provided, and asks follow-up questions for clarification. Written questioning and documentary disclosures are often supplemented by telephone or in-person management interviews. The due diligence process helps confirm the proper valuation of the business, and helps in the drafting of the acquisition agreement.
The areas covered by legal due diligence include the following:
Organizational Documents
Larger companies tend to have a number of subsidiaries and affiliates, some of which may be located in other countries. It is often important to understand how these entities are set up, the role they play in the business, and the presence and involvement of third-party business partners. Legal due diligence review also covers corporate resolutions and minutes in order to understand the timeline and background of key organizational decisions, as well as potential liability implications.
Financial and Tax Documents
Most investors hire accounting and tax advisors to focus on these documents. They are also important for legal counsel to review, since the assets, liabilities, income, expenses, and cash flows of the business will indicate which areas of the business warrant the greatest legal scrutiny, and the comments to financial statements often indicate key points for further legal review.
Capital Structure
Some businesses have a single owner, in which case this aspect of the due diligence can be very straightforward. However, venture-backed corporations often have several series of stock, and may have a number of stockholders in each series. Untangling the rights of each individual stockholder can be crucial in determining how to structure a transaction. The presence of stock options, restricted equity, and other contingent ownership interests can also pose risks.
Contracts
A review of contracts is important to identify a variety of potential issues, including the following:
Contingent liabilities: Contracts may provide for warranties, guarantees, indemnities, or other contingent liabilities that are not necessarily reflected in financial statements.
Key suppliers and customers: If a business relies upon certain suppliers or customers, it is critical to understand the security of those relationships, and under what circumstances those suppliers or customers may be lost.
Assignment and change of control provisions: Many types of contracts require the counterparty’s consent to any assignment (transfer of the contract) or change of control (transfer of ownership in the contracting entity), failing which the contract may be terminated or other liabilities may arise.
Compliance risks: Contracts may provide evidence that the company is quietly breaking the law, such as operating a business without a necessary license or engaging in corrupt activities.
Employees
Legal due diligence typically includes reviewing employment policies and procedures to determine whether any compliance or litigation risks may exist. These include confirmation of points such as wage and hour calculation, independent contractor classification, health and safety risks, immigration compliance, and personnel complaints. Many businesses have employee benefit plans, such as insurance and pension plans, which pose their own set of unique legal concerns and often require specialist review.
Litigation and Disputes
Legal due diligence typically includes a search of relevant court records for any lawsuits against the business or its owners, which may create contingent liabilities or impede the closing of a transaction.
Insurance
Insurance policies and claim histories are reviewed in order to determine whether any contingent liabilities may exist, and whether the company has sufficient coverage for the legal risks it faces.
Intellectual Property
It is often critical to understand the patents, trademarks, copyrights, trade secrets, and licenses used by the business, as well as any deficiencies in its IP strategy (such as technology or branding that is not protected by formal IP rights), and any potential grounds for infringement claims against the business. Intellectual property specialists may be used in this analysis as needed.
Regulatory
Legal due diligence usually includes inquiries as to whether the business has necessary licenses and permits, and whether it has received any correspondence, such as warnings or investigation notices, from government agencies. Businesses operating in specially licensed or regulated industries are often subject to a variety of special restrictions and regulations that require consideration and investigation on a case-by-case basis.