Best Practices in Legal Due Diligence

Even the most planned deal is rife with uncertainty. Whether it is the unexpected departure of a senior employee, the loss of a critical customer or supplier, or some transformative regulatory change, the terms of a deal can quickly change.

For Winston & Strawn, a leading international law firm, one of the best ways to prepare for these risks is to conduct comprehensive legal due diligence. “Legal due diligence focuses primarily on legal compliance, change of control triggers and uncovering the unknown,” says Justin Levy, Partner at Winston & Strawn.

He continued, “Our goal is to identify legal risks and liabilities, advise the client of such, and then negotiate with the seller in order to properly allocate risks and liabilities in the purchase and sale agreement.”

To best identify and prepare for the diversity of risks that can appear in a deal, Levy offered some strategies to recognize potential red flags.

Collaborate with Various Advisors and Consultants:

Since legal matters underpin almost every element of a deal, legal due diligence tends to interact frequently with other forms of diligence — like cultural or tax. In an effort to maximize productivity and expertise, “We regularly collaborate with finance, tax, and accounting advisors, IT consultants, and insurance specialists to ensure client satisfaction,” explained Levy. By working with the various consultants, Winston & Strawn can comfortably review all potential risks in a deal.

This type of broad-based understanding and review is critical, especially for any legal issues. To conduct effective legal diligence, “you need to understand both the business issues and the industry,” said Levy. Only by having a true and comprehensive understanding of the business and the broader industry can you be certain you are asking the right questions and uncovering the necessary risks.

Come Prepared with a Checklist:

Another great technique to ensuring there are no stones unturned is to enter the due diligence process with a checklist. “Every due diligence process begins with a general due diligence request list, which is modified depending upon the industry, whether or not the target is a private company, and a variety of other factors,” explained Levy. “The request list focuses on a number of different areas of law, including general corporate matters, litigation, material contracts, tax, environmental, labor, benefit plans and IP.”

Danny A. Davis, a leading M&A integration specialist in the UK, similarly echoed the importance of a checklist. He previously told us, “For each merger, I have a list of about 6,000 items to consider. With every new deal, I add a few items. Although deals are always different, and require different plans for different items, we can take a somewhat standard approach to increase efficiency. Many companies start from scratch each time, which costs money.”

Be Particularly Cautious of Regulated Industries…

While checklists and consultants allow you to comfortably review most companies, special attention is needed for carefully regulated industries. According to Levy, “Highly regulated industries are one of the biggest causes for alarm. Because regulations can be so intricate, you always want to confirm compliance and understand change of control risks.”

He continued, “It is critical to understand these industries and the issues facing them, and advise the client appropriately so that they can adequately assess the risks associated with their investment.”

Levy also explained that hot industries also need particular attention. “There are so many industries that are under the public spotlight,” said Levy. “Fracking business, logistics companies with independent contractor risks, and the eCommerce industry in respect to privacy and sales and use taxes, are some current examples.” Because of the public scrutiny surrounding these types of industries, unidentified risks can be much more problematic and costly.

…Especially if the Company is Owner-Operated:

Particular attention must also be paid for businesses that are owner-operated. “Smaller founder-owned companies are not as professionalized from a legal diligence perspective,” explained Levy. “Because they do not have the infrastructure and resources of larger companies, they are understandably more focused on building their business as opposed to legal and regulatory compliance matters.”

While the focus on the business model can be extremely promising for growth, it can also create some outstanding risk.  Levy explained, “This lack of infrastructure and lack of compliance needs to be accounted for in diligence, and private equity sponsors need to determine how to remedy post-closing. Specifically, any resolution may give rise to added costs, through initiatives and/or hires, and this could have a meaningful impact on going forward EBITDA.”

Focus on Litigations:

Another major concern for any legal diligence process is litigation. “Litigation — both past and outstanding — is always a concern,” said Levy. “While identifying historic and settled litigation is relatively easy, identifying current and future litigation risks requires in-depth communication with the target company and a strong understanding of the industry.”

Levy mentioned that most litigation-related issues are identified early in the diligence process, most often during the initial questioning.

Although uncovering any litigation can be unpleasant — both for the company and for the deal — you should not dwell unnecessarily on it. “In smaller deals, you are often buying from founders that are rolling over equity,” said Levy. “In situations like that, most sellers appreciate the partnership post-closing, and therefore are typically forthright in disclosing information.”

Best Practices in Legal Due Diligence is the third installment of Axial’s six-part series on due diligence best practices. The first two installments discussed the importance of tax due diligence and cultural due diligence. Future articles will discuss operational, IT, and other guidelines.