Buying an existing business or company can provide access to established customers, assets, employees and market presence, but the business may also carry hidden liabilities and legal risks.
What Is Legal Due Diligence?
Legal due diligence is a structured review of a business before a proposed acquisition, investment or takeover.
- Ownership of assets
- Enforceability of contracts
- Existing disputes and liabilities
- Legal ability to complete the transaction
Why Is Legal Due Diligence Important?
A business may appear financially successful while having significant legal problems.
- Pending litigation
- Outstanding loans
- Tax liabilities
- Employee disputes
- Intellectual-property disputes
- Regulatory violations
- Property-title problems
- Undisclosed contractual obligations
- Guarantees or security interests
What Corporate Records Should Be Checked?
- Certificate of incorporation
- Memorandum and Articles of Association
- Directors and shareholders details
- Board and shareholder resolutions
- Statutory filings
- Share certificates
- Previous share transfers
- Charges registered against company assets
How Should Business Assets Be Verified?
The buyer should establish whether the business actually owns the assets represented as part of the transaction.
- Land and buildings
- Machinery
- Vehicles
- Equipment
- Inventory
- Software
- Trademarks
- Copyrights
- Domain names
- Other intellectual property
Which Contracts Should Be Reviewed?
Existing contracts can significantly affect the value of an acquired business.
- Customer agreements
- Supplier contracts
- Lease agreements
- Distribution agreements
- Franchise agreements
- Employment contracts
- Loan agreements
- Technology agreements
- Joint-venture agreements
- Change-of-control clauses
- Termination rights
- Assignment restrictions
How Should Litigation Be Checked?
The buyer should identify pending and potential legal disputes involving the business.
- Civil litigation
- Commercial disputes
- Consumer complaints
- Criminal proceedings
- Labour disputes
- Tax proceedings
- Arbitration
- Regulatory proceedings
- Government notices
What About Loans and Financial Liabilities?
Existing financial liabilities are an important part of legal due diligence.
- Bank loans
- Working-capital facilities
- Corporate guarantees
- Personal guarantees
- Mortgages
- Security interests
- Debentures
- Outstanding interest
- Existing defaults
- Restructuring arrangements
What About Employees and Intellectual Property?
Employee-related liabilities and intellectual-property ownership should be reviewed before completing the transaction.
- Employment agreements
- Salary and wage obligations
- Provident Fund compliance
- ESI compliance
- Gratuity obligations
- Employee disputes
- Trademarks
- Copyrights
- Patents
- Software
- Domain names
- Trade secrets
Share Purchase vs Asset Purchase
The legal consequences can differ significantly depending on how an acquisition is structured. In a share purchase, the company generally continues to own its assets and remains responsible for its existing liabilities. In an asset purchase, transaction documents should specify the assets, contracts, employees and liabilities being transferred or retained.
What If Due Diligence Finds a Legal Problem?
- Require the seller to resolve the issue before closing
- Negotiate a reduction in purchase price
- Obtain a specific indemnity
- Exclude certain assets or liabilities
- Make closing conditional upon required approvals
- Require escrow or other contractual protection
- Reconsider or terminate the transaction
Conclusion
Legal due diligence helps a buyer understand what is actually being acquired and what liabilities may accompany the transaction. A careful review of corporate records, property, contracts, litigation, loans, employees, intellectual property and regulatory compliance can help identify risks before completion.
