Conducting Legal Due Diligence in M&A Transactions

Have you ever opened a carton of eggs at a grocery store to check if any of the shells were cracked? Both this and conducting legal due diligence on a potential acquisition target for your client serve the necessary purpose of learning more about something you are interested in buying.

One of your main goals as an attorney representing the acquiring company in an acquisition is to ensure that your client does not acquire a business with cracks in it (e.g., a $500,000 outstanding loan or multiple pending products liability lawsuits) without being adequately protected. You must follow the legal due diligence process in a merger and acquisition (M&A) transaction and use that process to protect your clients from assuming unnecessary risk.

What Is Legal Due Diligence?

To set the stage, your client, ABC Corporation, has just told you it entered into a letter of intent to purchase XYZ Company and signed a nondisclosure agreement with respect to the information it will learn during the process. While the letter of intent contained the basic deal terms, you know nothing about XYZ Company. Your client is concerned about assuming XYZ Company’s liabilities and asks you how it can mitigate as much of that risk as possible—what do you do?

In an M&A transaction, legal due diligence is the process by which the acquiring company collects and reviews various categories of information about the seller or target entity for the broad purpose of making an informed decision about whether to consummate the transaction. You would often start by preparing a “due diligence request list” of XYZ Company, which is a list of questions, information, documents, and other items that you want XYZ Company either to answer or provide about its business. The content of a due diligence request list will, to some extent, depend on XYZ Company’s type of business and the structure of the transaction.

For example, if XYZ Company is a part of a regulated industry, then your due diligence request list should ask more questions about, among other things, regulatory compliance. Further, if ABC Corporation is interested in merging with or purchasing the equity of XYZ Company (as opposed to only XYZ Company’s assets), then your due diligence request list may ask more in-depth questions or make more detailed requests about XYZ Company’s debts and liabilities.

Any due diligence request list of XYZ Company, however, should contain questions and requests specific to its corporate organization, financial and tax information, tangible and intangible assets (including intellectual property), real property, employees and employee benefits, licenses and permits, contracts, customers and suppliers, insurance policies and litigation matters.

As you receive due diligence information from XYZ Company, you should review every page of every document provided and note any potential issues that ABC Corporation should be aware of. For example, when reviewing XYZ Company’s contracts, you might make a “contract review sheet” that lists each contract provided and the material information about the same. The material information you track for each contract will depend on the scope of the representations and warranties XYZ Company is making about its contracts (e.g., whether (i) any consent is needed to assign such contract to ABC Corporation or for a change in control of XYZ Company; (ii) XYZ Company is subject to any indemnification obligations or restrictive covenants; and (iii) any contract cannot be terminated without cause without more than 30 days’ notice).

During and after the due diligence process, you will have conversations with your client regarding the results and the specific information you have received. If certain documents or information provided raise other questions that need to be answered prior to closing, you should request further information and documents that will help resolve those outstanding issues.

Using Due Diligence to Mitigate Risk

While conducting due diligence is an important part of the M&A transaction process, it is even more important to use what you learn from it to protect your client.

During the period in which you receive the requested information from XYZ Company, you or other attorneys on your team will negotiate the definitive transaction documents in connection with ABC Corporation’s acquisition of XYZ Company (e.g., an Asset Purchase Agreement). These agreements contain representations and warranties of each party, which are statements of fact made at a specific time about that party’s business.

For example, a common representation and warranty of both parties to an M&A transaction is that such party is duly organized and in good standing in the state of its formation. Additionally, these agreements will set forth more specific information about the transaction, such as how the purchase price is paid and whether there are any conditions precedent to closing.

Depending on the results of your due diligence investigation of XYZ Company, you may want to advise your client that:

1. the purchase price should be paid differently (i.e., less in cash at closing and more in the value of a promissory note or via earnouts) due to certain risks,
2. closing should be conditioned on XYZ Company paying off certain debts or resolving outstanding litigation-related issues,
3. some of the purchase price should be held back at closing for a period to pay for potential indemnification obligations of XYZ Company, or
4. the failure to successfully assign a key contract should result in a reduction in the purchase price.

M&A transactions are often extremely complex and require in-depth investigation to ensure your client is adequately protected from potential financial and legal liabilities. The due diligence process is key to uncovering these potential liabilities. While each M&A transaction is unique, you should always carefully conduct due diligence and use the results to mitigate your client’s risk.