Legal Issues When Buying a Business: Due Diligence

As discussed in prior installments of this series on buying a business, there are a number important legal issues you need to consider before signing the purchase agreement.  The first installment discussed the role of the Exclusivity Agreement, the second installment examined the differences between structuring the transaction as stock purchase as opposed to a purchase of assets, and the third examined the importance of escrowing a portion of the purchase price to cover any issues that may arise post closing.  Part IV of this series explores important aspects of due diligence and how to address legal or financial issues in the purchase agreement.

Due diligence is a fundamental part of any purchase transaction as its purpose is to verify valuation assumptions (i.e., if the purchase price makes sense) and identify risks (whether they are legal, financial or operational).

1.  Conducting Legal Due Diligence.

The purchaser will obviously want to conduct due diligence of the business or assets being purchased.  The legal due diligence will examine an an array of legal issues, including:

      (a) Business Entity.   

• Are the company's organizational documents and records are in order and the entity in good standing.
• Are there any obstacles to the transaction such as a right of first refusal held by a shareholder or third party.
• Is there anything in the By Laws/Operating Agreement mandating a super majority or even unanimous approval of a sale.
• If the purchaser is buying the entity rather than the assets it is important to ensure there are no liens and that there aren't any third party's with rights with respect to the ownership interests.

     (b)  Permits/Compliance with Laws/Regulatory Matters.

• Are any permits, licenses or governmental approvals required by any jurisdiction where the business operates. 
• If permits or approvals are required, are the one's held by the seller assignable and if so what must be done to obtain the transfer of the permit.
• Does the business operate in a number of states or foreign countries, and if so what is necessary to operate the business in each jurisdiction.
• Are there particular regulatory concerns.
• Is any aspect of the business governed by privacy rules which mabe implicated by the purchase.  

      (c) Ownership and Transfer of Assets/Intellectual Property.

• The seller will need to prove good title to the assets of the business.
• Are any of the assets encumbered or pledged.
• Does the company own or license intellectual property. 
• If there is intellectual property, have the rights been registered, such a s trademark or are there pending or issued patents.
• Does the seller own the domain name(s) as often companies will overlook this issue and the domain will be registered in the name of the original web developer, an employee or a shareholder.
• All licenses that are key to operating the business must be assignable by the terms of the license agreement as the licensor could otherwise refuse or require additional payment for consent to the assignment.
• Have Invention Assignment Agreements been executed giving the seller rights to intellectual property developed by third parties or by partners, employees or consultants.
• Customer and Customer Information are important assets and therefore before purchasing the business the buyer must be sure customers and customer account information can be transferred to the purchaser without violating privacy or other laws, especially in the event of an asset sale. 

     (d) Material Contracts.  The material contracts must be reviewed to ensure they are assignable/assumable and that they don't terminate in the event of a sale of the business or change of control of the business.

     (e) Employment/HR Matters. 

• Make sure all the company's records are in order detailing information as to employees, including salary, sick/vacation time, and benefits.  
• Is there an employee manual. 
• Are there open employment or labor issues.
• Is there a stock option or similar employee incentive plan, and if so what are the obligations of the company under the plan.
• If there are employees in other countries, what are the foreign laws particular to those employees and what rights to employees have in those countries that are different from the US (for example, Hong Kong requires payment of an additional "13th Month" as an employee bonus).
• What is the status of the personnel -- employees vs. consultants, and are these employees being properly classified for purposes of FICA, etc. since improperly classifying an employee as a consultant will result in sever financial penalties.
• Are there any restrictions on the termination of employees.

      (f) Litigation. 

• If there are pending litigation matters, how you will these claims be addressed in the Purchase Agreement.
• Who will assume responsibility for these claims and related litigation costs.
• Has the company been threatened with any lawsuits or other claims, and if so how will these be addressed in the Purchase Agreement.
• Are there claims asserted by the company, and if so who has a right to receive the damages or insurance recovered on such claims.

     (g) Nature of the Business.

• Does the particular nature of the business give rise to areas of due diligence in addition to standard due diligence questions.
• An example of where additional due diligence will be required is environmental issues:  for example, a gas station, dry cleaner, manufacturing business will require specific environmental assessments.
• The business may implicate specific employee safety requirements under OSHA.
• The main point is that due diligence must be modified and/or expanded to address the particular nature of the business and therefore buyer should clearly understand what additional due diligence is required to properly vet all relevant issues.   

2.  Financial Due Diligence.  The buyer will need to conduct financial due diligence of the business, and therefore should engage an accountant or other financial professional who can examine the financial records.  A word of advice:  engage an accountant and/or other financial consultant that understands the business being purchased and has experienced with business buyouts.  It is not enough to understand a profit and loss statement (P&L) and ledgers, as an experienced financial consultant will be able to determine if revenues and expenses are properly booked, the method of accruing revenues and expenses (which will affect how the P&L looks), what tax obligations exist or may arise from the transaction, how the tax basis in the assets will be affected by the transaction, and a myriad of other issues.  Understanding these issues is important as it will reveal (a) if the profits/losses are being properly stated and (b) if any issues need to be addressed in the Purchase Agreement.  

3.  Technology Diligence.  Nowadays, most companies rely on technology for some aspect of the business.  In some cases, it is the essence of the business and for others it is simply an operational necessity. Therefore, technology due diligence is a must.  If the essence of the business is a technology company, the level of due diligence is obvious.  However, even where technology is more a matter of part of the operations, there are a number of due diligence concerns.

• Are there back-ups of key records, data and information.
• Are there back up copies of computer code and software. 
• Are the necessary redundancies in place.
• Does the business have in place a disaster recovery plan.

4.  Operational Due Diligence.  The buyer should conduct due diligence of the business operations, examining issues such as:

• Does the seller have a road map (manual) of important business processes as a buyer will appreciate anything that makes for a smooth transition.
• Will transitioning of the business require continued assistance from the seller or seller's key personnel post-closing.
• Will there be any issues with respect to the transfer of customers/clients.

5.  The Due Diligence is Completed, Now What?

Once the due diligence is completed, the buyer needs to consider how it wishes to proceed in light of any issues that may have been discovered.

    (a) Terminate the Transaction.  If the due diligence has disclosed material legal, financial or other issues, the buyer can choose simply to walk away.  The decision will be a function of how material the issues are and whether they can be resolved.

    (b) Reduce the Purchase Price.  In many cases, the due diligence issues can be resolved by adjustments to the purchase price (assuming the Seller is amenable).

    (c) Detail terms for transition of the business to the buyer, including any requirement that the seller or key personnel assist with the transition post-closing.

    (d)  Address the Issues in the Purchase Agreement.  The parties can agree to address any due diligence concerns in the Purchase Agreement by (i) requiring the Seller correct the issue(s) by a defined date, (ii) escrowing a portion of the purchase price, and (iii) defining the rights and remedies of the buyer in the event the issue(s) cannot be resolved.

Due diligence is an essential aspect of any purchase transaction, regardless of the size of the deal or whether the purchaser is buying assets rather than the company itself.  The above is by no means an exhaustive list of due diligence topics, but it should demonstrate the importance of:

• Tailoring the due diligence to the nature of the business (or business assets) being purchased.

• Engaging experienced professionals who can assist with the investigation of legal, financial, operational and technology matters relating to the business.

• Conducting thorough due diligence to ensure that any issues can, where possible, be addressed in the purchase agreement. 

Disclaimer: The discussions in this blog do not constitute legal advice nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters