Michael’s M&A Playbook: 7 Tips for the Legal Due Diligence
The legal due diligence process is one of the fundamental elements of the overall due diligence process. The reason is that every aspect of a company has at least some legal touchpoint. Whether you talk about employees or analyze assets and liabilities on the balance sheet, there is a legal topic that you need to address in the due diligence. Moreover, the legal due diligence must address issues that may arise during the due diligence from other workgroups and use those findings in the preparation of the M&A purchase agreements later in the process. In summary, it is a complex topic, and a simple legal due diligence checklist doesn't help. Here are some of my M&A tips to help you with your next legal due diligence.
Best Practice Tips for the Legal Due Diligence
Work with an external M&A lawyer - The more complex a topic is, the more helpful it is to combine internal resources with external experts. A due diligence process is different from a company's day-to-day legal work, and I suggest you work with an external law firm with experience with M&A transactions.
Understand the regulatory environment - This is primarily a topic for international M&A transactions. If you have targets in different countries, you need to look into the regulatory environment, including federal vs. regional laws, applicable competition laws, local labor laws, court decisions, enforcement, approach to dispute resolution, and many more. It also includes unwritten rules of conduct, such as ethical standards. An international M&A transaction can become very complicated when you buy a group of companies with subsidiaries worldwide, which is another reason for using external lawyers.
Start with the analysis of the legal entity structure - Depending on the complexity of the target, this can be easy or complicated. I worked in the past in some deals where the legal structure of the target company was the result of prior M&A transactions and has never been cleaned up. In such a case, you will find operating and non-operating entities. Sometimes, the legal entity structure also includes dormant entities. In a few instances, I found entities where the seller couldn't find legal documents because they were founded decades ago without any operational activity and no assets (except for a small cash and equity amount). You can also include the closure of legal entities as a condition precedent in the purchase agreement. Start working with your external M&A lawyers and tax experts on a target legal entity structure. It may take some time to implement those changes. Include related expenses in your business case calculations.
Go through all balance sheet and income statement items to identify legal topics - I usually take the target company's balance sheet and income statement and define with the M&A lawyers which issues must be part of the legal due diligence scope of work. For example, include real estate contracts if you have land and buildings on the balance sheet. Other examples are terms and conditions (T&Cs) of sales contracts and customer contracts (based on revenues and accounts receivable), vendor payment terms and agreements (for the cost of goods sold and accounts payable), debt agreements for financing (short- and long-term debt on the balance sheet), and employee contracts (for personnel expenses). Also, check whether there is any restricted or blocked cash in some entities. I have been in M&A transactions where it took years to get cash out of certain business situations and countries. Blocked cash is ammunition for your negotiations and purchase price adjustments. Line by line, think about what kind of legal documents should be available and what potentially could be an issue.
Intellectual property (IP) is a big topic - Patents, trademarks, or copyrights are examples of intellectual property and are fundamental to the valuation of a target company. In many industries, the majority of the purchase price is for intangible assets, including IP. Part of the legal due diligence is assessing intellectual property's scope and validity. Ensure that you review patent claims and check whether there are any infringement lawsuits or other related litigation risks. The enforceability of IP can be challenging in certain jurisdictions, and IP litigation is usually expensive. Also, understanding licensing and reporting requirements is essential.
Analyze past, ongoing, and potential litigation - It is a standard topic for the legal due diligence, and no surprise that it is on this list. Dig into past, ongoing, or potential litigation, arbitration, or legal disputes. Like tax topics, analyze how conservative or aggressive the target company has been with litigation. The more aggressive the approach is, the more litigation risk there is. Also, talk with the controller of the target company about how they accounted for litigation accruals and which notes they included in the audit reports about the litigation. Compare this with press releases and see whether there are any differences. I have found interesting differences between the stories about lawsuits of investor relations and accounting in my transactions.
ESG is a growing topic - Environmental, social, and governance (ESG) are becoming increasingly important. For some industries, such as energy, it is already a must on an international level to have ESG reports. Independent of the industry, ensure that you include ESG topics in your due diligence.
Summarize the Findings in a Legal Due Diligence Report
Different due diligence teams work in an M&A transaction, and the exchange of information between those teams is crucial. Set up weekly calls where the due diligence team leaders present their status and results. Those findings have many times an impact on the legal and financial due diligence. During critical times of an M&A transaction, it may be necessary to switch to daily calls. At the end of the legal due diligence, summarize the findings and your assessment in a legal due diligence report.
