Due Diligence | Part 2 | Legal Issues
In the introduction to due diligence, we explained the importance of engaging in extensive due diligence prior to purchasing a business, and we broke down due diligence into six categories. Today’s post will highlight the key legal issues the purchaser should be aware of when purchasing a business.
Reviewing the Owner’s Governing Documents
Prior to any acquisition, the purchaser will need to know the basic organizational structure of the business, i.e. how it was formed, its governing documents, and its key personnel. Knowing how the business is organized will dictate how the transaction will be structured.
Is the purchase going to be structured as a stock purchase? How many shareholders currently own stock in the company? Is there a shareholder agreement? Are there restrictions on acquisitions or transfers of stock? Will the transaction need to be registered with the SEC? These questions are just a glimpse at some of the securities matters the purchaser will need to consider during due diligence. Generally outside legal counsel will conduct an audit of the owner’s business to identify the key securities issues that the owner and purchaser need to be aware of.
Is the owner’s business subject to special government regulations? Are there environmental considerations that the purchaser should be aware of, e.g. permits, hazardous waste handling, and EPA regulations? These are important considerations as they will affect the purchaser’s ability to continue the business. Certain regulations can be costly and time consuming to comply with, and even more costly if the purchaser is unaware of them and fails to comply. This portion of due diligence requires reviewing any licenses or permits that business currently holds, reviewing the facilities and location of the facilities to be aware of the environmental risks and regulations, and researching any additional licenses or permits the purchaser may be required to obtain. An environmental audit typically requires hiring an environmental engineering firm to complete the environmental review.
Pending or Threatened Litigation
The purchaser will need to be aware of any pending or threatened litigation the owner is involved in. Litigation is expensive and time-consuming and will subject the purchaser to significant hassles if left undisclosed or undiscovered. While a public company is required to disclose any pending litigation matters in its SEC filings, discovering pending litigation for a private company can be more difficult. For any pending or threatened litigation, it’s important to determine the relevant information, including the parties involved, the nature of the proceedings, the timing of future hearing/trials, the status, relief sought, and settlements offered, estimated future costs, relevant insurance coverage, and any legal opinions on the cases.
It is also important to establish a materiality threshold regarding each claim, i.e. a threshold for walking away because of a pending claim. By evaluating each claim and quantifying the potential liability or recovery, the purchaser can assess whether the pending litigation is a deal breaker or whether the deal can be restructured to minimize the purchaser’s risks associated with the on-going litigation. In some cases the acquisition may compromise the current strategy for the on-going litigation.
Stay tuned for our next post in this series that will cover the financial issues surrounding due diligence.