When preparing to sell your business, one of the most critical and potentially challenging stages is legal due diligence. If you haven’t been through a sale before, the term may seem daunting, but it essentially involves the buyer’s in-depth review of your business to confirm there are no unforeseen issues and to validate its valuation for your business.
Due diligence typically covers legal, financial, tax and operational matters. Depending on the nature of your business and the industry in which it operates, additional specialised due diligence may be required (e.g., for businesses with substantial real property holdings, intellectual property assets such as patents or operations in highly regulated sectors).
Below, we provide an overview of the legal due diligence process, along with practical tips to help you prepare to ensure it doesn’t become a major obstacle during the sale.
1. What is legal due diligence?
Legal due diligence is generally undertaken by buyers before formally committing themselves to a transaction, and often follows the acceptance of a non-binding offer. It provides a prospective buyer an opportunity to mitigate risk by reviewing and analysing relevant documents and information related to the target business. Through this process, buyers aim to gain a comprehensive understanding of the business and identify any potential risks to ensure they are not inheriting historical issues or otherwise overpaying.
For vendors, this stage is critical, as any red flags could negatively affect the deal. Adverse findings may give the buyer leverage to renegotiate the price, request specific indemnities or holdback provisions in the sale agreement, or, in extreme cases, withdraw from the transaction altogether.
2. What will the buyer review?
Key areas of focus for buyers often include:
- Corporate structure: Buyers will examine your company’s corporate setup and verify that you have the authority to sell either the shares or assets (e.g., reviewing the members register, share certificates and any shareholders agreement). Some buyers may also wish to review the constituent documents (such as trust deeds) for each vendor.
- Contracts: Buyers will scrutinise key contracts with clients, suppliers and employees to ensure they are valid and enforceable. They will also look for change-of-control clauses that might require customer or supplier consent to complete the transaction.
- Real property: If your business leases premises, buyers will review the leases to confirm your business has the right to occupy the relevant properties and determine whether landlord consent is required for the transaction to proceed.
- Intellectual property (IP): For businesses reliant on intellectual property, buyers will want to ensure the business either owns or has rights to use its IP. For technology businesses this will often require reviewing software development agreements with developers or employment agreements with key individuals.
- Employees and contractors: Buyers will want to obtain a level of comfort that the business complies with all applicable laws in relation to the employment and engagement of employees and contractors. This may include verifying that employees are paid in accordance with any applicable awards and contractors have been properly classified. If a large proportion of your workforce are engaged as contractors or casual employees, expect this to be a key focus area. Retention of key personnel is also often a priority with buyers wanting to review contracts for appropriate restraint clauses and notice periods.
- Legal Disputes: Buyers will review current and past legal disputes, including those involving customers, employees, regulators or shareholders. A history of disputes may signal poor governance or non-compliance, and buyers will be cautious of inheriting ongoing liabilities.
3. How to prepare for legal due diligence
The best way to ensure a smooth due diligence process is to prepare well in advance. Here are a few key steps:
- Organise your documents: Ensure all legal documents — contracts, licences, corporate records and employee records — are well-organised and up to date. Delays in providing these documents can slow the process or raise concerns.
- Use a data room: A virtual data room (VDR) is generally preferred over platforms like Dropbox for M&A transactions due to enhanced security, customisable user permissions, audit trails and structured folder systems. VDRs also offer Q&A functionality to streamline communication with the buyer’s team.
- Review key contracts: Ensure that key contracts with customers, suppliers and employees are properly executed and current. Vendors may consider reviewing agreements in advance to identify any potential issues and mitigate risks where practicable, for example, by extending material customer contracts that have expired or are close to the end of their term.
- Resolve compliance issues: Address any outstanding compliance issues before entering the sale process. It is better to proactively resolve these matters than have the buyer uncover them later.
- Address ongoing disputes: Try to resolve any ongoing disputes or potential legal claims prior to the sale. Buyers are understandably wary of assuming historical liabilities, and unresolved disputes can serve as an unhelpful distraction, consuming valuable management time and resources during the sale process.
- Secure your intellectual property: Ensure your business’ key intellectual property assets have been properly registered and are owned by the business. If any issues exist, aim to address them before the buyer’s review. This may include ensuring all trade marks and domain names are registered in the names of the right legal entities and entering into deeds of intellectual property assignment with founders, developers or any employees responsible for creating any material intellectual property used in the business.
- Be familiar with industry developments: Regularly monitor developments within your industry, including recent or proposed reforms, such as proposed legislative changes, new regulatory requirements or emerging market trends that may impact your business. Buyers may inquire about industry-specific risks or opportunities, and being prepared with a response will showcase your sector expertise and help inspire confidence in how the business has been managed.
- Restructure: If the target entity does not own all the assets necessary to operate the business (for example, the business uses assets which are owned personally by the vendor or via a related entity), a pre-completion restructure may be required to ensure the buyer acquires a fully operational business without gaps in asset ownership. While it is important for vendors to proactively identify these issues, they should seek professional advice before implementing any restructure to ensure that it is conducted in a manner that optimises the tax outcomes. Additionally, when a restructure is necessary to facilitate the transaction, buyers often require input on the process and associated documentation.
- Prepare for requests for information (RFIs): RFIs are a critical part of the due diligence process, helping clarify details and ensure the buyer has all necessary information. This ongoing Q&A process can be managed through a data room’s tracking features. While responding to RFIs can be demanding and time-consuming, it’s important to remain patient and avoid frustration with the buyer, as thorough and transparent communication is key to building trust and moving the transaction forward smoothly. If any requests become overly burdensome, consult with your advisers and push back where appropriate.
4. Common challenges vendors encounter
Even with preparation, vendors may encounter some common issues during due diligence, such as:
- Missing documents: Delays in providing essential documents can raise concerns or slow down the process.
- Undisclosed issues: Failing to disclose actual or potential key issues early on can damage trust and lead to renegotiation of terms. Examples include unresolved disputes, regulatory compliance issues or agreed bonus payments or salary increases for certain employees. Being transparent about these matters from the outset helps maintain credibility and facilitates a smoother negotiation process.
- Late disclosure: Whether intentional or simply via oversight, dumping documents into the data room late in the transaction can create confusion and frustration for a buyer. It can lead to rushed reviews and increased scrutiny, potentially causing delays or even jeopardising the deal. To avoid this, vendors should aim to upload documents in a timely manner and ensure they are organised and accessible throughout the process.
- Third party consents: Contracts with change-of-control clauses may require consent from certain counterparties. While this can seem challenging, it is typically manageable with the right approach. Close consultation with your advisers and collaboration with the buyer are crucial in securing the necessary consents, particularly when it comes to coordinating timing and communication strategies.
5. Final thoughts
While legal due diligence may seem daunting, with the right preparation and deal team, it can be managed effectively. By organising your documents, resolving issues in advance and working closely with your advisers, you can streamline the process, reduce delays and increase the likelihood of achieving your desired purchase price.
Ultimately, legal due diligence helps both parties build confidence in the transaction, and with thorough preparation, you can move forward knowing your business is ready for sale.
If you have any matters or clients that require advice in this regard, please do not hesitate to contact Steven Wambeek or Nicholas von Schoenberg on 1300 363 314.
