Legal Due Diligence: What You Need to Know Before Acquiring a Business

Due diligence is a vital step in any business acquisition. It’s been mandatory ever since the introduction of the Securities Act of 1933.

According to investor.gov, the chief objectives of this act are to:

• require that investors receive financial and other significant information concerning securities being offered for public sale; and

• prohibit deceit, misrepresentations, and other fraud in the sale of securities

If you want to dive into the details of this act—also called “the truth in securities act” – you can read it here.

Many acquisition entrepreneurs are unaware of the legal complexities that often lie in wait when they are performing due diligence on a business they’re thinking of purchasing.

Before we discuss these complexities, let’s bust a common myth related to acquisitions:  “Getting a dedicated deal team is not necessary. It’s just extra expenses.”

Many entrepreneurs lend credence to this myth. So they do not contact a legal firm or lawyer until after they’ve signed themselves into some uncomfortable agreements.

The right team by your side can ensure that you:

• Get a better valuation
• Speed up the closing of the deal
• Are spared from making costly mistakes.

Instead of shunning experienced legal advice, consult a legal advisor before due diligence begins.  It is crucial to the success of the acquisition.

Legal Due Diligence in a Business Acquisition

Recently we had a group call between our legal team from Aegis Law and participants of the Acceleration Gauntlet.  We discussed several legal topics in business acquisition that are of interest.

In this article, we’ve highlighted excerpts from that video to show you what you need to know about the legal aspects of due diligence before, during, and after an acquisition.

Here’s the video, and its content:

Meet Our Legal Experts On the Group Call

Jeff Baughman:  Jeff practices corporate law focusing on corporate, regulatory, and transactional matters.

Alex Prasad:  Alex is an M&A attorney for early-stage businesses.

Together under Aegis Law, they work with Acquira to assist acquisition entrepreneurs and business sellers close successful deals.

Let’s dive in…

Common Legal Pitfalls When Acquiring a Business

The business acquisition might be initiated as a casual chat over coffee, but it is never concluded that way.. “Entrepreneurs are mostly eager to close the deal, whereas seller’s counsel might love to spend weeks and months on the process,” says Jeff.

“Entrepreneurs are mostly eager to close the deal, whereas seller’s counsel might love to spend weeks and months on the process.”

So, how do you speed things up? One excellent way is to avoid these common pitfalls.

Legal Areas You Should be Scrutinizing

Understandably, you may be new to acquisitions. And comprehending some technicalities takes time. However, being completely clueless about what’s happening will not take you to a successful close. As Jeff advises acquisition entrepreneurs, “Be upfront about yourself.” You must know what your concerns are so you can ask the right questions.

“Be upfront about yourself.”

Whether you’re performing due diligence by yourself (you shouldn’t do this) or you’ve hired a dream team, what will secure your best interest is vigilance and awareness about what you are dealing with.

You and your lawyer need to investigate the following legal areas.  You can usually only do this after signing the LOI (Letter of Intent).  Remember that you are looking for legal red flags that will get in the way of your purchase.

• You need to allay any concerns you might have about contractual agreements that the seller has in place. This means obtaining and examining employee contracts and NDAs.  Similarly, you should look at the terms of contracts with vendors, lessors, and large customers.  Will all of these be transferable to you as the new owner?  What are the legal implications of any warranties the business has with suppliers or gives to its customers?
• Look for the existence of legal issues related to financial arrangements.  Are there loans,  liens, or other types of guarantees in place?  What are the terms governing them?
• Are there trademarks or patents you should be concerned about?  These may belong to the company, or the company may violate trademark or patent law.
• What, if any, licenses are required to operate the business?  Who in the company holds these licenses?
• Are there OSHA requirements relative to the storage and use of toxic materials?  Have there been inquiries in the past from OSHA or the EPA that you should be aware of?
• Are there past lawsuits against the company that have damaged its reputation, or that could come back to bite you? 

Believing the myth that legal advice is not worth it

If you think legal advice during due diligence is not worth it and your tax or finance professional is enough to perform the process, you could be making a serious mistake.

Incompetent seller counsel 

As Jeff highlighted, incompetent seller counsel can become the number one killer of the deal. It’s unwise to use the services of a lawyer who has spent a career dealing with wills and bankruptcies.  If you live in a smaller town, this may be the only counsel you have at hand – and they may be someone you are comfortable with and trust.

“If the seller has chosen a legal person who has been dealing with wills or bankruptcies in his career, it won’t help for acquisition.”

Additionally, suppose your counsel is not aware of laws such as those regarding M&A and SBA guidelines about financing and selling. In that case, the experience will be more stressful and expensive than it needs to be.  Getting the seller the right counsel is an important time and money saver.

One of the best ways to avoid these pitfalls is to build a mutual relationship of trust with the seller. As Alex says, “Negotiations are 90% human, 10% legal”.

Overdependence on your legal advisor

“Be clear about your relationship with the legal advisor.”

Alex said, “Be clear about your relationship with the legal advisor.” He pointed out that the entrepreneur is the principal and the lawyer is an agent in the deal. Your lawyer can only do what you authorize them to do.  But because a savvy lawyer has the preponderance of knowledge about the areas that must be investigated, it is tempting to treat them as the lead partner. 

You cannot occasionally call your lawyer and ask what’s up about the deal. You are the deal maker or breaker; therefore, your involvement and presence during discussions and issue resolution are primely important.

What to Expect During Legal Due Diligence

Due diligence can become complicated – and unnecessarily expensive –  if you don’t know the right attitude to bring to the table. As Jeff says,

“If you are the kind of person who goes with the flow and leaves everything on time, you shouldn’t be in entrepreneurship.”

You have to be proactive to be a successful entrepreneur. Your legal team will assist you but you still need to pull much of the weight.

Pulling your weight means that you, the prospective buyer, will visit the vendor and have multiple discussions with them, before due diligence starts.  This is where you will begin to:

• Build a relationship with the seller
• Get a high-level idea of the business model and procedures
• Understand the business’s strengths and the issues it faces, as the seller sees them
• Tease out the reasons behind the decision to sell.  Remember that in life there are generally multiple reasons driving people’s decisions.  The unobjectionable reasons provided by the seller, like  “to spend more time with my family” or “it’s time to retire” are unlikely to be the only ones, and you will benefit from knowing the others.

Having a due diligence checklist like the one we’ve discussed in this article will give you direction and spare you grief down the road.  As Jeff says, 

“We … arm our clients with due diligence checklists because the most dangerous questions are the ones you didn’t even know to ask.”

Your Relationship With Your Lawyers

Alex stresses that the success of your deal depends on how much regard you are paying to the principal/agent relationship with your lawyer.

They are not supposed to make final decisions. Your legal advisor is your coach who will equip you with the tools to take the deal. Alex added about Aegis law and Acquira,

“We’re going to coach you and get you to the finish line. But we are football coaches, you know, not the running back.”

How to Keep Legal Costs Down During Due Diligence

You can manage your legal costs during due diligence by following this advice from Jeff:

Build a trustworthy relationship with your seller and help them get the right counsel to deal with things. A bankruptcy-specialized lawyer or will-specialized lawyer should not be dealing with the acquisition. It will save the time of all parties and the costs, as most legal advisors charge per hour.

Instead of going into a full due diligence process, it is better to find the areas of concern you have identified in the initial discussions with the seller. Instead of operating all organs, scanning the area of the problem is cost-efficient and effective.

Key Takeaways

• Understand the importance of time in the due diligence process and choose competent legal advice to help you sail your ship.
• Communication and discussion with the prospective seller will be a time saver, and the seller’s response will help you identify the business issues in depth.
• Own your relationship with a lawyer and, as the principal, stay involved during the process.

If you're considering beginning your own acquisition journey, schedule a call with us now to learn more about how we can help.

Team Acquira

Acquira specializes in seamless business succession and acquisition. We guide entrepreneurs in acquiring businesses and investing in their growth and success. Our focus is on creating a lasting, positive impact for owners, employees, and the community through each transition.