Important Due Diligence Items To Consider When Buying a Business
When deciding to purchase a business, one of the most important pre-transaction items for the buyer to complete is a due diligence review of the target company. Sufficient due diligence will ensure both buyer and seller are clear as to which liabilities are being assumed in the purchase documents, bring to light unknown liabilities, and assist in the post-closing integration process. Best and typical practice involves the buyer and seller agreeing ahead of time, either through a letter of intent process or otherwise, the scope, logistics (some due diligence may require in-person site visits), and responsibilities for due diligence. Important categories of a thorough due diligence review include an analysis of the legal contracts which the target company has entered into, real estate and environmental matters, intellectual property and cybersecurity concerns, and the target company’s employment matters.
When reviewing legal contracts of a target company, a major point of concern will focus on whether there is an anti-assignment or change of control provision. The relevance of either provision will depend on whether the transaction is structured as an equity or asset transaction. If an important contract of the target company includes an anti-assignment or change of control provision, the parties will likely need to receive consent for the assignment or change of control from the other contracting party. This procedure can take time and potentially require more negotiation with the third-party. While dealing with an anti-assignment provision can lead to some expense, addressing consent issues pre-transaction will place the buyer in a better bargaining position with the other contracting parties and reduce potential delays in closing.
Whether the target company owns or leases real estate is an important inquiry to make, particularly if there is liability associated with issues to the chain of title to real estate, if the real estate is subject to a mortgage or other security arrangement, or if landlord-tenant relations are strained. If the target company does own real estate, specific due diligence inquiries need to be made regarding the legal rights the target company owns in that real estate as well as the owner’s potential environmental liability. Alternatively, if the target company merely leases real estate, a detailed review of the lease is crucial. The buyer must ensure that it can “enter the shoes” of the seller in the lease without liability, and if not, negotiate with the landlord with regard to taking over the lease. Additionally, it is important to understand whether the lease terms are sufficient for the buyer’s plans and to assess how the lease fits in with the buyer’s strategic planning after the transaction.
Intellectual property continues to demand increasing relative value in a business’s going concern. Even if the target company is not a technology or IP-centric business, the target company will own intellectual property rights in its name, website addresses, any form of software developments or enhancements, and related items. Pre-transaction due diligence into intellectual property matters will ensure that a buyer takes title to all the intellectual property of the target company, not just traditional intellectual property assets such as patents or trademarks.
As cybertheft continues to become more prevalent, and state and federal laws protecting individual and consumer information become more restrictive, it is crucial to know whether the target company has experienced a cybersecurity breach, as well as determine what the risk is that the target company has or could fall victim to a cybersecurity breach.
Finally, it is important to understand, comprehensively, the relationships between the target company and its employees, both in the context of potential legal liability and in terms of post-transaction integration. Buyers, as a matter of state and federal employment laws, could assume long-term liability related to employee benefits (health insurance, 401k and retirement planning, etc.) and employment discrimination or safety proceedings. Additionally, it is important to understand whether the target company’s employees are subject to written or oral employment agreements, as well as confidentiality and non-compete agreements. If the target company does not enter into confidentiality and non-compete agreements with its employees, the buyer should consider using such agreements in its plans for post-transaction integration and assess how the presence or absence of such agreements will affect navigation of future employment relationships.
It is important for a buyer to understand all aspects of the business it is purchasing. Failing to do so will result in the assumption of unknown liabilities and severely limit the upside of the buyer’s investment. Proper due diligence, starting with the above considerations, is a crucial item to undertake before a buyer purchases another business.
If you have questions or would like assistance with a due diligence process, or any other aspect of a business purchase transaction, please contact a member of Barrett McNagny’s Corporate and Business Law Group.