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The Ins and Outs of Legal Due Diligence

Show Notes Of Podcast

Why conduct legal due diligence?

The purpose of legal due diligence is to gain a legal perspective on the target company. As with any component of the DD process, the ultimate aim here is to ‘check under the hood’ and ensure that everything is in order. Buyers, or rather buyers’ legal team, approach the legal due diligence process by asking: “Is there any legal reason that we shouldn’t acquire this firm?”

One area of the due diligence process stands head and shoulders above the others in terms of its complexity and its importance: Legal Due Diligence (sometimes referred to as ‘LDD’). While it is possible to conduct due diligence yourself, the scope of legal due diligence, taking in everything from IP to litigation, may be too much for your in-house counsel.

Some of the ins and outs of the legal due diligence process are covered below.

One area of the due diligence process stands head and shoulders above the others in terms of its complexity and its importance: Legal Due Diligence (sometimes referred to as ‘LDD’). While it is possible to conduct due diligence yourself, the scope of legal due diligence, taking in everything from IP to litigation, may be too much for your in-house counsel.

Some of the ins and outs of the legal due diligence process are covered below.

Why conduct legal due diligence?

The purpose of legal due diligence is to gain a legal perspective on the target company. As with any component of the DD process, the ultimate aim here is to ‘check under the hood’ and ensure that everything is in order. Buyers, or rather buyers’ legal team, approach the legal due diligence process by asking: “Is there any legal reason that we shouldn’t acquire this firm?”

This question needs to be fleshed out. Few target companies are likely to have a completely clean slate when it comes to their legal history. Common examples include HR issues with departing employees or contractual disputes with suppliers or clients. Your legal due diligence process should set out to find the ‘red line’ issues, the deal-breakers.

What does legal due diligence cost?

Legal due diligence isn’t cheap, but it’s a lot cheaper than finding some legal skeletons in the closet six months after the deal has closed. It’s a necessary expense. Don’t cut corners or you may end up paying the price down the line. Instead, create an agenda with the legal experts you hire, establishing where and when the costs will arrive so that everyone knows what to expect.

Legal due diligence on the sell-side

It’s good practice for owners on the sell-side to have conducted at least part of the legal due diligence. Having an external attorney sign off on some of the internal legal workings of your company is a courteous way to treat buyers. It also speeds up the process and better prepares your business for a frictionless and timely sale. Furthermore, if both companies have in-house legal teams, this also provides a useful opportunity for an icebreaker between the two teams.

Ensuring a smooth process

The most efficient way to conduct legal due diligence is by using a virtual data room for legal due diligence, which will be shared between the buy side, the sell side and the legal teams on both sides. The buy side, in tandem with their attorney, should agree to a checklist of legal documents that will be requested from the sell side.

It’s important to establish some order at the outset. Begin processes which inevitably take longer first, allowing the typically faster items till last. Your attorney will know from experience which documents take longer but a good rule of thumb is, the further back you go with a document which can’t be retrieved in-house, the longer it’s likely to take to process.

Obtaining a legal opinion on the target firm

Even if your legal due diligence process doesn’t raise any red flags, there will always be some element of risk. This is where legal due diligence is subtly different from other parts of the process: Many of the risks you’re trying to uncover here won’t be hiding in plain sight - it will involve asking questions about what might be, not what has been.

To take one example, suppose you’re acquiring a small pharmaceutical firm that sells drugs with some potential side-effects that haven’t caused any issues until now. What are the side-effects and what kind of liability would they endow your company with should one of your customers be hit with them? Or several customers? Or even worse side-effects?

Answering questions like these is where your highly priced legal team pay for themselves: They’ll provide you with an expert legal opinion on whether you should acquire the company from a legal perspective. The answer will rarely be a straight ‘yes’ or ‘no,’ but at least you’ll be making a far more informed decision on the back of their advice.

Legal due diligence checklist 

Having a checklist in place helps to keep everyone organized and on-task during due diligence.

The following are some examples of what you can expect to see in a checklist during legal due diligence.

General

ITEMS IN GENERAL LEGAL DUE DILIGENCE INCLUDE:

  • Copies of agreements or instruments that place restrictions or encumbrances on assets.
  • Contracts that restrict the target's right to conduct its business.
  • Contracts with obligations such as covenants and indemnification.
  • Summary of the target's compliance program and copies of all policies, procedures and other related documentation.
  • Confirm that the firm is not restricted from doing business under OFAC regulations or similar.
  • Confirm whether the target has any direct or indirect presence and/or other engagements.
  • Summary of regulations applicable and/or its business, and anticipated changes
  • Copies of any letters with any regulatory agencies or authorities.
  • List of states and countries in which the target has operations.
  • Good-standing certificates or qualification to do business from state of incorporation and states where qualified.
  • Schedule of any significant U.S. import or export restrictions that relate to the target's operations.

Organization/Ownership

ITEMS IN ORGANIZATION/OWNERSHIP DUE DILIGENCE INCLUDE:

  • List of current shareholders detailing the amount of shares each owns.
  • List of stock transfer records.
  • List of stock broker contracts and agreements.
  • Evidence that outstanding stock is paid in full.
  • Identify issues associated with transfering equity.

Litigation

ITEMS IN LITIGATION DUE DILIGENCE INCLUDE:

  • List of all threatened, pending, current, and closed litigations from the past five years.
  • List of arbitrational procedings from the past five years.
  • Summaries of current and closed governmental investigations and proceedings on the target, directors, and executives from the past five years.
  • Responses from the company regarding audit inquires.
  • List of all statutory orders, decrees, and rulings to which the company be subject.

Product/Service

ITEMS IN PRODUCT/SERVICE DUE DILIGENCE INCLUDE:

  • Detailed list of all products and services.
  • Verify compliance with FDA, CPSC, OSHA, and FLSA regulations for products, services, and operations.
  • Copies of all product warranties.
  • Summary of all material warranty claims brought.
  • Summary of all product recalls.
  • Identify potential liabilities associated with products/services.

Contacts/Obligations

ITEMS IN CONTACTS/OBLIGATIONS DUE DILIGENCE INCLUDE:

  • Copies of service contracts.
  • Copies of vendor contacts.
  • Copies of customer contracts and obligations.
  • Copies of outstanding contracts to purchase machinery or real estate.
  • Copies of contracts for construction, architectural or engineering services for any buildings or improvements.
  • Copies of operating contracts.
  • Copies of employee contracts and retirement agreements.
  • Change of control regulations.
  • Copies of material contracts that are terminable upon a change of control or other corporate transaction.
  • Copies of all joint venture, partnership, and franchise agreements.
  • Identify any contracts or provisions that may be out of the ordinary course of business.

Permits/Licenses

ITEMS IN PERMITS/LICENSES DUE DILIGENCE INCLUDE:

  • Summary of permits, licenses, and other authorizations including any required export control and pertinent governmental licenses.
  • Summary of icense, sublicense, royalty and franchise agreements.
  • Schedule of permit and license renewals and associated fees.
  • Copies of automobile registrations.

Intellectual Property

ITEMS IN INTELLECTUAL PROPERTY DUE DILIGENCE INCLUDE:

  • List of all patents, trademarks, trade-names, service marks and copyrights held or applied for.
  • List of the creator(s) for each IP component.
  • List of all patents, trademarks, and copyrights held by an employee, shareholder, director or any other affliated that are used by the target.
  • Summary of material trade secrets.

Material Assets

ITEMS IN MATERIAL ASSETS DUE DILIGENCE INCLUDE:

  • List of equipment
  • List of real estate of a company
  • Summary of inventory stock
  • Technology summary

HR/Operations

ITEMS IN HR/OPERATIONS DUE DILIGENCE INCLUDE:

  • List of all employees including those covered by any disability legislature in the company.
  • List of OSHA citations, employee health issues related to the target, and any other adverse environmental or occupational safety or health condition or concerns.
  • History of all sexual harassments accusations, charges, and convictions from the past five years.
  • Copies of all current employment applications, interview guides, and hiring procedures.
  • Verify compliance with equal employment opportunity and anti-discrimination legislature.
  • Summaries of disciplinary and termination procedures and all involuntary employee terminations from the past five years.
  • History of Unemployment and Worker’s Compensation claims.
  • Verify compliance with Fair Labor Standards Act, i.e. minimum wage, child labor, etc. (if U.S. based).
  • Ensure employee personnel files and Form I-9s (if it is United States-based company) are in compliance with legal standards.
  • Copies of all SBCs for current benefit plans.
  • Copies of all union and labor contracts.
  • History of labor-related disputes, grievance procedings, and arbitrations.
You can download legal due diligence checklist questions here

Legal due diligence in a foreign country

The importance of conducting legal due diligence when acquiring a foreign firm, entering a joint venture or beginning a business partnership cannot be overstated. This is as true for foreign companies coming to the United States as it is for American companies moving abroad: Different legal environments bring new risks. Accordingly, they require proper assessment.

When looking into acquiring a company in a foreign jurisdiction, shop around among the local legal firms, seeing which ones best fit your requirements in terms of service and cost. If the transaction is closed, the relationship with this legal team may become long-term, so it’s worth putting extra time in at the outset to make sure it’s a fit for your firm.

Conclusions

The conclusion is simple: Conduct high-quality legal due diligence now to minimize the chances of unwanted legal liabilities after the transaction has closed. The universe of legal issues is too complex to leave to chance. By conducting a thorough LDD, you give your acquisition every chance to create long-term shareholder value.

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One area of the due diligence process stands head and shoulders above the others in terms of its complexity and its importance: Legal Due Diligence (sometimes referred to as ‘LDD’). While it is possible to conduct due diligence yourself, the scope of legal due diligence, taking in everything from IP to litigation, may be too much for your in-house counsel.

Some of the ins and outs of the legal due diligence process are covered below.

Why conduct legal due diligence?

The purpose of legal due diligence is to gain a legal perspective on the target company. As with any component of the DD process, the ultimate aim here is to ‘check under the hood’ and ensure that everything is in order. Buyers, or rather buyers’ legal team, approach the legal due diligence process by asking: “Is there any legal reason that we shouldn’t acquire this firm?”

This question needs to be fleshed out. Few target companies are likely to have a completely clean slate when it comes to their legal history. Common examples include HR issues with departing employees or contractual disputes with suppliers or clients. Your legal due diligence process should set out to find the ‘red line’ issues, the deal-breakers.

What does legal due diligence cost?

Legal due diligence isn’t cheap, but it’s a lot cheaper than finding some legal skeletons in the closet six months after the deal has closed. It’s a necessary expense. Don’t cut corners or you may end up paying the price down the line. Instead, create an agenda with the legal experts you hire, establishing where and when the costs will arrive so that everyone knows what to expect.

Legal due diligence on the sell-side

It’s good practice for owners on the sell-side to have conducted at least part of the legal due diligence. Having an external attorney sign off on some of the internal legal workings of your company is a courteous way to treat buyers. It also speeds up the process and better prepares your business for a frictionless and timely sale. Furthermore, if both companies have in-house legal teams, this also provides a useful opportunity for an icebreaker between the two teams.

Ensuring a smooth process

The most efficient way to conduct legal due diligence is by using a virtual data room for legal due diligence, which will be shared between the buy side, the sell side and the legal teams on both sides. The buy side, in tandem with their attorney, should agree to a checklist of legal documents that will be requested from the sell side.

It’s important to establish some order at the outset. Begin processes which inevitably take longer first, allowing the typically faster items till last. Your attorney will know from experience which documents take longer but a good rule of thumb is, the further back you go with a document which can’t be retrieved in-house, the longer it’s likely to take to process.

Obtaining a legal opinion on the target firm

Even if your legal due diligence process doesn’t raise any red flags, there will always be some element of risk. This is where legal due diligence is subtly different from other parts of the process: Many of the risks you’re trying to uncover here won’t be hiding in plain sight - it will involve asking questions about what might be, not what has been.

To take one example, suppose you’re acquiring a small pharmaceutical firm that sells drugs with some potential side-effects that haven’t caused any issues until now. What are the side-effects and what kind of liability would they endow your company with should one of your customers be hit with them? Or several customers? Or even worse side-effects?

Answering questions like these is where your highly priced legal team pay for themselves: They’ll provide you with an expert legal opinion on whether you should acquire the company from a legal perspective. The answer will rarely be a straight ‘yes’ or ‘no,’ but at least you’ll be making a far more informed decision on the back of their advice.

Legal due diligence checklist 

Having a checklist in place helps to keep everyone organized and on-task during due diligence.

The following are some examples of what you can expect to see in a checklist during legal due diligence.

General

ITEMS IN GENERAL LEGAL DUE DILIGENCE INCLUDE:

  • Copies of agreements or instruments that place restrictions or encumbrances on assets.
  • Contracts that restrict the target's right to conduct its business.
  • Contracts with obligations such as covenants and indemnification.
  • Summary of the target's compliance program and copies of all policies, procedures and other related documentation.
  • Confirm that the firm is not restricted from doing business under OFAC regulations or similar.
  • Confirm whether the target has any direct or indirect presence and/or other engagements.
  • Summary of regulations applicable and/or its business, and anticipated changes
  • Copies of any letters with any regulatory agencies or authorities.
  • List of states and countries in which the target has operations.
  • Good-standing certificates or qualification to do business from state of incorporation and states where qualified.
  • Schedule of any significant U.S. import or export restrictions that relate to the target's operations.

Organization/Ownership

ITEMS IN ORGANIZATION/OWNERSHIP DUE DILIGENCE INCLUDE:

  • List of current shareholders detailing the amount of shares each owns.
  • List of stock transfer records.
  • List of stock broker contracts and agreements.
  • Evidence that outstanding stock is paid in full.
  • Identify issues associated with transfering equity.

Litigation

ITEMS IN LITIGATION DUE DILIGENCE INCLUDE:

  • List of all threatened, pending, current, and closed litigations from the past five years.
  • List of arbitrational procedings from the past five years.
  • Summaries of current and closed governmental investigations and proceedings on the target, directors, and executives from the past five years.
  • Responses from the company regarding audit inquires.
  • List of all statutory orders, decrees, and rulings to which the company be subject.

Product/Service

ITEMS IN PRODUCT/SERVICE DUE DILIGENCE INCLUDE:

  • Detailed list of all products and services.
  • Verify compliance with FDA, CPSC, OSHA, and FLSA regulations for products, services, and operations.
  • Copies of all product warranties.
  • Summary of all material warranty claims brought.
  • Summary of all product recalls.
  • Identify potential liabilities associated with products/services.

Contacts/Obligations

ITEMS IN CONTACTS/OBLIGATIONS DUE DILIGENCE INCLUDE:

  • Copies of service contracts.
  • Copies of vendor contacts.
  • Copies of customer contracts and obligations.
  • Copies of outstanding contracts to purchase machinery or real estate.
  • Copies of contracts for construction, architectural or engineering services for any buildings or improvements.
  • Copies of operating contracts.
  • Copies of employee contracts and retirement agreements.
  • Change of control regulations.
  • Copies of material contracts that are terminable upon a change of control or other corporate transaction.
  • Copies of all joint venture, partnership, and franchise agreements.
  • Identify any contracts or provisions that may be out of the ordinary course of business.

Permits/Licenses

ITEMS IN PERMITS/LICENSES DUE DILIGENCE INCLUDE:

  • Summary of permits, licenses, and other authorizations including any required export control and pertinent governmental licenses.
  • Summary of icense, sublicense, royalty and franchise agreements.
  • Schedule of permit and license renewals and associated fees.
  • Copies of automobile registrations.

Intellectual Property

ITEMS IN INTELLECTUAL PROPERTY DUE DILIGENCE INCLUDE:

  • List of all patents, trademarks, trade-names, service marks and copyrights held or applied for.
  • List of the creator(s) for each IP component.
  • List of all patents, trademarks, and copyrights held by an employee, shareholder, director or any other affliated that are used by the target.
  • Summary of material trade secrets.

Material Assets

ITEMS IN MATERIAL ASSETS DUE DILIGENCE INCLUDE:

  • List of equipment
  • List of real estate of a company
  • Summary of inventory stock
  • Technology summary

HR/Operations

ITEMS IN HR/OPERATIONS DUE DILIGENCE INCLUDE:

  • List of all employees including those covered by any disability legislature in the company.
  • List of OSHA citations, employee health issues related to the target, and any other adverse environmental or occupational safety or health condition or concerns.
  • History of all sexual harassments accusations, charges, and convictions from the past five years.
  • Copies of all current employment applications, interview guides, and hiring procedures.
  • Verify compliance with equal employment opportunity and anti-discrimination legislature.
  • Summaries of disciplinary and termination procedures and all involuntary employee terminations from the past five years.
  • History of Unemployment and Worker’s Compensation claims.
  • Verify compliance with Fair Labor Standards Act, i.e. minimum wage, child labor, etc. (if U.S. based).
  • Ensure employee personnel files and Form I-9s (if it is United States-based company) are in compliance with legal standards.
  • Copies of all SBCs for current benefit plans.
  • Copies of all union and labor contracts.
  • History of labor-related disputes, grievance procedings, and arbitrations.
You can download legal due diligence checklist questions here

Legal due diligence in a foreign country

The importance of conducting legal due diligence when acquiring a foreign firm, entering a joint venture or beginning a business partnership cannot be overstated. This is as true for foreign companies coming to the United States as it is for American companies moving abroad: Different legal environments bring new risks. Accordingly, they require proper assessment.

When looking into acquiring a company in a foreign jurisdiction, shop around among the local legal firms, seeing which ones best fit your requirements in terms of service and cost. If the transaction is closed, the relationship with this legal team may become long-term, so it’s worth putting extra time in at the outset to make sure it’s a fit for your firm.

Conclusions

The conclusion is simple: Conduct high-quality legal due diligence now to minimize the chances of unwanted legal liabilities after the transaction has closed. The universe of legal issues is too complex to leave to chance. By conducting a thorough LDD, you give your acquisition every chance to create long-term shareholder value.

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