Legal due diligence can be a tricky minefield to navigate. One of the most rewarding things you can do as a legal professional is help a client close a major deal — whether it’s a business acquisition, a collaborative manufacturing agreement, or real estate venture.
Yet, if you’ve ever been a part of that process, you know that it takes a lot of work. And the bulk of that work is what we call due diligence.
In this post, we hope to provide a useful guide to conducting effective due diligence, from understanding its fundamental principles to finalizing your report.
As usual, there’s a lot to cover here, so let’s get started.
Understanding legal due diligence
What is legal due diligence?
Due diligence is the comprehensive appraisal of a target business or individual before entering into a legal agreement or transaction. Typically, it involves a thorough investigation to verify facts, assess risks, and ensure compliance with all relevant laws and regulations.
While different deals may require slightly different aspects of due diligence, most require a review of factors such as contracts, intellectual property assets, litigation history, financial health, and employment issues.
This process is standard in things like mergers and acquisitions and real estate deals, though it can apply to a myriad of transactions. Regardless of the deal-type, effective due diligence is designed facilitate your client’s informed decision-making.
As the lawyer overseeing the process, your job is to protect their interests and mitigate their risks.
Why do due diligence?
Why is due diligence necessary? Well, because sometimes people who are desperate to make business deals play a little fast and loose with the truth. You may have heard the expression “lipstick on a pig”? Due diligence is intended to remove the lipstick.
The truth is, due diligence is critical for ensuring the integrity and success of any legal transaction. And it’s not just pomp and circumstance. In fact, it’s estimated that half of all business deals fall apart during the due diligence process.
For example, a selling company may accurately report during negotiations that its products have sold in all 50 states. Due diligence, meanwhile, might reveal that there’s pending legislation in 49 of those states that will soon outlaw its best-selling product. You get the picture; it’s important.
So, let’s talk about how to get it done.
Preparing for legal due diligence
As with just about everything else in the law, effective due diligence begins with careful planning and preparation. Here are some of the key steps:
Strategizing
- Define the scope: The first step is identifying the key areas that need examination. This includes understanding the specific objectives of the transaction and tailoring the due diligence plan accordingly.
- For example, is it a business acquisition or a distribution rights transfer? Are the parties foreign or domestic? The answers to these fundamental questions will guide your entire process.
- Build a dedicated team: Different aspects of the transaction may require specialized knowledge. You probably don’t want a plumber assessing profit and loss sheets, but if the transaction involves a plumbing fixtures business, you may want that plumber to analyze product complaints.
- Create a comprehensive checklist: It’s always good to have a roadmap outlining all the documents and information needed for review so nothing important is overlooked.
- Set clear timelines and milestones: Left unchecked, business deals can go on forever. Having clear timelines and project milestones helps keep the process on track and safeguards your client’s intentions for closing the deal.
Gathering documents
In most transactions, documents will be the key to assessing the viability and risks of the deal. Key documents typically include things like financial statements, tax records, contracts, corporate governance documents, intellectual property records, and any pending litigation files.
Obviously, these documents need to be requested from the other party early in the process. It is also essential to verify the authenticity and accuracy of the provided information.
Using a secure, organized method to store and manage these documents, such as a virtual data room, can facilitate easier access and collaboration among the due diligence team.
Key players
Of course, business deals aren’t just about paper – they’re also about people. As such, identifying and involving key players in the process is also essential. At a minimum, here’s who you can’t live without:
- Your client: Even though your client is relying on you to conduct due diligence, they still have to participate. After all, they’ll provide context, set objectives, and make major final decisions based on what you find.
- Your team: Depending on the size of your firm (and the deal), your legal team will typically include both attorneys and paralegals who will conduct a detailed review and analysis of the information gathered. It may also include outside experts if the deal involves niche businesses.
- Financial advisors: Unless someone on your legal team has a solid accounting background, use financial experts to assess the economic feasibility of the transaction.
- Target company representatives: You’re going to want to talk to the people who’ve been running the target company. These are typically executives or compliance officers who can provide information pertinent to the deal. Depending on the deal points, you may also need to conduct some due diligence about them.
Doing due diligence
At some point, you’ll have to stop planning and start doing. When you get there, here are the key areas that your due diligence process must focus on:
Organizational
Review all corporate documents, including articles of incorporation, bylaws, shareholder agreements, and minutes of board meetings. Understand the org chart and look for any disruptions to the leadership team.
Contractual
Review all contracts, leases, and other legal agreements to identify any potential liabilities or ongoing obligations. These might include employment contracts, supplier agreements, vendor contracts, real estate leases, and intellectual property transfers.
Financial
Have your money-team analyze audited financial statements, tax returns, and internal reports to assess the financial health of the entity. Look for any signs of financial distress or irregularities.
Also check for outstanding debts, unrecorded liabilities, or discrepancies in financial statements.
Operational
Examine the company’s business operations, including its organizational structure, management practices, and operational efficiency. Are operational shortcomings something your client can fix easily or will they require substantial investment beyond the deal itself?
You’ll also want to check for operational risks like supply chain issues, public complaints about management, or non-compliance with industry standards.
Employee information
If employees of the target entity will soon be employed by your client, you’ll want to analyze employment contracts, benefit plans, and compliance with labor laws. Have employees sued the company in the past?
How were those suits resolved? Is there a risk of future employment litigation?
Regulatory
It’s critical for you to understand the regulatory environment in which the target entity operates. A shipping company, for example, is going to have different rules and regulations than a bakery.
Check to make sure all necessary licenses and permits are in place, and review any correspondence with regulatory bodies. Also look for any past or ongoing regulatory issues.
Is there a history of non-compliance with any laws or regulations that could result in future fines or legal actions?
Legal risks and liabilities
Nobody wants to assume a major liability risk. Ask to see details of pending, settled, or past litigation, including claims, lawsuits, and arbitration/mediation.
Analyze the types of litigation at issue. If there’s a deep history of product liability claims against the target, for example, that signals something very different than a history of employment litigation.
You’ll need to be able to explain the significance of each ongoing risk to your client.
Intellectual property
What intellectual assets does the company own? Review relevant patents, trademarks, copyrights, and any agreements related to those assets. Make sure intellectual assets are held by the target entity and not by individual owners or employee-inventors.
Also, check to see if intellectual property use rights have been granted to others.
Insurance policies
You’re going to need the details regarding all insurance coverage, including liability, property, and employee benefits.
If the target entity owns vehicles (or boats or planes or trains), check for coverage on those assets and determine what ongoing insurance costs will be to your client.
Reporting and analysis
Once the due diligence process is complete, you’ve got to compile your findings into a clear and comprehensive report.
Typically, your report will begin with an executive summary that provides a high-level overview of the findings.
Next, you’ll organize detailed information into sections based on areas of focus, such as legal, financial, operational, etc. (everything we talked about above, actually). Each section should include a concise analysis of the identified issues and their potential impact on the transaction.
From there, you’ll move on to risk assessment and mitigation, as these are two of the most important components of the due diligence report. Evaluate the severity and likelihood of each potential risk and liability you’ve identified. This involves analyzing how these risks could impact the transaction and the overall business.
For each identified risk, provide actionable recommendations for mitigation. This could include renegotiating contract terms, setting aside reserves for potential liabilities, or implementing compliance programs to address regulatory concerns.
Finally, whenever you can, use tables, charts, and bullet points to make the information in your report easily digestible.
Remember, the key to any effective due diligence process is diligence. Do the work, do it well, and have fun closing those big (and safe) deals for your clients.
