Due Diligence

Legal Due Diligence – Everything You Need to Know

If we speak in layman language due diligence is the process of investigating and considering an action before its commencement. Due diligence is that reasonable verification and precautions which are taken to identify and avoid the calculable risks. Legal Due Diligence is a process to review all the documents the company possesses. During mergers and acquisitions, these legal documents play an important role to know the possible risks and even for the successful transaction. These risks involve corporate structures, assets, customer and employee contract or any risk related to Intellectual property.

Meaning of Legal Due Diligence

Legal due diligence is performed when a buyer wants to buy a company, normally during mergers and acquisitions. It is a process of collecting, understanding and analyzing all the risk associated during the mergers and acquisition process. During such process, the buyer or acquirer or the investor review all the legal documents and sometimes even interview the people associated with the company. The motive behind such a process is simple, that the acquirer or the investor wants to understand whether there will be any future legal problems due to this acquisition or investment. Hence, legal due diligence can be explained as the process where a detailed analysis is performed to access the possible legal issues facing a target company. It is investigation seeks to reveal all the potential and important fact about the business to make sure that the investment or purchase is beneficial.

Subcategories of legal Due diligence

Subcategories of legal Due diligence for seeking a more specific piece of information;

• Intellectual Property due diligence
• Business due diligence
• Financial due diligence
• Administrative due diligence
• Legal due diligence  

Intellectual Property Due Diligence:

This is an essential audit to access the quantity and quality of Intellectual property assets owned by the company. The IP review include the assessment that how IP is gained, protected by the company or business. The main reason behind this investigation is to understand the worth of the company’s IP assets so that the third party can able to put a value over them. The conduct can also ensure that whether any third party is or is suspected to be infringing the company’s IP rights.

Business Due Diligence:

With this conduct information related to investments, vendor, and about partner can be obtained. Business due diligence is required to identify and mitigate operational and security risks associated with business or company before any such alliance or investment.

Financial Due Diligence:

One of the mandatory types of due diligence, with which it can be checked whether the financial statement of the company mentioned in Confidential Information Memorandum (CIM) are accurate or not. With this review, information of financial statement from recent to last three year complied with the information related to unaudited financial statements can be carried out. It also involves analysis of major customer’s accounts, fixed and variable cost analysis with the analyzing of profit and loss.

Administrative Due Diligence

In this process verification of admin related items such as facilities, occupancy rate, number of workstations, etc. Administrative due diligence can provide the information related to operational cost and even the information can be drawn whether the operational cost is mentioned in the financial.

Checklist for Legal due diligence  

Legal due diligence, extremely important due diligence. This typically includes the examination of the various contracts and elements such as

• Copy of memorandum  of association
• Minutes of Board Meetings for the last three years
• Minutes of all meeting or actions of shareholders for the last three years
• Copy of share certificate issued to Key managements personnel’s
• Copy of all guarantees to which company is the party
• Copy of loan agreements, bank financing agreements, and lines of credits to which company is the party
• Licensing or franchise agreements
• Material contracts such as joint venture or partnership agreement, or any other operating agreement

Objectives of Legal Due Diligence

Before any acquisition or any investment due diligence is the foremost process needs to be performed. The main objectives of the Legal due diligence are as follows;

• Evaluation and measure the main legal risks
• To provide alternative solutions to reduce the legal risks
• Get a full understanding of various contracts the company has undergone
• Information related to various employment conditions and the company’s accountability towards its employees
• Information gathered can be used for the drafting of agreements ^[1] and the same can be used for various types of negotiation and to draft appropriate merger and acquisition documents, or sale purchase agreement
• Can provide better information to the acquirer or investor
• Can determine the right amount to pay for the transaction

Documents Examined during Process of Legal Due Diligence

• Certificate of Incorporation
• Company’s by-laws
• Limited Liability agreement
• Stockholder agreement relating to management, ownership, and control of the company
• Shareholder agreement
• List of property owned by the company
• List of legal for and against the company
• Employment agreement
• Company capital (no. of authorized share, outstanding share, a record of the owner of shares of each class series or stock)
• Documents like stock purchase agreement, stockholder agreement, Registration rights agreements
• Stock records which include books, a ledger account, etc…

Example of Legal Due Diligence

Each of the legal due diligence is unique in itself. The nature of legal due diligence investigation depends upon the nature of the transaction. Let’s take the example of the property transaction. This type of legal due diligence will need access.

• Environmental Liabilities
• Real estate records
• Liens on the property
• Itemized list of necessary repairs
• Deferred maintenance items
• Compliance issues
• Building code requirements
• ADA regulations

Reports and Proof of Due Diligence

The reports and proof of the due diligence depend completely upon the size and nature of the acquisition. For the proof, a due diligence certificate is provided.  The report will describe all the documents examined and key problems resolved. For any kind of alliance or for investigation^[2] it’s always good to have a legal due diligence well-prepared report. This report can be used to show in the court that all legal measures to notify that person have been taken.

Time Taken for Legal Due Diligence

Depending upon the size of the company mainly decides the time required for the completion of the process. Legal due diligence can take time anywhere between several days to several months. Buyer can determine the time required for the investigation, once he is satisfied by the information gathered by the investigation, the process tends to be completed.

Conclusion

Merger and acquisitions are such a process in any company which shall be conducted with full due care. Legal Due Diligence is processed a company undergoes to prevent any future legal risks. Even also company after conducting this investigation can know its company’s worth. Legal due diligence may also find the potential issues of the company and a company can take various steps to tackle overcome those issues. After determining the status of the company, merger and acquisition process can ensure that no false information has been provided to an investor or to the acquirer.

 Suggested Reads:

• A Roadmap to Financial Due Diligence / Accounting Due Diligence
• Summarizing the Due Diligence Process in India