Why Legal Due Diligence is Important?

due diligence legal

For both the buyer and the seller, an M&A (mergers & acquisitions) transaction, such as a company sale or merger, involves legal risks.

By uncovering the risks that affect both the transaction and the company itself, potential liability risks can be shifted in the interests of the parties involved or used for negotiation. If warning signals are unexpectedly uncovered in the process, the deal should be aborted.

Therefore, prospective buyers and sellers should always conduct legal due diligence at least in certain constellations.

Based on our experience, we would like to show you in this article what to look out for when preparing for legal due diligence.

Apart from the legal due diligence we also wrote articles in the past about tax due diligence, commercial due diligence, financial due diligence and due diligence in general.

What is Legal Due Diligence?

Legal due diligence is of decisive importance in the context of a company acquisition. It fulfils the functions of information gathering, risk assessment, warranty and preservation of evidence and serves to round off the economic basis in the context of the financial, tax and business audit in the entire due diligence process.

However, it does not have an independent assessment task, because, in addition to the legal basis, the target company must always be able to prove that its activities are economically profitable.

The findings from the legal due diligence must therefore always be considered in a critical context and under consideration of the essential due diligence sub-reviews: Financial, Tax and Market Due Diligences.

When legal due diligence is necessary?

The extent of due diligence varies and depends on the legal complexity of the company at hand.

The following exemplary scenarios can help you to understand if the legal examination of the company is needed.

  • In the case of widely ramified and complex corporate structures

If the target company is integrated into a holding structure or a similar group construct, legal and tax due diligence is unavoidable. If only to know the ownership structure in detail before buying the company.

  • In the case of risky or highly regulated business models

Some types of business models are subject to special regulations. If the company falls into one of these groups, a detailed examination should not be missing.

  • In the event of noticeable irregularities during the initial meeting

The typical course of an M&A transaction provides for a discussion stage at which not all information and documents are yet provided. If certain inconsistencies come to light that are difficult to explain by the seller, great care should be taken.

  • In the case of innovative, patent-worthy technologies

If industrial property rights are an important pillar of the business model, detailed legal due diligence should not be missing.

  • Sellers: carry out a preventive check if necessary

As a business owner, you should be aware of any legal disputes and risks, even if they lie far in the past. To ensure that these do not go unmentioned and are later uncovered as a value-reducing factor and brought into the negotiation, a preventive check and transparent presentation can be useful.

This can prevent damage to the relationship with the prospective buyer. Deal with problems proactively and present practicable approaches to solutions.

The process of legal due diligence

The legal due diligence process can be divided into three parts. They are as follows:

1. Preparation

Legal due diligence begins when the acquiring company and the target company have reached an initial agreement on the M&A transaction. Having completed this step, the companies have to set up the legal boundaries and form the legal due diligence group.

2. Implementation

During the implementation phase, the legal due diligence group gathers information, analyses and evaluates it, and finally communicates the results of its analysis or evaluation. This part of the process can take a while.

3. Conclusion

Once the legal due diligence process has been completed, it is time to communicate the results of the legal due diligence process to management, who will make the final decision.

The structure of legal due diligence

Which points you should check depends strongly on the target company. As a rule, it is more advantageous for you to have an experienced M&A advisor prepare and accompany the review as part of an overall due diligence review. He can, for example, point out hidden risks that he knows from a past corporate transaction.

The following extract of possible audit points does not claim to be complete and serves as a summary.

Company relations

The investigation of the so-called chain of title (rights chain) serves to provide complete evidence of the ownership rights of the company shares. Disclosure of the partnership agreements and any shareholder agreements also brings to light the exact rights and obligations of the shareholders and the circumstances of their ownership.

It is interesting to know, for example, what conditions are attached to a change of ownership. Often, for example, certain qualifications are required for succession. The form of the articles of association can thus have considerable consequences for the valuation of the company.

The corporate structure, the legal form and the size of the company have a decisive influence on what all should become part of the analysis.

Group structures

If the target company is part of a group or if an entire group is to be taken over, the contractual relationships and the structures of the companies involved must be examined in detail.

Group financial statements and the contents of contracts must be examined intensively. Above all, the ownership of jointly used assets must be determined. In the worst case, certain assets might not even be legally attributed to the target company and its sphere of influence, even though the buyer has perceived them to be the subject of the transaction.

Financial circumstances: Loans and collateral

To know the financial situation of the target company in detail, any loan arrangements must also be thoroughly examined.

It should be assessed whether the financing structure corresponds to the information provided by the seller and whether it entails any risk.

Away from the legal circumstances, the purely business analysis of the financial structure takes place in the context of financial due diligence.

Existing contracts with third parties

An examination of all contracts and related documents with outside companies, such as freelancers or service providers, customers, suppliers and other third parties should be the focus of any legal due diligence.

The aim of the analysis should be to identify possible harmful contractual relationships.

For example, there could be dependencies, such as supplier contracts whose conditions are no longer in line with the market.

A fundamental critical evaluation provides clarity.

Regulations and necessary licences

Legal due diligence should examine the general legal framework of the business model. At the latest since the EU-​​GDPR, the topic of data protection must be included if no dedicated IT due diligence takes place.

Intellectual property & patents

Particular attention should be paid to IP (Intellectual property) rights and patents in the legal due diligence. Particularly if these are significantly responsible for the value of the company and their underlying objects of protection are already an integral part of day-to-day business.

It is also important to know whether these are legally attributed to a person or the company and how a transfer after the sale is legally feasible or whether there are circumstances that stand in the way of this transfer.

If the business is particularly technologised, a separate technical due diligence is recommended.

Current or past criminal proceedings

Even apart from the information provided by the seller, you should obtain information on possible criminal or other proceedings or legal disputes against personnel of the target company, provided they are related to the business activity.

In individual cases, it should be examined whether the business model or certain circumstances of the operation could be associated with risk under criminal law. Also concerning current legislative developments.

Employees & labour law contracts

The topic of employment law and employees are important issues that should be addressed in the legal due diligence process.

A thorough inventory of all employment law provisions for permanent and external employees, including all terms and conditions, such as termination, collective bargaining agreements and other company agreements. However, the guidelines prescribed by data protection law must be taken into account when processing employees’ personal data.

However, not only the recording of the employees’ circumstances under labour law but also the legal risk posed by the employees is part of the legal due diligence.

Property, plant and equipment

A basic review of all rental and leasing contracts for the plant, machinery and vehicle fleet should be undertaken, as should a review of all contracts for the purchase of fixed assets.

Insurance

Review all insurance contracts and, if necessary, request further data and information from the vendor. Of interest are any insurance claims that have already been made against the company. Also relevant are applications made for insurance cover and whether they have been refused or allowed.

Checklist

The following list is intended to assist the issuer in compiling documents and information. It is not exhaustive, but may also contain items that are not relevant in individual cases. If the issuer has significant subsidiaries, corresponding information for these subsidiaries shall also be entered into the data.

In individual cases, a materiality threshold is usually agreed upon, above which the information must be provided. The information listed partly corresponds to the information in the “Financial Due Diligence Checklist”. In this respect, the documents compiled in this section would be reviewed in the course of both financial due diligence and legal due diligence.

1. Corporate Structure

  • Group structure
  • List of all affiliated companies
  • Extract from the commercial register
  • Foundation documentation
  • Articles of association
  • Minutes of all board resolutions and current draft resolutions
  • Rules of procedure of the Executive Board and the Supervisory Board
  • List of supervisory board committees
  • Information on advisory boards and similar Committees
  • Minutes of general meetings and documents convening them
  • Complete documentation of all capital measures in the past and information on the use of proceeds from capital increases
  • Details of outstanding capital contributions
  • Documentation of issued options, profit participation rights, convertible bonds, etc.
  • Documentation of conversions or restructuring processes
  • Documentation of any post-formation transactions
  • List of shareholders, if known
  • Description of all changes in the size and legal basis for the composition of the bodies (including information on status procedures)
  • Information on shareholder agreements (pooling, voting trust agreements, silent partnership agreements, etc.)
  • Information on the number and book value of own shares
  • Agreements on encumbrances and restrictions on disposal of shares
  • Control, profit transfer and other inter-company agreements
  • Dependency reports
  • Description of all transactions and legal relationships with related parties
  • List of members of the executive board and supervisory board as well as members of senior management
  • Description of existing forms of employee participation and stock option programmes, etc.
  • Prospectuses, information memoranda prepared or used in the past about the company
  • Proof of proper disclosure of the annual and, if applicable, consolidated financial statements for the last three financial years
  • Audit reports on these financial statements

2. Acquisitions & disposals of businesses, joint ventures

  • Contracts (including contracts under negotiation) and due diligence reports
  • List of existing joint ventures or joint ventures under negotiation (joint ventures)

3. Credit & security agreements

  • All credit agreements;
  • Agreements on the granting of collateral;
  • Debtor warrants;
  • Agreements or correspondence relating to prepayment or early repayment of loans and relating to breaches of contract;
  • List of all debentures, promissory notes, participation certificates, etc. issued by the company;
  • List of all outstanding liabilities between the Company and its shareholders;
  • List of all liabilities under swaps, options, forward contracts, contingent liabilities, etc.;
  • Commitments to grant loans;
  • Statement of cash management and any cash pooling arrangements.

4. Real estate

  • List of all business premises, land and buildings used by the company for business purposes
  • List of all rights in rem granted with respect thereto
  • Submission of all material contracts relating to real property
  • Excerpts from the land register and part-ownership land registers
  • Extract from the register of building encumbrances
  • Rental and lease agreements
  • Overview of building permit status
  • Known neighbour claims and any agreements with neighbours

5. Material contracts with third parties

  • Description of the dependence of business operations on specific contracts, customer or supplier relationships
  • List of the ten largest customers
  • List of the ten largest suppliers
  • Statement of all material contracts not entered into in the ordinary course of business
  • Presentation of all framework agreements, supply and distribution agreements
  • Presentation of all contracts for IT services
  • Submission of all standard contracts used
  • Submission of all agreements restricting competition
  • Submission of all other material contracts

Conclusion

Legal due diligence is indispensable in corporate acquisitions and other M&A transactions. This article has given you an insight into the complexity of the subject. However, please note that the subjects of the audit depend on the individual case.

We will be happy to advise you and accompany and support you in the preparation and implementation of legal due diligence in the context of a company sale or acquisition. Contact our tax advisors in Barcelona by email or phone.

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