The Ins and Outs of Legal Due Diligence

Kison Patel is the Founder and CEO of DealRoom, a Chicago-based diligence management software that uses Agile principles to innovate and modernize the finance industry. As a former M&A advisor with over a decade of experience, Kison developed DealRoom after seeing first hand a number of deep-seated, industry-wide structural issues and inefficiencies.

This post was originally published on July 10, 2019 and has been updated for relevancy on September 10, 2024.

Due diligence, or the audit and review process that accompanies any M&A transaction, covers four main areas: financial, legal, operational, and tax. Of these, legal due diligence, or LDD, stands head and shoulders above the others in terms of complexity and importance.

The scope of legal due diligence encompasses everything from IP to litigation. In this post, we’ll review the many steps of LDD and dive into its (often) complicated process.

What is legal due diligence, and why is it important?

Legal due diligence is one step of the mergers and acquisitions process. During LDD, the potential buyer seeks to gain a full legal picture of the target company. As with any component of the DD process, the ultimate aim here is to “check under the hood” and ensure everything is in order. Typically, LDD includes thorough analyses of licenses, regulatory issues, contracts, and any pending legal liabilities.

Buyers (or buyers’ legal teams) should approach the legal due diligence process by asking, “Is there any legal reason that we shouldn’t acquire this firm?” Few target companies are likely to have a completely clean slate regarding their legal history. Common examples include HR issues with departing employees or contractual disputes with suppliers or clients. Your legal due diligence process should set out to find the “red line” issues, aka the deal-breakers.

How much does legal due diligence cost?

Legal due diligence isn’t cheap, but it’s a lot cheaper than finding legal skeletons in the closet six months after the deal has closed. Don’t cut corners or you may end up paying far more than you expected down the line. Instead, create a clear agenda with the law firm and legal experts you hire, establishing where and when the costs will arrive so everyone knows what to expect.

How to perform legal due diligence

During LDD, the legal teams on both the buy side and the sell side will conduct due diligence investigations into the target company’s legal background, operations, and documentation. The goal is to uncover potential risks, review regulatory compliance, and understand current liabilities.

The LDD process will likely begin with a general review of the target company’s legal standing, and then move into an in-depth examination of the following areas:

• Organization/ownership
• Litigation
• Product/service
• Contracts/obligations
• Permits/licenses
• Intellectual property
• Material assets
• HR/operations

Legal due diligence on the sell-side

It’s good practice for owners on the sell side to conduct at least part of the legal due diligence process. For one, having an external attorney sign off on some of the internal legal workings of your company is a courteous way to treat buyers. For another, it speeds up the process and better prepares your business for a frictionless and timely sale. Furthermore, if both companies have in-house legal teams, LDD offers a useful icebreaker opportunity.

Legal due diligence on the buy side

The main goal of LDD on the buy side is to ensure the target company doesn’t have any hidden legal problems that could make the sale fall through. However, LDD also helps ensure a fair valuation and purchase price and can inform the details of the purchase agreement.

How long does legal due diligence take?

Legal due diligence can take as little time as a month to as much as half a year, with the majority of LDD processes taking some amount of time between. Although LDD can be time-consuming, it’s well worth it to be as thorough as possible.

How to ensure a smooth LDD process

The most efficient way to conduct legal due diligence is via a virtual data room, which will be shared between the buy side, the sell side, and the legal teams on both. The buy side, in tandem with their attorney, should agree to a checklist of legal documents that will be requested from the sell side.

It’s important to establish some order at the outset. Begin processes that inevitably take longer first. Your attorney will know from experience which documents take the longest, but a good rule of thumb is: The further back you go with a document that can’t be retrieved in-house, the lengthier the process will be.

The importance of obtaining a legal opinion on the target firm

Even if your LDD process doesn’t raise any red flags, M&A always comes with some element of legal risk.

This is where legal due diligence differs from other parts of the process. Many of the risks you’re trying to uncover here won’t be hiding in plain sight. Suppose you’re acquiring a small pharmaceutical firm that sells drugs with some potential side effects that haven’t caused any issues until now. What are these side effects and what kind of liability would they create for your company should one (or several) of your customers be hit with them?

Answering questions like these is where your legal team pays for itself. They’ll provide you with expert opinions on whether you complete the acquisition process. The answer will rarely be a straight “yes” or “no,” but at least you’ll be making a far more informed decision based on their legal advice.

A legal due diligence checklist for M&A

The LDD process has a lot of moving parts. Having a checklist in place helps keep everyone organized and on-task from beginning to end. Below, we’ve laid out a basic checklist by LDD category that you can fit to your own needs.

General

• Obtain copies of agreements or instruments that place restrictions or encumbrances on assets.
• Review contracts that restrict the target's right to conduct its business.
• Review contracts with obligations such as covenants and indemnification.
• Obtain a summary of the target's compliance program and copies of all policies, procedures, and other related documentation.
• Confirm that the firm is not restricted from doing business under OFAC regulations or similar.
• Confirm whether the target has any direct or indirect presence and/or other engagements.
• Obtain a summary of regulations applicable to the business, and anticipated changes.
• Create copies of any letters with any regulatory agencies or authorities.
• List the states and countries in which the target has operations.
• Obtain good-standing certificates or qualifications to do business from state of incorporation and states where qualified.
• Obtain a schedule of any significant U.S. import or export restrictions that relate to the target's operations.

Organization/Ownership

• Obtain lists of:some text
  • Current shareholders detailing the amount of shares each owns
  • Stock transfer records
  • Stock broker contracts and agreements

  Litigation

  • Obtain lists of: some text
    • All threatened, pending, current, and closed litigations from the past five years
    • Arbitrational proceedings from the past five years
    • All statutory orders, decrees, and rulings to which the company may be subject

    Product/Service

    • Obtain a detailed list of all products and services.
    • Verify compliance with FDA, CPSC, OSHA, and FLSA regulations for products, services, and operations.
    • Get copies of all product warranties.
    • Summarize all submitted material warranty claims.
    • Summarize all product recalls.
    • Identify potential liabilities associated with products/services.

    Contacts/Obligations

    • Obtain copies of:some text
      • Service contracts
      • Vendor contacts
      • Customer contracts and obligations
      • Outstanding contracts to purchase machinery or real estate
      • Contracts for construction, architectural, or engineering services for any buildings or improvements
      • Operating contracts
      • Employee contracts and retirement agreements
      • Control regulations
      • Material contracts that are terminable upon a change of control or other corporate transaction
      • All joint venture, partnership, and franchise agreements

      Permits/Licenses

      • Summarize permits, licenses, and other authorizations, including any required export control and pertinent governmental licenses.
      • Summarize license, sublicense, royalty, and franchise agreements.
      • Obtain a schedule of permit and license renewals and associated fees.
      • Gather copies of automobile registrations.

      Intellectual Property

      • Obtain lists of all:some text
        • Patents, trademarks, trade names, service marks, and copyrights held or applied for
        • Creator(s) for each IP component
        • Patents, trademarks, and copyrights held by an employee, shareholder, director, or any other affiliated party

        Material Assets

        • Obtain lists of equipment and real estate.
        • Summarize inventory stock.
        • Summarize all technology owned by the company.

        HR/Operations

        • Obtain a list of all employees, including those covered by any disability legislature.
        • Obtain a list of OSHA citations, employee health issues related to the target, and any other adverse environmental or occupational safety or health conditions or concerns.
        • Get a history of all sexual harassment accusations, charges, and convictions from the past five years.
        • Obtain copies of all current employment applications, interview guides, and hiring procedures.
        • Verify compliance with equal employment opportunity and anti-discrimination legislation.
        • Summarize disciplinary and termination procedures and all involuntary employee terminations from the past five years.
        • Review all Unemployment and Workers’ Compensation claims.
        • Verify compliance with the Fair Labor Standards Act, i.e. minimum wage, child labor, etc. (if U.S.-based).
        • Ensure employee personnel files and Form I-9s are in compliance with legal standards.
        • Obtain copies of all SBCs for current benefit plans.
        • Obtain copies of all union and labor contracts.
        • Review any labor-related disputes, grievance proceedings, and arbitrations.
          

        Get your complete legal due diligence checklist here.

        

        Legal due diligence in a foreign country

        The importance of conducting legal due diligence when acquiring a foreign firm, entering a joint venture, or beginning a business partnership cannot be overstated. This is as true for foreign companies coming to the United States as it is for American companies moving abroad: Different legal environments bring new risks.

        Accordingly, they require proper assessment. When looking into acquiring a company in a foreign jurisdiction, shop around among the local legal firms to determine which ones best fit your requirements in terms of service and cost. Once the transaction is closed, the relationship with this legal team may become long-term, so it’s worth putting extra time in at the outset to ensure it works for your firm.

        Avoid legal surprises

        The conclusion is simple: Conduct high-quality legal due diligence now to minimize the chances of unwanted legal liabilities after the transaction has closed.

        The universe of legal issues in M&A is too complex to leave to chance. By conducting a thorough LDD, you give your acquisition its best chance to create ongoing shareholder value.