A Guide to Legal Due Diligence: The Target Company's Perspective

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If your company has ever been involved in a significant transaction, whether in the form of a business combination, a public offering of securities or securing a credit facility, you are probably painfully familiar with the due diligence process. Although the due diligence process can be time consuming and sometimes overwhelming, especially for a target company unfamiliar with the process, it is a crucial component to significant corporate transactions.

Due diligence is essentially the investigation of a target company through reviewing documents and interviewing persons with knowledge about the company. For the buyer of a business or an investor in a significant equity stake in a company, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target business or company. There are various sub-categories of due diligence, including business due diligence, legal due diligence, accounting due diligence and even "special" due diligence. This column will focus on the legal due diligence process, generally from the perspective of a target company, in connection with a merger or acquisition transaction. The summary provided in this column will be helpful for a target company in understanding how to efficiently navigate the legal due diligence process and generally what to expect. The column will briefly summarize (i) the primary reasons for legal due diligence and (ii) the basic manner in which legal due diligence is usually conducted.

Why Is Legal Due Diligence Necessary?

Some of the primary reasons for conducting legal due diligence are outlined below.

  • Better Understand Your Business. Legal due diligence is necessary to give the buyer the information that it needs to learn about your target company and to structure its purchase of your company. In addition, legal due diligence will help the buyer's counsel to become acquainted with your company so that they can communicate effectively with your company's counsel and with the buyer in structuring the transaction.
  • Help to Value the Target Company. The buyer will use the information learned in the legal due diligence process to determine how much to pay for your company. In addition to carefully examining obvious indicators of value such as your company's cash flows and balance sheet, the buyer and its counsel will search for more subtle indicators of value or potential liabilities in things such as (i) your organizational documents and important contracts (e.g., is your company restricted in how or where it operates its business or subject to unusual pricing terms or contingent liabilities?), (ii) lawsuits to which your company is a party, (iii) insurance policies benefiting your company, (iv) employee benefit and labor arrangements, (v) potential environmental claims, (vi) intellectual property owned or used by your company and (vii) rights or obligations under earn-outs or indemnification provisions.
  • Help in Drafting the Relevant Documentation. The information learned in the legal due diligence process will be helpful for both the buyer's counsel and your company's counsel in drafting and negotiating the merger or acquisition agreement and related ancillary agreements. This information will be particularly helpful in allocating risk when drafting your company's representations and warranties, your company's pre-closing promises and the post-closing indemnification rights of the buyer. Further, your company will likely need to prepare a disclosure schedule, to be delivered at the time the primary transaction agreement is executed, that discloses exceptions to the representations and warranties made by your company in the agreement. The information gathered in the legal due diligence process will be helpful for your company and your counsel in preparing the disclosure schedules. In addition, if the transaction includes a securities component, this information will be very helpful in crafting a disclosure document that may need to be delivered to the buyer.
  • Identify Impediments to Closing. In the legal due diligence process the parties will attempt to identify everything that must happen before the transaction can close. For example, counsel will focus closely on (i) your organizational documents, to determine the stockholder and other approvals required to complete the transaction, (ii) your contracts, including assignment clauses, and your permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required; (iii) regulatory requirements, to determine if any governmental approvals are required; and (iv) your debt instruments and capital leases, to determine repayment requirements. With respect to item (ii), note that if the transaction is structured as a sale of your company's assets, it is likely that you will need to seek consent from the other parties to many of your contracts before assigning the contracts to the buyer. If the transaction is structured as a sale of your company's stock, consent will only be required if "assignment" is defined broadly to include a change of control transaction (common in real estate leases). If the transaction is structured as a merger, depending on the applicable state statute, whether consent is required may depend on whether it is a forward merger (in which case the legal existence of your company ceases and seeking consents may be advisable) or a reverse merger (in which case the legal existence of your company continues and it is less likely that seeking consents is required).
  • Legal Opinions. Often the target company's counsel, the buyer's counsel or both will be expected to render a legal opinion at the closing of the merger or acquisition transaction. In order to reach the relevant legal conclusions in the legal opinions, counsel will need to rely on factual information provided by the target company. The legal due diligence process provides counsel with the opportunity to learn this information.

How Is Legal Due Diligence Accomplished?

Some of the primary steps involved in the legal due diligence process are outlined below.  

  • Help Establish the Big Picture First. Before diving into a stack of thick contracts, competent buyer's counsel will first seek to understand your company at a broader level. Unless your company is a public company with SEC reports available at the click of a button, be prepared to help the buyer establish a big picture understanding of your company by providing concise summaries about your business and industry. Such summaries are often found in offering memoranda or in audited financial statements. You might also consider directing the buyer to your website or to relevant news articles about your company.
  • Be Prepared to Provide Documents and Interviews. Buyer's counsel will likely prepare a lengthy due diligence request list asking you to provide every piece of paper that possibly relates to your company. The request list will likely be daunting, but take comfort in knowing that it is often over-inclusive. Still, be prepared to provide copies of all important documents relating to your company, including your company's organizational documents, all material contracts, all documents relating to pending litigation and litigation recently completed, all documents relating to labor and employee benefits matters and tax documents, among others. These documents are often organized in a central "data room," which may be located in your company's offices and where the buyer's counsel and your counsel can convene to spend countless hours reviewing documents. Increasingly, electronic "virtual data rooms" are replacing physical data rooms. In addition, be prepared to make available members of your executive management (preferably your Chief Financial Officer) to answer questions about your company. Interviews can be an extremely efficient way to quickly address issues and resolve concerns in the legal due diligence process.
  • How Much Legal Due Diligence Is Necessary? The legal due diligence process can take anywhere from several days, in a relatively small and uncomplicated transaction, to several months, in a larger and more complex transaction. The scope of legal due diligence in your transaction will depend on the size of your company and the number of issues requiring additional analysis. The legal due diligence process will end when the buyer is satisfied that it has sufficiently identified and analyzed the relevant issues and gained an adequate understanding about your company. The buyer will typically try to substantially complete the legal due diligence process before the primary transaction agreement is executed.
  • Presentation of Legal Due Diligence Findings. The presentation of legal due diligence findings is really only a relevant issue for the buyer and its counsel. The buyer will normally expect its counsel to present legal due diligence findings promptly and in a user-friendly format. For small deals or cost-sensitive buyers, the presentation may take the form of a verbal conversation. On the other end of the spectrum, for large complicated deals, it is not uncommon for legal due diligence findings to be presented in the form of a memorandum, ranging from 50 to 100 pages, that describes all documents reviewed, analyzes the key issues discovered and recommends various solutions. Many buyers simply ask for a bullet-point list of key issues identified in the legal due diligence process. The point is that, if you are a buyer, you should make your expectations clear and communicate with your counsel regarding any cost sensitivities and the format in which you would prefer the legal due diligence findings to be presented.

Legal due diligence is a crucial component to any significant corporate transaction. Although it can be a demanding process, once your company understands the reasons for legal due diligence and the basic manner in which it is usually conducted, the process should proceed more efficiently, saving costs and headaches.

This article was written by Benjamin W. Bates and originally appeared in The Enterprise Newspaper, April 14-20, 2008.

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