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Due Diligence Tests – The Legal Side

By Generational Equity

legal due diligence

A few days ago we published a piece on due diligence, focusing on one of the many financial “tests” that buyers often do prior to closing a transaction in order to have some assurance that their assumptions about the financial health of the transaction are sound. We looked at the Net Working Capital test (NWC) and discovered that even though the idea of the test is straightforward, ensuring that it is done accurately is vital, hence the need for professional help.

Today I thought we would shift our focus from the financial side of the due diligence equation and provide you with insights on the legal arena. One of the complicating issues, as you can imagine, is legal M&A due diligence.

For example, the following section is actually a document from a potential buyer sent to one of our dealmakers. Have a peek at what is going to be required of the seller by this buyer:

Representations, warranties, and indemnities will be typical or “market” terms. Representations and warranties of the Sellers shall include, but not be limited to, representations and warranties regarding ownership, capitalization, transaction expenses, tax, compliance with environmental, ERISA, and other laws, financial statements, receivables, undisclosed liabilities, absence of changes, contracts and commitments, absence of litigation, licenses and permits, customers and suppliers, employee and labor relations, product liability / warranty, intellectual property rights, insurance, affiliate transactions, compliance with regulations, and prohibited payments.

Representations and warranties will survive for 18 months with the following carve outs: environmental, compliance with laws, tax, and ERISA representations and warranties, which will survive for the statute of limitations, and fundamental representations and warranties (consisting solely of ownership, capitalization, authority, and affiliate transactions), which will survive indefinitely.

As we get further into diligence we will provide more specificity to these provisions and commit to negotiate in good faith for a fair and reasonable allocation of risk. The cap on seller’s indemnification for breaches of representations and warranties will be $1.8 million, with a Purchase Price cap for breaches of environmental, compliance, tax, ERISA and fundamental representations and warranties. These items are subject to final diligence but are based on our diligence to date. Seller’s liability for indemnification obligations (and other obligations under the purchase agreement) will be on a joint and several basis. Indemnification claims will be subject to a $200,000 ‘tipping basket.’

OK, if you read that closely, you are now out of breath. And if you are a business owner and you don’t have an M&A advisory team (which at a minimum should include an experienced M&A consulting firm and an attorney) and you get this from a buyer, you should be shaking in your boots!

How do you know if any of this is comprised of standard legal M&A terms? For all you know, your buyer could be taking advantage of your lack of M&A experience and creating a transaction that is completely to their benefit, not yours.

Help is on the Horizon

If you have an M&A advisor, like Generational Equity, and an experienced M&A attorney working with you, they would be able to walk you through this type of request in short order and protect your interest.

I bring this topic up because it is consistent with a conversation I recently had with Brad Whitlock, an M&A attorney with Scheef & Stone LLP. We have worked with Brad on a number of transactions over the years. He has decades of experience in M&A law and was able to provide us with some fantastic input for business owners to be aware of:

If you listen closely to these segments you will hear a common theme:

Closing a deal without professional help is possible; however, closing an “optimal” (as Brad puts it) deal with a premium buyer and creating a deal structure that benefits you is clearly your goal, and doing so requires professional guidance and consultation.

One more point to be made: When you look for legal advice to close your deal, look for an attorney, like Brad, that focuses on M&A law. This is a very specialized field and even though your family attorney that set up your trust could legally review your docs, he/she will most likely be working on their first M&A transaction. Requests from buyers, like the one above, might be new to them, causing your deal to progress far more slowly than if you have an M&A attorney with 30 years of experience.

Take a look at the segment above regarding reps and warranties: If any of that confuses you, causes you to scratch your head, or even makes you grimace in pain, then you need professional guidance.

Fortunately, Generational Equity, the leading M&A advisory firm in North America, is here to help. We have closed more deals over the past few years than any other firm in our niche (the lower middle-market – deals valued below $150 million), according to Thomson Reuters. If you would like to see if our skills are a good match for your needs, call me at 972-232-1125 or send me an email at cdoerksen@genequityco.com. I will be glad to discuss our services with you and connect you with the appropriate member of our team for further information.