Introduction To Legal & IT Due Diligence

Here, we'll look at how the buyer's due diligence team will assess the business for legal risks and liabilities, as well as gain insights into the business' IT infrastructure.

While due diligence priorities are naturally going to be unique to the business itself, there are four main areas that will be examined during due diligence in most cases.

1. Financial Due Diligence
2. Operational & HR Due Diligence
3. Tax Due Diligence
4. Legal, Environmental, & IT Due Diligence

This guide will focus on legal and IT due diligence specifically, to learn more about these other due diligence priorities, we recommend our guide: Four Main Areas For Due Diligence.

First, we'll look at legal due diligence and then move on to IT due diligence.

Legal Due Diligence

A team of attorneys will thoroughly examine all contractual agreements to identify any terms or conditions that may pose a risk or impact the business. Additionally, they will conduct a comprehensive review of leases, ongoing or past litigation, corporate records, ownership of stocks and assets, as well as all relevant company documentation.

As the definitive purchase agreement is being drafted during this due diligence process, the results of legal due diligence will have an impact on the final contract.

The two main areas that will be impacted are the seller's "representations and warranties" and "indemnification".

Representations and Warranties - The buyer will require the seller to make representations and give warranties about the business in the definitive purchase agreement. These are to protect the buyer in the event that the target business should prove to be less valuable at closing than the buyer was led to believe. Representations and warranties are statements, both positive and negative, that are made about the target company and its business. These statements are made by the seller to the buyer. The purpose of these statements is to force disclosure of any known issues that would be useful or concerning to the buyer, prior to closing. Two examples could be:

• "That receivables are recoverable at their book value."
• "That management accounts have been prepared under accounting policies that are consistent with the audited financial statements."

In most transactions, sellers commonly provide representations and warranties pertaining to the following areas:

• Financial statements
• Books and records
• Accounts receivable
• Inventory
• Employees
• Key suppliers and customers
• Taxes
• Title and condition of assets
• Litigation and claims
• Compliance with laws and regulations
• Conflicts and consent requirements
• Authority and enforceability
• Intellectual property
• Real estate and leases
• Undisclosed liabilities
• No material adverse change

Indemnification - Indemnification is another critical aspect of merger and acquisition transactions. Simply put, an indemnity is an absolute obligation from the seller to pay the buyer a predetermined amount should a particular circumstance arise or be discovered. A practical example may be; that if the company being acquired is currently involved in a million-dollar lawsuit, the seller would agree to cover these potential losses, often through an escrow account. One common type of indemnity found in most definitive purchase agreements is a tax indemnity. Its main purpose? To ensure the seller covers all tax liabilities up until the closing date. This provision plays a key role in protecting the buyer from unexpected tax burdens.

IT Due Diligence

The buyer's due diligence team will assist the buyer in understanding the significance of technology for your business.

These experts will evaluate the state of your IT networks, analyze historical spending patterns, project future budget expectations, and identify any potential infrastructure risks that could pose a threat to your operations. Additionally, the buyer is trying to understand the implications that growth and operational scale could have on your IT infrastructure, as well as the costs associated with that growth.

Naturally, IT due diligence will be of greater importance for some types of businesses than others. IT due diligence will be more heavily emphasized in software business acquisitions versus plumbing businesses for example—although both will utilize and depend on technology.

In the instance that the business does rely heavily on its IT infrastructure, the main problems that sellers will run into are when their IT infrastructure is deemed unscalable (from a cost perspective), or it has been falsely represented. So, aside from those two problem areas, most of IT due diligence is confirmatory in nature.

Here are some things that buyers are looking to confirm:

• Does the technology actually exist (as the seller has represented it)?
• Is the technology we're buying compatible with our technology?
• Can we scale this infrastructure without a large capital injection?
• Are there any licensing risks?
• Are there any ways we can cut costs (ie. synergies)?
• Who are the key employees responsible for maintaining this? Can we retain them?

Recommended Resources:

• (eBook) Due Diligence: A Seller's Perspective
• Operational & HR Due Diligence
• What To Expect During Due Diligence
• Four Main Areas For Due Diligence