Articles/Publications

Due Diligence in Business Transactions

By J. Jordan Scott

            Business revolves around transactions. Most transactions occur in the ordinary course of business, such as selling products and services to clients. Some transactions are less common, but may fundamentally alter the business itself:  mergers and acquisitions. A merger is a combination of two or more companies, while an acquisition involves one company buying the stock or assets of one or more other companies. These transaction structures, along with related structures like share exchanges, can provide great opportunities for businesses to consolidate operations, shore up weaknesses, and open new lines of business. The businesses themselves, after agreeing to enter some sort of transaction, are usually eager to hit the ground running. However, the process known as “due diligence” is vitally important for the future of all parties.

            Due diligence is the process of exchanging information, often non-public information, in order to understand as much of the other company as possible before consummating the transaction. Any competent transaction lawyer will request a variety of information, and businesses should be prepared to work with their attorneys (and often accountants and chief financial officers) to deliver the requested information and review the same. Although the specific diligence requests can vary from deal to deal, many aspects are similar, and preparing for the process can save all parties time and money. What are some common due diligence topics?

Entity Organization. Most businesses involved in a merger or acquisition are corporations or limited liability companies. Each of these companies is supposed to be properly formed and maintained in its home state, and it is necessary for transaction attorneys to verify that the business does in fact exist. While that may seem silly, for how can an operating business not really “exist,” the legal details do matter and can hold up the deal itself or any business financing. Any corporate clean-ups (such as a company not being in good standing with its home state) should be cleaned up before the transaction.

Authority. All entities are governed by a set of documents that list the individuals or businesses that have control over the company: for corporations, that includes the board of directors and the stockholders, and for limited liability companies, that includes the managers and members. It is very important to make sure that a sufficient number (based on the entity’s organizational documents) have formally authorized the transaction. If that does not happen, then the aggrieved owners may be able to unwind the transaction through a costly and complicated lawsuit.

Titles, Liens. A merger or acquisition is often planned because one company wants access to the products or property of another company. Thus, it is necessary to ensure that the company with the goods has complete ownership of the goods, meaning that they are not subject to a lien or something else that could prevent the acquiring company from actually taking possession of the goods it targeted.

Intellectual Property. Intellectual property is increasingly important in today’s world, and many businesses acquisitions occur merely to acquire patents or technology. Does the company fully own its intellectual property? Are there any outstanding licensing agreements that may affect the transaction? Depending on the deal structure, the brand or technologies of the acquired company may be central to the deal and these questions must be answered as early as possible.

Taxes. Everyone is familiar with the truism that there is no escaping basic tax obligations. Depending on the structure of the transaction, a business may be acquiring both the assets and the liabilities of the other business. The last thing anybody wants to see is a surprise tax bill (or worse, tax lien) because the acquired company failed to meet its IRS obligations.

Litigation. Litigation is a part of life for most businesses. However, litigation can be a costly endeavor that lasts for several years. It is necessary for companies to determine their potential litigation exposure: what lawsuits are ongoing, but also what lawsuits are threatened. Litigation may be of particular concern in the technology sector, as a patent infringement suit can bankrupt some companies. Some lawsuits are also employee based, from nonpayment of wages to discrimination cases. Knowing what is out there is vital to managing risk.

Real Estate. Many commercial leases contain a clause that states the lease cannot be assigned without the landlord’s consent. If the acquiring company intends to run the acquired company as-is, maintaining its current office or facility is important. A merger or acquisition often meets the definition of “assignment,” in a lease, and breaching a commercial lease may trigger substantial penalties. Landlords will often provide their consent, especially if the acquiring company will assume the full lease obligations, but none of that can happen if nobody takes the time to find and review the lease.

The foregoing list is by no means exhaustive, and is intended merely to illustrate some of the matters businesses should be prepared to consider when entering into a substantial transaction like a merger or acquisition. Minimizing and controlling risk is essential to business endeavors, and it is impossible to control what you do not know. Any Massachusetts business contemplating a merger or acquisition should consult with a qualified business transaction attorney to ensure that the business is properly protected.

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