Due Diligence | Part 6 | Material Contracts and Information
We continue our series on due diligence and our series on the purchase and sale of a business by tackling—yes, this word was chosen in part because of last night’s pre-season opener for our Seahawks—the next phase of due diligence: material contracts. So far we have covered the financial, legal, and operational issues associated with the due diligence process. In today’s post, we’re exploring one of the more time-consuming aspects of due diligence, reviewing every material contract of the target company.
Who, What, When, Where (and How?)
As we have been discussing throughout this series, it’s incredibly important to know the business you are acquiring in and out. This includes examining every contract the company has entered into and is bound by at the time you acquire the company. What obligations will be attached to the business? Are the contracts assignable? Are there strategic partnerships that the company relies on? Who are those partners and what are the terms of the agreement? If you’re just buying the assets, will the assets be burdened by these agreements?
One important issue to iron out is how the information will be exchanged between the buyer and the target company. Some companies are comfortable exchanging copies of all the information that is requested, while others prefer to set up a data room that is located on-site at the target company’s offices. The data room is where boxes of contracts and other documents will be stacked up and reviewed by the buyer and his legal counsel. Another (and increasingly popular) option is to create a virtual (or online) data room, a password-protected website that contains all of the contracts and documents requested by the buyer. The advantage to virtual data rooms is that they are convenient and efficient. These virtual data rooms are especially convenient when the buyer and seller are not located in the same geographic area. The ability to exchange information electronically makes this phase of due diligence quicker and cheaper than it used to be.
However, regardless of how you exchange information, this portion of due diligence will inevitably require patience (and stamina), as reading through dozens of contracts can take its toll after a few days—trust us, we do that for a living. Below are a few of the key agreements you should be aware of and keep an eye out for when you’re performing due diligence.
A license is a contractual right that helps you control, manage and protect your intellectual property. Intellectual property has significant value, and you will want to make sure that the target company’s intellectual property is properly protected. Further, you will want to be aware of those third parties that have been granted a license to use the target company’s intellectual property, since these obligations may continue once the company is acquired. You’ll want to determine the scope of the license to make sure you are comfortable with the extent of third parties’ ability to use your new business’ intellectual property.
Last, licensing can generate revenue for companies and understanding who is obligated to pay your company (or vice versa) is an important piece of information to obtain during due diligence.
Joint Venture and Other Acquisition Agreements
As part of this phase of the due diligence process, you’ll also want to investigate look into any partnership or joint venture agreements. Has the target company entered into any strategic partnerships or joint ventures? Has the target company obligated itself to make any major purchases in the near future? How will these agreements be affected by your purchase of the business? If they fall apart, how will your new company be affected?
Non-compete and Exclusive Sales Agreements
How terrible would it be to purchase a business knowing that you have a strategic partner that you’re looking to bring on only to find out you can’t because the target company is restricted from doing so by a non-compete or exclusive sales agreement..
For example, let’s say you purchase a bakery and you have a friend who sells great flour at a low price. You’ve done the math and you believe you can save a significant amount of money by purchasing the flour from this new vendor. You begin negotiating the terms of the vendor agreement, and you get a call from the flour vendor that currently supplies the company because he heard that you’re looking to start buying from a different vendor. He informs you that your new company has an exclusive agreement to buy flour only from him for a term of two years (only one of which has gone by). You’re now forced to cancel negotiations with the new vendor (or risk breaching the prior agreement) and you lose out on saving money with the new vendor.
Reviewing Material Information
Material information is any information that would affect your decision about buying the business. Regardless of the type of business you are purchasing, you need to make sure you ask the right questions, review the right contracts (or hire an attorney to do so for you), and understand the on-going obligations of the company you are purchasing. The goal in reviewing material agreements is to have a broad understanding of the agreements that are material to the target company and that will be material to the buyer going forward. For example, if an important contract can be terminated by either party following the transaction, the buyer should be aware of the other party’s ability to walk away from the agreement. A key issue in a contract review is whether the proposed acquisition results in the right of the other party to terminate the contract.
If you’d like to learn more about reviewing contracts and material information or the due diligence process in general, please contact us today for your free initial consultation.