What is Legal Due Diligence

Legal due diligence is an investigation into a business by re viewing documents and interviewing employees. A legal due diligence investigation is completed when a business or investor is interested in buying a business or investing in that business.

A legal due diligence investigation is seeking information about the business to make sure that the investment or purchase is beneficial. The investigation seeks to reveal all important facts and potential liabilities. Once the facts are collected and analyzed, an informed decision can be made.

There are subcategories of legal due diligence. These subcategories seek more specific pieces of information.

  • Intellectual property due diligence

  • Business due diligence

  • Accounting due diligence

Due diligence is most often performed in preparation for a merger, acquisition, licensing, or other transaction.

Due diligence seeks to understand all of a company's obligations. This includes:

  • Debts

  • Pending and potential lawsuits

  • Leases

  • Warranties

  • Long-term agreements

  • Contracts

  • Distribution agreements

  • Compensation

  • Much more

Why is Legal Due Diligence Important?

Legal due diligence is important for many reasons, but most importantly to make informed business decisions.

Understand Your Own Business

Legal due diligence is commonly thought of an investigation performed by one company on another company. Legal due diligence can also be an investigation into your own company.

A legal due diligence investigation into your own company is most helpful if you're considering a merger or major sale. Before negotiations begin, it's important to understand the worth of your business.

A legal due diligence investigation can also help the buyer better understand the company. This includes all of the agreements that make it up.

Value a Target Company

In the same way that a legal due diligence investigation can help your company value itself, a legal due diligence can help you understand the value of another company.

Legal due diligence seeks to understand a value through information on the company's agreements, assets, and potential problems.

Drafting and Negotiations

A large part of a merger or acquisition is negotiating and drafting the agreement.  The good and bad information gathered during the legal due diligence will lend support to the negotiations. This is true whether a merger or acquisition.

The information discovered in a legal due diligence is especially helpful in assessing risk.

Drafting of the agreement is in-depth and complicated. This should be created by an experienced lawyer.

Identify Potential Closing Problems

A legal due diligence may also find potential problems that could delay closing the deal. There are many steps that must be taken before closing. A legal due diligence gathers the information to make that list.

Legal Opinion

A legal due diligence is typically completed by an attorney who specializes in due diligence investigations. The lawyer or lawyers will prepare a legal opinion based upon all of the gathered factual information. Often, a legal due diligence investigation is completed by the selling company and the buying company. This insures an unbiased opinion.

Goals of Legal due diligence

The goal of legal due diligence investigation is to assess the potential benefits and risks of selling or buying another business or business assets. There are two main areas of focus in a due diligence investigation.

  1. Current status

  2. Consequences of potential agreement

Status

At the beginning of a legal due diligence investigation, lawyers are seeking to understand the current status of the business. This includes investigating relevant laws, governing documents, and contracts.

Determining status can also help to value a company and find ways to potentially improve that value.

Consequences

Along with the good, lawyers must establish a company's negative qualities during a legal due diligence investigation. This includes seeking potential problems with the transfer of assets or potential litigation.

When is Legal Due Diligence Necessary?

Legal due diligence is most common in two situations:

  1. Sale of the proprietary rights to goods or services

  2. Sale or purchase of a business in a merger, acquisition, or partnership

The sale of proprietary rights to goods has become more common in the digital age. With the sale of intangible goods and trademarked intellectual property, an investigation into right to use and ownership is very important.

Legal due diligence investigations are must more comprehensive for a merger or acquisition. There's simply more information to sift through and investigate. Mergers often include intellectual property and digital information now as well.

Legal Due Diligence Process

A legal due diligence investigation takes place in three stages.

  1. Preparation

  2. Investigation

  3. Results

The most time-consuming part of the process is the investigation or the gathering of facts.

Preparation

This stage of the legal due diligence is to set goals and priorities. Often there is one central goal or multiple smaller important goals that stand out from the rest. Legal due diligence investigation are often limited by time and budget pressures. It's important to prioritize what information is most important.

Investigation

During the investigation a lawyer or team of lawyers collect facts and documents. The findings will allow them  to formulate a legal opinion as to whether the sale or purchase is worthwhile. There are many parts to the investigation.

  • Establish the Big Picture. This comes back to the goal of the investigation. It's important to formulate the investigation around the central question or goal. This is also a good time to help the investigating lawyer understand the broad overview of your company.

  • Provide Documents and Interviews. The list of documents and interviews necessary for a legal due diligence investigation will likely surprise you with its length. The list of documents requested will likely be more documents than are actually necessary. The lawyer's job is to create a full picture, which means being thorough in gathering information. Consider making one of your c-level officers available to answer questions. Interviews are an efficient way to gather information.

Results

The results of a legal due diligence investigation are revieled at the end of the investigation. In the results, the lawyer will present the data in as concise way as possible. The lawyer will also present a results summary which will point out the most important discoveries.

The results may also provide analysis or opinion. The lawyer may offer an opinion as to the validity of the sale or purchase.

The results may be provided in written format or verbal conversation. This depends upon the size of the investigation and the preference of the lawyer and the client.

Presentation of Legal Due Diligence Investigation Findings

The findings of a legal due diligence investigation are really only important to a buyer and the buyer's counsel.

The buyer will typically want the due diligence finding to be presented in a compact and user-friendly way. The presentation can take many forms:

  • Verbal conversation: This is a great method for small deals or a buyer who is concerned about cost.

  • Memorandum: This memorandum can greatly range in length and depth. For larger deals, the written document will be longer.

Whichever form it takes, the presentation of the legal due diligence investigation findings should describe all of the reviewed documents, analysis of key issues discovered, and make recommendations as to a solution to presented issues.

If you are having a due diligence investigation performed, be clear with your expectations. Be specific on how you would like information and issues presented to you at the end of the legal due diligence investigation.

Documents Examined During a Legal Due Diligence Investigation

There are many types of documents that are examined during a legal due diligence investigation. The documents provide information about the company and it's current performance.

Organizational Documents

This section includes documents such as:

  • Certificate of incorporation

  • Company by-laws

  • Limited liability agreement

  • Stockholder agreement

Common problems to look for here include:

Ownership: By looking through these documents, the lawyer is looking to establish who owns the company's equity. This establishes the majority equity owners and any subsidiary owners. This will also attempt to show if there will be any issues when acquiring the company.

Consent: What actions of the sale will require consent? From whom?

Transfer: Are there any restrictions on transferring company equity? Do equity holders have rights?

Dividends: What is the dividend policy? How can it be changed?Unusual points: Are there any points of agreements that seem unusual? Is there anything strange that could effect the transfer of the company?

Contracts

This part of the investigation looks at all of the contractual agreements that the company is a part of. This includes:

  • Customer contracts

  • Supply contracts

  • Operating contracts

  • Licenses

Common problems to look for here include:

Parties: What parties have entered into the contractual agreement?

Change of control: Do the contracts provide regulations for a change of control?

Assignment: Can the contract be assigned? What are the provisions for an assignment?

Termination: What is the contract's termination policy?

Economics: What are the contractual agreements on economics? Can they be changed?

Merger and Acquisition Agreements

This section looks for any provisions for a potential merger or acquisition.

Parties: Who is part of the agreement?

Purchase price: Are there any purchase price adjustments that affect the business?

Escrow: Are there any escrow accounts? What funds are in the accounts? How will the funds be used?

Survival of warranties, representations, and indemnification: Does the business anticipate further indemnification claims?

Unusual provisions: Look for non-compete obligations and agreements.

Finance Documents

This part of the investigation looks at all financial documents. This includes:

  • Loan agreements

  • Hedging agreements

  • Guarantees

  • Promissory notes

Common problems to look for here:

Parties: What parties are named on the contract?

Basic terms: Is there outstanding debt? Are there loans?

Contingent obligations: This includes guarantees.

Restrictive covenants: Look for restrictions that could affect future transactions and operations.

Change of control: Are there any provisions for change of control?

Liens: Are there any liens on the business?

Litigation

Any current or potential legal issues should be examined here. This includes:

Pending claims: How many pending claims? What is the damage estimate?

Litigation history: What claims have been paid in the past? Any class action lawsuits?

Litigation trends: What types of litigation has the company been involved in? What are the average damage costs?

Legal Due Diligence Checklist

When completing a legal due diligence investigation, it's common for lawyers to use a due diligence checklist to create organization. The checklist should include a suggested list of documents to gather.

The legal due diligence checklist is also used to keep the investigation focused on the primary goals. The due diligence checklist can also improve the efficiency of the investigation.

Example of Legal Due Diligence Checklist

The following information is an example of what should be included on a due diligence checklist.

Legal Documents

  • A list of all company subsidiaries, direct or indirect

  • Company capital

    • Number of authorized share for each class or series of stock

    • The number of issued and outstanding shares of each class or series of stock

    • The record owners of each class or series of stock

  • Certificate of incorporation

  • Company bylaws or articles of organization

  • Meeting minutes from stockholder meetings, board of director's meetings, and any committee meetings for the past three years

  • Stockholder agreements relating to management, ownership, or control of the company

  • Documents pertaining to prior financings or equity issuances. This might include:

    • Stock purchase agreements

    • Stockholder agreements

    • Registration rights agreements

  • All correspondence between the company and the directors that relate to:

    • Indemnity

    • Employment

    • Loans

    • Advances

  • Stock records

    • Books

    • Transfer ledgers

    • Other records

  • Any documents issued by the company such as options, purchase rights, and warrants. These documents must include:

    • Name of the holder

    • Number of options

    • Rights or warrants issued

    • Date granted

    • Option or purchase price

    • Position of the holder within the company

  • Address list of all land, buildings, and improvements leased or owned by the company.

  • All pertinent government permits, licenses, or authorizations. This should include all related correspondence.

  • And federal, state, or local regulatory agreements in which the company is a party.

Example of Legal Due Diligence

A legal due diligence investigation can take many forms and gather many different types of information. Each legal due diligence investigation will be unique.

Take the example of a property transaction. This type of legal due diligence will need to assess:

  • Environmental liabilities

  • Real estate records

  • Liens on the property

  • Itemized list of necessary repairs

  • Deferred maintenance items

  • Compliance issues

  • Building code requirements

  • ADA regulations

The nature of the legal due diligence investigation depends upon the transaction.

Intellectual Property Map

A legal due diligence investigation gives the owner an opportunity to create an intellectual property map also known as an IP map.

An IP map documents:

  • Each component of IP

  • The inventor or creator of each IP component

  • The current owner or licensee of the IP component

  • Identifies the chain of ownership from inventor to owner to licensee. This cross references multiple supporting documents that validates each link. These documents might include:

    • Employment contract

    • Collaboration agreement

    • Joint venture agreement

    • Assignment from a student

    • Assignment from a contractor

    • Consultancy agreement

    • License

    • Material transfer agreement

    • Consent from a joint owner

    • Many others

There are two main goals of an IP map:

  1. Facilitates an IP owner in undertaking a legal due diligence investigation. It helps to identify any gaps or problems. It begins the process of fixing any gaps or problems.

  2. The IP map can be presented to anyone who is interested in the IP and who might want to perform their own legal due diligence. This document may be able to help speed up any purchases or sales that are being done.

Proof of Due Diligence

A due diligence affidavit is provided to prove efforts made.  Often this is the case of an attempt to serve papers. The affidavit will list each attempt to serve the papers. The affidavit might also list the efforts made to locate the person being served.

The affidavit is used to show a court that all legal obligations to notify the person have been met.

How Long Does Due Diligence Take?

Legal due diligence investigation take a proportional amount of time to information. The more information that needs to be investigated, the longer the investigation takes.

A legal due diligence investigation can take anywhere from a few days to several months. The size of the company also plays a role in the length of the investigation.

The time required for the legal due diligence is determined by the buyer. Once the buyer is satisfied that enough information has been gathered, the investigation is completed.

A mistake that is commonly made is not leaving enough time to complete a thorough due diligence investigation. The limit may be due to time or budget.

Common Mistakes

Not Enough Resources

It's common for legal due diligence investigations to be limited by time and budget. This limitation can result in a lack of thoroughness. If the investigation isn't thorough, important potential problems may not be identified.

Not Completed

Some companies choose not to complete a legal due diligence prior to a sale or purchase. This greatly increases the risk of potential problems in the transaction.

Some problems may not appear for extended periods of time. There is no legal recourse for solving those problems after the transaction is complete.

Bias

Whether intentional or unintentional, owners, managers, employees, or researchers may influence the results of the legal due diligence investigation. This influence may taint the outcome of the legal due diligence investigation.

If the investigation is being done by in-house lawyers, consider getting a second opinion from unbiased lawyers.

Check Legal Coverage

The potential legal risks are often the most important aspect to assess in a legal due diligence investigation. It is pertinent to not skip this aspect of the investigation.

Protection From Mistakes

It is becoming more common for businesses to seek extra protection when entering into a transaction such as a merger or acquisition.

This extra protection can come in the form of special insurance. This insurance is known as "representations and warranties liability insurance." This insurance basically protects a business from wrongful acts.

Wrongful acts might include:

  • Misstatements

  • Misleading information

  • Errors

If you're considering merging with or acquiring another business, a legal due diligence investigation is in your best interest. A legal due diligence investigation provides insight into the new business. It also gives you an information to make an informed decision.

A lawyer who is knowledgeable in legal due diligence can help you complete the investigation. Consider hiring one of UpCounsel's knowledgeable lawyers.

Frequently Asked Questions

  • What is legal due diligence?

Legal due diligence is an investigation into whether a business transaction is worthwhile. This type of transaction might be a merger or acquisition.

  • When do I need legal due diligence?

A legal due diligence investigation is necessary anytime there is the sale or purchase of another business. It might also be necessary when evaluating the purchase of proprietary goods or services from another company.

  • What's the cost of legal due diligence?

A legal due diligence investigation ranges in cost. The cost of the legal due diligence investigation is proportionate to the amount of research necessary.

Get Legal Assistance

If you are looking for help with legal due diligence as well as general advice along the way, you can post on UpCounsel to receive free custom quotes from the top 5% of attorneys with experience in your area. Customers have typically saved up to 60% on legal fees in comparison to large law firms. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe and Twilio.