Legal Due Diligence

September 28th, 2017

By Catherine Lapointe, partner.

If you are considering selling your business or if your plans will soon require equity or quasi-equity financing, now is the time to prepare for the legal due diligence of your company. And the sooner, the better. Though this may seem obvious, we regularly encounter some wonderful companies who haven’t put in the necessary effort, and thereby risk being seen as a company in disarray that, as a result, has to suffer the consequences of their lack of preparation. In fact, poor preparation leads to delays and when the target has to bear the other party’s fees, as with a financing, this translates into additional costs for the company itself.

Let us take a closer look at the legal aspects of due diligence, specifically its range and importance, aspects that are sometimes underestimated.

A Rigorous and Thorough Review

Due diligence is a rigorous review of all the business, financial and legal aspects of a company. It usually consists of an investigation conducted by a potential buyer or investor.

Legal due diligence focuses specifically on the compliance of the target company with the relevant corporate laws, the review of issued capital and major contracts, the identification of consent required by the target company were it to engage in the proposed funding or sale transaction and any restrictive clauses that prevent it from doing business in certain places or with certain individuals, the review of guarantees granted to clients for goods sold or services rendered, the identification of mortgages and other charges on its assets, the review of its property titles, when applicable, a compliance assessment pertaining to labour law and private law, the protection of confidential information, the review of its intellectual property and any disputes it may be involved in and any other relevant legal issues in the circumstances.

When a buyer or investor initiates legal due diligence, a list of all required information on the target and its shareholders is provided to the company and its lawyers. They, in turn, must provide the required information in the order in which it appears in the list so as to allow a well-ordered review process. Nowadays, the required information is almost always made available by means of a virtual data room, where one can file electronic data; the best websites designed for this purpose offer both the security and flexibility needed to access different types of information according to the persons for which they are provided. They can also produce reports on the information consulted. Information provided willy-nilly through a multitude of emails–or even on paper!–or that involves incomplete documents, can generate costs and delays.

The Preparation: Take the Time Required

First, take the time needed to prepare for proper legal due diligence. Appoint someone within the company to oversee this preparation. This person will be responsible for compiling the necessary information and assigning the legal mandates that might be required to organize the information or to complete certain of its aspects.

Are the minute books up to date and in order?

The very first thing that must be done is to ascertain if the targeted company’s minute books are up to date and in order. If this hasn’t been recently confirmed, it is recommended to do so in order to send well-ordered books to the buyers’ or investors’ lawyers. They will want to confirm, in particular, that the title chain of the company shares is in order, that the individuals who will be signing the directors and shareholders resolutions as part of the transaction are in fact the correct individuals, and that the minute books are complete and up-to-date. Any irregularities revealed during this preliminary review can be then be corrected before the books are sent and the impact of any major irregularities which cannot be corrected in the transaction and its structure can be evaluated ahead of time.

Important Contracts and Required Consents: A Key Element

Prepare a comprehensive list of the company’s current major contracts, by contract types (contracts that no longer have an effect should be omitted). Also, complete copies (including schedules) of all these contracts should be identified. This will prove to be very useful when the time comes to provide the contracts requested in the due diligence list.

There are several reasons why important contracts are reviewed during legal due diligence. First, a buyer or financier will want to know the content of fundamental contracts supporting the funding, the operations and the sales of the company as well as relations between shareholders. When do they expire? Are their monetary terms consistent with what was provided? In what circumstances can they be terminated? Do they include restrictive clauses that limit the company’s activities (non-competition for instance)? Another aspect of the contract due diligence consists of identifying any third-party consent which the targeted company or its shareholders must obtain under the terms of said contracts in order to complete the planned transaction. For instance, does the main parts suppliers or of licensor of an important intellectual property license have to consent to a change in the control of the company?

With this in mind, certain companies will choose to identify the required consents at a preliminary stage. This will let them get a head start in the process of obtaining these consents by providing the other party involved in the transaction with a list of identified consents and planned draft letters of consent for comments, at the very beginning of the due diligence process.

Intellectual property: who is the rightful owner?

The company should also review its intellectual property portfolio. Due diligence often reveals that patents or brands used by the target company are still registered under the names of the individuals who established the corporation, and that these rights have yet to be transferred to the company. Furthermore, we often see that an employee, as opposed to the company itself, holds the rights to domain names. Accordingly, a preliminary review ensures that the intellectual property title chain is consistent with what it should be and, if it isn’t, that the required corrective measures are undertaken. Intellectual property agreements will have been identified as important contracts.

Selling Your Assets Free of All Security Interests

The company should prepare a report on any security in its assets as this will be required as part of due diligence. Furthermore, where all the company shares are being sold, an informed buyer will want any remaining security, if no longer serving a purpose or that is to be replaced on closing, to be cancelled prior to or during the closing, or will require an undertaking from the holder to cancel it off subsequently. Additionally, during a sale of assets, the assets will be sold free of any security interest. In such a case, the report identifies, among other things, any security interests that must be cancelled following the payment of the sums that they secure, payments which are often supported by the sale of said assets.

Disputes: Transparency Is Essential

The company should draw up a list of any important disputes in which it is involved and be ready to provide adequate answers to the questions which it will be asked pertaining to these disputes. A lawsuit which focuses on a key element, such as the validity of a patent on which the company’s technology relies, or a dispute with significantly adverse monetary consequences if lost, must be thoroughly analyzed and straight forward answers provided to the other party. It may also be appropriate in certain cases to seek legal advice ahead of time to ascertain whether such a lawsuit is likely to be successful. This aspect must be carefully examined as it might derail a proposed funding or sale. If it is a significant dispute, it may at the very least have an impact on the company’s valuation until the matter is resolved and it could result, for instance, in a portion of the purchase price being held back.

A Confidentiality Agreement, First and Foremost

The company should have a draft confidentiality agreement drawn up to ensure that it has properly protected itself before providing any confidential information to third parties. No sensitive information should be given before they have signed such an agreement. Furthermore, it may be interesting to consider the sequence, or the order in which the information will be provided. Elements which could be more harmful to the company’s future operations, should the proposed transaction not take place, should be disclosed to the other party at a later date than other elements of a more general nature.

Plan ahead so you can Negotiate Better

Being properly prepared for legal due diligence reflects well on your company and projects a professional image. You will be able to respond more quickly when asked to provide information, and the correction of any irregularities uncovered during this preparation will reduce the comments received and, accordingly, the delays and costs incurred. Should certain important problems be identified during this review, you would then have the opportunity to consider them ahead of time, rather than simply reacting when informed of the situation by the buyer or financier. You will then be able to decide on the strategy you will adopt to deal with these issues during negotiations.

It is undoubtedly in your best interest to take a proactive, rather than reactive, approach towards legal due diligence and to be as well prepared as possible.