Today we go through the areas we consider during legal due diligence for a business acquisition, particularly in the context of a higher risk or larger value transaction.
- Focus on issues that bear the most risk
- Ownership structure and history
- Financial agreements
- Commercial contracts
- Intellectual Property
- Legal environment around IT systems
- Agreements with employees and contractors
- Assets, insurances, and the regulatory and litigation environments
Joanna: Hi, it’s Joanna Oakey here and welcome back to the Deal Room podcast. Today we are talking all about due diligence from a legal perspective and I am here today talking with Liz Lee from Aspect Legal.
Hi Liz, welcome back!
Liz: Hi Joanna. Thank you for having me back.
Joanna: Great. Okay. If you listened to our last episode, you will have heard that at the moment we’re talking about due diligence. In that previous episode, we talked a little bit about what due diligence is and why we go through a due diligence process.
In that issue, we also talked about what due diligence you might consider doing or we might consider doing from a legal perspective for smaller transactions or lower risk transactions. Today we are getting a bit more detailed and we’re going to talk about the types of due diligence that might be considered for larger, more complex or more risky transactions.
If you haven’t heard the first episode, I highly recommend that you go back and have a listen to that episode. We’ll have a link in our show notes back to that episode so you can find it, or of course look on your podcast player for the episode prior to this one. But today we’re going to move right on to the considerations for larger matters.
Focus on issues that bear the most risk
Now one of the comments we made Liz, in the previous podcast episode on this due diligence side, was that due diligence, the due diligence process itself really has to be reflective of the commercial realities of the transactions. You can’t investigate everything in an organization or a business. You have to work out where to spend your time, and that is certainly true of the smaller transactions we talked about in the last episode. But it’s also very true of the larger transactions Liz, right?
Liz: Yes, correct. Because with the larger transactions, the businesses tend to be much larger and therefore you really want to be focused on making sure that you’re looking at the right issues that’s going to bear most risk.
Joanna: Yeah, and I think the larger transactions sometimes there’s the risk of not being able to see the wood for the trees if you don’t have enough of a focus on what the commercial imperatives of the deal are, and the risk profile of the buyer and the business itself. Larger organizations often have a sea of documents and materials, and due diligence request will then result in lots of documents coming forward. It’s really about being able to be really focused on what are the important elements that we’re looking at, as I said, so you don’t lose the wood for the trees.
Liz: Yeah, that’s right. For example if you’re looking at employment contracts, for a small business you tend you know if there’s three or four employees you might actually look at every contract just to make sure that they are all the same. Whereas for a larger business with hundreds of employees or even thousands, you can’t be looking at contract. You’re going to have to ask for a sample.
Joanna: Yeah. And this is where I guess it’s important to say we tie also our due diligence process in with the warranties and indemnities that are provided within the contract itself so we can use these you know we use both of those processes in tandem to achieve a risk mitigation perspective for the buyer.
Liz: That’s right. You want to make sure that whatever samples that they’ve given you is representative of the workplace contracts and that they back it up with a warranty.
Joanna: Yeah, absolutely. Absolutely. Okay. Well look, let’s run through some of these areas. Now these are similar areas that we covered in the last podcast but as we work through it, if you listened to the last episode, you’ll see that we’re looking at different things in a different way. And certainly, we’re looking at these areas a lot deeper.
Ownership structure and history
Joanna: If we start off with the first area, the corporate owner of the business or the structure of the ownership, we will look here in a more detailed way than just the searches that may be done in a smaller transaction where we’re doing searches on the company itself and historically in this, for larger transactions we might start looking closer at office holders, shareholders, and shareholdings individually and together.
Liz: Yeah, that’s right. It really does depend on the nature of the business, but if a business is strongly held by a particular individual for example, when it’s done through a corporate structure, you will probably still run some searches on the individual, that principal as well as the corporate structure to make sure that there’s no bankruptcy or reputational type issues that’s associated with the individual.
Joanna: Yeah, absolutely. Particularly where there’s a very controlling individual personality in the business. We might look back at, you know certainly looking at the documents relating to the structure of the business so looking at the constitutions and any of those other documents that are relevant to the business as a whole and the corporate structure and the management structure.
Liz: Yep, that’s right.
Joanna: We might look at other entities owned or controlled by shareholders or directors that have been used in connection with the business. I guess that’s one other area we might dive deeper in for larger matters.
Liz: Yeah, that’s right and inquire about whether there’s been any sort of commercial arrangements between the business and side businesses held by the officers and shareholders.
Joanna: Yeah, absolutely. We certainly want to be uncovering here if there’s any sort of related party transactions that we should have our eye on, particularly to the extent that they might carry forward in the business moving into the new ownership structure.
All right. Now what else are we looking at in the ownership side of the business in due diligence.
Liz: Yeah. You would want to know about whether there have been any past acquisitions in the last 18 months or 2 years, to make sure you’ve got the full picture of that whole corporate group and whether there were any issues that were uncovered during due diligence in the acquisition process.
The other thing that we would look at also is the company registers, so usually with large scale transaction you’re often involved in share purchase and that’s where we would have to look through company registers too.
Joanna: And any of the say for example if there’s a trustee sitting anywhere in the business then we need to be investigating the trust records, the unit register, the trust deeds, all of those sorts of things if trusts are interlaid in the structure at all.
Joanna: Okay. All right, so I guess next second we move on to finance. Here we might be looking at for example details of leased or hired equipment, and we might be looking at the leasing and the financing agreements.
Liz: Yep. Any guarantees and letters of comfort that have been given, particularly with trading agreements with suppliers and with clients. Often, let’s say if they had a government client, the company might have to provide some sureties.
Joanna: Yep, absolutely and sometimes they can be stuck within you know right within client contracts, and we’ll talk about that when we get to the client contract side but these are certainly part of the pool of things that we look at when we’re looking through client and supplier agreements. Sometimes they might sit in supplier agreements as well.
We certainly always would be looking at any securities that are granted in relation to the business, so once again as we talked about in the last podcast episode we’d be doing PPSR searching. If you don’t know what that is, go listen to the last episode where we talk a bit about what the PPSR is. We might also be looking at banking arrangements I guess as a whole.
Liz: Yep, that’s right. Any overdrafts and so forth, that the purchaser would be interested in knowing about it.
Joanna: Yeah, and any other financing arrangements or agreements.
Joanna: All right. So then next we would be moving on to commercial contracts which generally we’re looking specifically at client and supplier contracts but we might also have partner agreements, depending on how the business is operated and whether it uses any sort of distribution arrangement or partner agreement approach. But looking particularly at client and supplier agreements, there can be a lot that we’re looking for here in these agreements and there can be a large volume of agreements provided.
Once again it’s about really managing the way the questions are asked in relation to these agreements and managing how you’re actually going to do the review so that you don’t miss the wood for the trees.
Joanna: So here I think we’re particularly looking for elements that relate to the risk of the business moving forward, but also to the practical side of how we’re going to deal with assignment of these contracts if that’s what’s required or change in control consents where that may be required if it’s a share sale.
Liz: Yep, that’s right. With these businesses, you’d also want to ask about whether there’s any sort of open offers, tenders or quotations that’s outstanding, that that’s capable of acceptance by third party. It may be, depending on what the purchaser wants to do with business, there may be certain parts of the business it is no longer interested in pursuing and so they want to make sure that there aren’t any sort of open offers out there.
Joanna: Yeah. I think the way forward in relation to this area, as with all other areas as we’ve talked about is to have a really strong grip on who the buyer is what their risk profile is and what they see of value in the business that they’re buying because it’s important that you don’t get taken down a rabbit hole I think in these areas and really keep focused on the commercial realities of the deal, in terms of working out what you’re reviewing here and to what degree.
Joanna: All right. I guess the next area that perhaps will be useful to talk about is intellectual property. Now we’ll always look at some level of intellectual property for a business, but our investigations in relation to intellectual property will vary depending on how important IP is to the business.
I guess from the high level Liz, we can always say that we’re looking at trade names, trademarks, all of those sorts of general intellectual property in the business.
Liz: That’s right. And plus related to that, look at their domain names that are registered and business names, if any.
Joanna: Yeah, and then I guess then we’re starting to get a little bit deeper now. Now we say okay well what is the intellectual property that is important in the business, where does value lie. This might be in copyrighted material. This might be in trademarked material or this might lie for example in patents or other intellectual property rights.
The important thing in all of these areas that we’re digging into is establishing chain of title. If it’s important to the business, can the business prove that it owns this intellectual property and that might be proof by way of registrations for example for trademarks and patents, or it might be by way of assignment clauses from employees and contractors and general suppliers where it relates to other intellectual property rights.
We’ll really analyse what is the important intellectual property for a business and can we see where the chain of title has been created for this should the buyer ever be in the position that they’re going to need to substantiate their ownership of the IP into the future. For example, if they need to defend themselves against actions by others or indeed if they need to take action to stop others from misusing their IP.
Joanna: It can also be useful for us to dig into what the policies and procedures are for the business relating to intellectual property creation and protection and enforcement and training. Once again, depending on the importance of IP in a business, we might really go deep here in terms of how the business has dealt with its IP in the past.
Now some businesses will have clearly developed IP registers. Some businesses will be a mess and that can impact the risk level or the risk profile of the IP sitting in that organisation.
Liz: Yes. The difficulty with IP is that there is no hard and fast rule as to how you identify IP has been created, and in most cases people don’t know even if they’ve created IP. So yes, asking about policies and procedures is probably an important way to reveal whether or not the company actually has those in place. At least you’ve ask the question.
Joanna: Absolutely, and then once again this as an example of another area that ties into the warranties and indemnities that sit in our transaction documents.
Legal environment around IT systems
Joanna: All right, so then moving next to IT systems. As we said in the last episode, we’re not about reviewing the IT itself, but just the legal environment surrounding the IT and once again this is all based on how important any of the IT systems are in the running of the business by the new owners.
Liz: That’s right, and in some sort of large organisations, they might have developed some platform internally. In that scenario, you want to make sure that whoever they’ve used to create software is actually owned by the business.
Joanna: Yeah, absolutely. I think that’s a really important one. Also, where there’s license agreements in place for software that is owned by a supplier, another organisation, it’s really important to understand how those license agreements work if the software is going to be important to their running of the business through the new ownership.
Liz: Yep, correct.
Joanna: Then let’s look at employees and contractors, and I guess I just want to quickly step back here and say we’re running through each of these areas and not covering everything that we would look at obviously because I don’t think there’s enough time in this podcast. It would be very boring if we ran through exactly what we’re doing so here we’re just giving you a high level overview.
Liz: It would be pretty tedious. Yes.
Agreements with employees and contractors
Joanna: All right, so moving on then to the general areas of employees and contractors. Liz, maybe let’s talk about what’s the general things that we’re looking for here.
Liz: Generally, we want to look at their typical employee contracts and typical contractor agreements. We want to make sure that there’s, just like for small business, adequate protections with regard to confidential information, restraints, appropriate restraints in case they leave the business, and also IP that would be vested in the company should the employees create any IP.
Also important area to look at is to see if there’s any awards that’s applicable to certain categories of employees in the business. You want to make sure that you’re across what awards apply and whether there’s any sort of special arrangements under those awards for those employees.
Joanna: And I guess we’re also here looking at making sure we’ve got a clear understanding of period of service of employees and how this reflects in things like entitlements because that can be an important area and this is something that generally as a whole is an area for accounting due diligence. But from a legal perspective it can also be interesting here as well to understand some of these elements that we’re dealing with.
Liz: Yeah, that’s right and there’s intricacies involved with how you treat leave, employees leave entitlements, whether it’s going to be assumed by the purchaser or whether the vendor will pay it out and whether the purchaser will recognise period of service from when they actually started versus them drawing a line in the sand to say that well you’ve paid out your entitlements. We’re starting from scratch.
Joanna: Absolutely. And then generally we’ll be looking also at employment policies, manuals and handbooks. There might be share options or incentive or profit sharing schemes or arrangements so we need to be understanding those. And finally, I guess ensuring that we’re right across any employment or industrial related complaints that may have been made or claims that may have been made in the past or that indeed may be on foot.
Liz: Yeah, that’s right. That’s probably a very important area to investigate.
Assets, insurances, and the regulatory and litigation environments
Joanna: Absolutely. Let’s just quickly run through the last few areas which are generally the assets, the insurance, and the regulatory and litigation environment. I know that’s a lot there but I guess we’re investigating the assets, we’re looking at the adequacy of insurance in place and understanding what insurance has been in place.
Liz: Yeah, that’s right because there was a claim after purchaser has taken over the business, you want to make sure that there’s appropriate level of insurance cover to mitigate that risk.
Joanna: Absolutely absolutely, and then we’re also looking at the regulatory environment so understanding the licenses or permits or accreditations or whatever it may be in relation to running the business and understanding whether there has been any issues with any of these in the past and the extent to which any consents or transfers may be required to move it into the new ownership.
Liz: Yeah. So tied in with this regulatory aspect, one of the things that we would look at if we were to look at their contracts with customers is that we need to consider are they trading with consumers, are consumers rights being breached, are they in compliance with the Australian consumer laws in terms of how they put the contracts forward, those sorts of aspects we would look quite closely at.
Joanna: Absolutely. And then we’d also look at litigation. The extent to which there’d been any litigation either on foot or present in the past and I guess we define that quite broadly. It might just relate generally to disputes, and particularly disputes that might be at risk of turning into litigation into the future. We would also be looking at any real property as well, whether that’s owned or leased or even perhaps licensed by the business.
Liz: Absolutely. Same issues as due diligence process for smaller business on the leasing side.
Joanna: Yeah, absolutely. All right, well look I think that’s been a very quick run through. If you are interested in finding out more about due diligence for an organisation that you’re looking at acquiring or participating in acquiring or selling, just head over to our website at www.aspectlegal.com.au and organise a time to talk to one of our legal eagles about your situation. We’re happy to chat at anytime.
Well thank you Liz. Thanks for coming along and chatting to us again.
Liz: My pleasure Joanna! Thanks for having me along.
Joanna: Well that’s it for today. I hope you enjoyed this discussion just as much as I did.
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