Due Diligence for Buying a Business 101 – Part 2: Legal Due Diligence

Previously, I wrote about the need for the purchaser of a business to do due diligence on its prospective target. As I previously discussed, due diligence on a business can be split into three sections: legal, financial, and operational. This post will explore what is involved with the legal portion of due diligence.

The legal portion of due diligence involves ensuring (a) that the company has been validly formed and exists, (b) that the buyer has an accurate understanding of the company’s ownership and the rights of the different owners and the company’s management, (c) the buyer understands what litigation is pending or could arise in the future, (d) that the current insurance is adequate, and (e) that the company is in compliance with all applicable laws and regulations.

Below, I’ve created a non-exhaustive list of the types of documents that a buyer should request over the course of their due diligence. Obviously, every deal is different, so there are likely to be additional documents that would be necessary in any particular deal.

To ensure items (a) (corporate existence) and (b) (ownership rights) above, a buyer should request:

1. The company’s organizational documents. If the company is a corporation, this includes any charter, articles of incorporation, certificate of incorporation, bylaws, and stock certificates. If the company is an LLC, this includes any articles of organization, certificate of organization, operating agreement, and membership certificates (if any).
2. Any record of meetings of the board, shareholders, members, or managers, plus any subset of the foregoing operated as a committee. Also request any stockholder lists or record books.
3. Any documents required by a state other than the company’s state of incorporation that permit the company to do business in that other state. These are frequently called “foreign qualification documents.”
4. Any kind of agreement giving owners options, rights of first refusal, preemptive rights, warrants, or any agreement limiting the owners’ rights to transfer their ownership interests or the ability of owners to vote their shares/interests. For a corporation, this is frequently included in a stockholder’s agreement or a buy/sell agreement and in an LLC, this is frequently included in the operating agreement.
5. If the company has any subsidiaries or affiliates which will be involved in the deal (as part of the target or otherwise), a list of those subsidiaries and affiliates, and items 1-4 above for each subsidiary or affiliate.

To ensure item (c) (litigation) above, a buyer should request:

1. A list of all threatened or pending litigation over the past five years.
2. The files of all litigation included in item 1, including any correspondence, judgments, injunctions, or settlement agreements.
3. If the seller has hired a law firm, a letter certifying that the firm knows of no threatened litigation or contingent liabilities. This may be difficult to obtain if no firm regularly represents the interests of the target.
4. Documentation as to who owns the IP of the firm. It must be clear that the company owns the IP of the firm and not any employee, founder, or other party. Otherwise, the buyer is just purchasing a lawsuit.

To ensure item (d) (insurance) above, a buyer should request:

1. Copies of all insurance policies, including property casualty, general liability, D&O liability, and excess umbrella policies.
2. A list of any claims made during the previous 5 years and any related correspondence.

Ensuring item (e) (regulatory issues) above can vary greatly depending on the industry. It can be as simple as obtaining copies of business licenses and health inspections, or as complex as obtaining all reports, permits or registration statements, and disciplinary proceedings from a regulator that oversees the company. In addition, if the company owns real estate, separate due diligence needs to be done on the real estate, including environmental and title.

As you can see, doing due diligence on a business acquisition involves reviewing a large amount of documentation. This post discussed just one-third of the process. In future posts, I’ll discuss the other two: financial due diligence and operational due diligence.

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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.