Legal due diligence is largely comprised of “confirmatory” due diligence, which is to say that at this stage the buyer should be highly confident of their decision to move forward absent any new material findings. As we have discussed, on most transactions due diligence should be staged with the areas of greatest concern prioritized. Once concerns have been alleviated, and the buyer has concluded that they wish to move forward, additional due diligence is required to confirm assumptions made to arrive at this conclusion.

As such, legal due diligence is largely concerned with exposure to potential off-balance sheet liabilities and corporate structure. With respect to the former, the variables that can create liabilities are many. By way of example, this can include regulatory issues, required permits, ongoing or threatened lawsuits and onerous contract language to name a few. 

The due diligence topics that follow contain a short description of the objective. For a more comprehensive review of the data requests required to scrutinize the target company on each of these topics please see the Excel workbook associated with this lesson.

General Corporate Information: Here the objective is largely twofold: (1) To understand the company’s structure and confirm that it is “duly organized, validly existing and in good standing;” and (2) to confirm that the seller has the authority to enter into the purchase agreement and sell the assets or securities described. 

Governmental and Regulatory Documents: The degree to which this topic applies to a particular investment opportunity can vary substantially, but in any instance, operating without proper permits and regulatory approval can expose the company to substantial liability. In extreme cases noncompliance can result in forced closure. Post transaction, it is also important to know which consents, permits, licenses and / or approvals are required to operate. In summary, this section confirms compliance with all local, state, federal and foreign governmental authorities where the business has commercial activity and requests all related correspondence.

Financial Documents: You may have noticed that some form of financial due diligence appears in all three categories (i.e. commercial, financial, legal). Here the objective shifts from analysis of historical performance to documented and undocumented exposure, specifically on the liability-side of the balance sheet. As it relates to the asset-side of the balance sheet, the focus is to uncover how any assets of the target might be encumbered. Any potential legal claims on assets must be documented ahead of the transaction to avoid conflicts post close.

Litigation Documents: Exposure to litigation can be costly both as it relates to financial outcomes and the burden placed on the employees of the company. For this reason, the degree to which a company is exposed to ongoing or threatened litigation, and the frequency with which this has been true in the past, is critical. The data requests listed under this topic in the Excel workbook attempt to explore this to the degree possible. 

Business Contracts: There is no uniform or universal process for contract approval across companies, and even if there were, the terms one business might be willing to accept may be entirely unacceptable to another. Furthermore, some businesses have terms dictated to them, and consequently have unique language in most of their contracts.

The number of contracts can sometimes appear overwhelming. As you will see in the Excel workbook, there are many types of contracts that need to be requested and reviewed. These requests will be compared to lists citing the most important relationships the company has so that review can be prioritized by order of significance. Nevertheless, all contracts should be reviewed. Onerous terms can appear anywhere, and the dollars associated with the contract may not accurately represent the potential exposure to the company.

Author’s Note: In my opinion a member of the private equity investment team should also read most contracts. Many of these relationships will persist for the duration of the hold period, and it has been my experience that the company’s management team is not always aware of the terms that were drafted (in some cases simply because they were executed years prior). In some instances, it is also possible that legal review does not report on terms that the investment team would deem important.

Real Estate and Tangible Assets: All of a company’s assets need to be described and documented. This will confirm property transferred to the buyer and provides an opportunity to further explore whether any assets required for operation are encumbered. A primary focus of this section is the company’s real estate. A violation of zoning compliance, for example, could expose the buyer post transaction if they are not protected under the purchase agreement.

Author’s Note: I once worked on a sale where the company we held required highly unique and expensive equipment to manufacture its product, which made moving the facility extraordinarily difficult. The buyer we were negotiating with wanted to be fully protected in the event that a zoning violation was revealed during the hold period. The fact that the company was fully compliant was not sufficient; their concern was that city council might conclude later that even though the business was in compliance when the transaction closed, it may not have been for the previous X years. As the seller, we found this frustrating, but ultimately decided that the risk was remote and decided to accept the buyer’s language in the definitive agreements. 

Environmental: This section covers exposure to liability through violations of environmental laws. While it is easy to imagine violations via a company intentionally exposing the ground around its facility to hazardous waste, it is not always something so obvious. Consider California’s Proposition 65:

Proposition 65 requires businesses to provide warnings to Californians about significant exposures to chemicals that cause cancer, birth defects or other reproductive harm.  These chemicals can be in the products that Californians purchase, in their homes or workplaces, or that are released into the environment. By requiring that this information be provided, Proposition 65 enables Californians to make informed decisions about their exposures to these chemicals.

Proposition 65 also prohibits California businesses from knowingly discharging significant amounts of listed chemicals into sources of drinking water.

Proposition 65 requires California to publish a list of chemicals known to cause cancer, birth defects or other reproductive harm. This list, which must be updated at least once a year, has grown to include approximately 900 chemicals since it was first published in 1987. 

As this list of chemicals has grown, compliance has grown more difficult. Companies that outsource manufacturing or operate as resellers risk unknowingly violating Proposition 65 if they do not thoroughly audit their supply chain with some frequency. There are also groups in California with access to labs that regularly test products for violations, making the risk very real. 

Employee Compensation and Benefit Documents: A comprehensive understanding of all compensation and benefit plans available to employees is critical to understanding if the company is at risk. This information is also critical to understanding the organizational and operational structure of the organization.

Intellectual Property: This section has several objectives. The first is to identify all intellectual property (IP) developed by the company, and to evaluate how this is being used. The concern broadly relates to IP infringement. Is the company in violation or breach of protected IP rights, or are other entities infringing on the company’s IP? The second objective applies the logic under “Litigation Documents” to the topic of IP.

Tax Matters: The ultimate objective of this section is to confirm that all taxes have been paid and returns have been filed in a timely manner. To confirm that no tax liabilities exist, a thorough list of data requests are included (please see Excel workbook).

Insurance: Confirming that a business has adequate insurance policies and coverage in place is a critical part of due diligence. Data requests include all insurance policies with specific information related to each policy, and any correspondence where coverage was denied. It is common to have a third party (beyond legal counsel) evaluate the adequacy of the company’s insurance policies and attempt to identify savings.

Final Thoughts

Many of these items described above will be included in the purchase agreement under representations and warranties, and the detail behind some of the data requests will be included as schedules to the purchase agreements. As we will explain, the purchase agreement is the single most important document in a private equity transaction. So thorough legal due diligence is one of the best ways to be certain that the purchase agreement accurately captures both the buyers and sellers concerns as it relates to the transaction. 

To better acquaint yourself with this process, please download and review the hypothetical legal due diligence request list included as part of this lesson. As you read through the items listed, think through why each data request is important. It will give you a better appreciation of the process and the risks a company is exposed to.