If You Need Some Help with Understanding Legal Due Diligence
Date: 6 May 2016 Share on Twitter Share on Facebook
‘Legal due diligence’ – three words that, in combination, don’t sound particularly exciting. But if you’re looking to sell a startup or acquire a business, you’ll need a decent grasp of what it actually is – so read on…
Due diligence might sound a little cryptic, but really it’s just a corporate phrase that means doing your homework. You wouldn’t buy a car without test-driving it first, or stay in a hotel without at least glancing at the online reviews – and similarly, when carrying out a business deal, it’s important to really understand the company in question. Fundamentally, that’s all due diligence is – looking carefully at a company’s finances, structures and operations to make sure it’s in good shape, and that there are no glaring issues that could flare up in the future.
What is Legal Due Diligence?
One of the most important aspects of a company to evaluate when carrying out due diligence is its legal position. Essentially, this boils down to two things: evaluating what the rights and responsibilities of the company are according to the law, and checking whether there are any irregularities or concerns that might endanger either the purchaser or the execution of the deal itself.
Legal due diligence can take a few days or several months, depending on the size and complexity of the target company. However, there are three key questions that will crop up in some form or another, whether you’re looking at a startup or a corporate behemoth.
Where are we now?
This question revolves around the current status of the company in question. Initially, what’s needed is a reasonable understanding of the big picture: how the business functions, where it operates, and what the key trends are in the relevant sector. Particularly for smaller companies and startups, it’s incredibly important that whoever is carrying out the due diligence starts from a solid foundational knowledge of the nature of the business.
The next step is to look more closely at the company’s current legal status. What sort of entity is it now, and how is it structured? What binding contractual relationships does it have? Lawyers might also be concerned about how likely litigation from customers or suppliers could be – or, conversely, how valuable the company’s intellectual property is. So legal due diligence on Apple a couple of months ago would have noted its spat in court with the FBI, but also the huge number of patents that it has registered.
Other important areas of investigation include beneficial insurance policies, the company’s arrangements with its employees, and whether its activities are restricted, regulated or controlled by any external bodies. All this information adds up to a fuller picture of the overall legal situation.
How might this happen?
Understanding the status and execution of the planned transaction is also vital. What are the requirements to carry out this sort of deal in accordance with laws and regulations, and through what legal mechanisms could it be achieved? Ensuring you have a clear sense of how things could progress helps to keep the deal process smooth.
The key question here is whether there are any major legal obstacles to the transaction. That means working out who needs to give their approval, what current parties with contractual relationships have to agree to, and how financial obligations will be transferred. At this stage, another question is whether the deal would run afoul of regulators – like the scrapped merger between Halliburton and Baker Hughes.
Paperwork is the bane of our lives, for lawyers more than most. Even so, it’s vital, because it helps us to prove things – and for anyone doing due diligence, nothing could be more important. That means that a large portion of the legal side of things involves finding all of the relevant documentation, and ensuring that everything is in order. This will range from certificates of incorporation and supplier contracts to trademark registrations and tax returns – so to make the operations more manageable, the paperwork is often gathered together in a ‘data room’. Although in the past these tended to be physical spaces, the use of ‘virtual data rooms’ is increasingly common – it can help to streamline an already laborious process.
What are the benefits?
Whether you’re investigating a target company or having your own examined, there’s no doubt that legal due diligence can feel a little arduous, but the upsides to sticking it out are considerable.
If you’re selling, the heightened legal scrutiny will actually help in the long run, by ensuring that the deal progresses smoothly without encountering any nasty legal surprises. For acquirers, increased legal knowledge and expertise will help to build a more accurate valuation of the company while highlighting any potential legal issues in the future. It might not be exciting – but much like reading hotel reviews, it should give you some piece of mind.