In this episode, we run you through the sorts of things we would be looking at during legal due diligence in an acquisition of a business, particularly in the context of a lower risk or smaller value transaction.
- Importance of doing due diligence
- Determining appropriate level of due diligence
- Basic searches on ownership structure and history
- Looking into contracts with customers and suppliers
- Chain of title and ownership of Intellectual Property
- Contracts with employees and contractors
- Finance facilities and encumbrances
- Legal environment around IT systems
- Insurance, litigation searches, and licensing requirements
- Property lease and other assets of the business
Joanna: Hi it’s Joanna Oakey here and welcome back to the Deal Room podcast brought to you by our commercial legal practice Aspect Legal. Now today we have Elizabeth Lee back with us to talk about the area of due diligence in an acquisition of a business. And we’re actually going to talk about this in two parts so this will be a 2-part series.
In the first part, we’ll talk about due diligence in small transactions and in the second part we’ll talk about due diligence in larger transactions. We’re doing this because due diligence can take a lot of time, and so it’s really about finding the appropriate level. All of these and more in this episode of the Deal Room podcast, here we go!
Joanna: Welcome back Liz! It is good to have you back on the program.
Liz: Thanks for having me back Joanna.
Joanna: Great. Okay. Let’s start off with due diligence. What is it? Let’s maybe talk about why we do due diligence and what it is, Liz.
Importance of doing due diligence
Liz: Oh look. Due diligence is very in part and part of the sale and purchase process because as a buyer you want to make sure that you have done all your checks on the company from a legal perspective as well as from a financial and tax perspective, because you really need to have assurance that your investment is going to be a good one.
Joanna: Absolutely. And I guess it’s about ensuring the assets that you think or the value that you think you’re getting in the business A) is there and B) is protected and C) there aren’t risks in the business that you’re not aware of at the point of acquisition.
Liz: Yes, absolutely.
Determining appropriate level of due diligence
Joanna: All right. Let’s talk about, in part one here we’re talking specifically about smaller transactions and as I alluded to in the introduction, we’re talking about smaller transactions versus larger transactions. I guess the way we’re categorizing it perhaps isn’t exactly correct. Really what we’re looking at here is lower risk transactions versus larger risk transactions.
With any transaction no matter what the size, there is complexity in deciding the appropriate level of due diligence I think Liz, right? I think it really starts with standing back and saying okay well what is this acquisition all about, where does the value lie in this business or this company depending on what we’re purchasing, what’s the risk levels and therefore how much time, energy, and money should we be pouring into the due diligence process for this particular acquisition.
Liz: Yes, absolutely correct because with every acquisition it’s different. Every business is different. They all have their different value and risk points, and therefore it’s very important to step back at the outset to figure out well what is this business about, where are the key value points and the risk points.
Joanna: Absolutely, absolutely and I think many times I guess we see, when we are acting for a seller perhaps, due diligence checklists sent in, that sometimes can be out of all proportion to the value of the business, the level of risk in a business.
I’m thinking right now Liz of a transaction we had a month or so ago which was a fairly small transaction and the due diligence process went on for I think months, right? You probably know what I’m talking about here.
Liz: Yes, I do remember now. Yes, it was a very small transaction. But the questions were very extensive.
Joanna: And we’re talking under a million dollars here, and to have due diligence processes going on for months on end for transactions under that 1 million dollar mark with a low risk profile I think just demonstrates where perhaps the lawyers haven’t really sat down and really thought carefully about where the real risk is in the business and what the commercial reality is of what they’re digging to find.
Liz: Yes, that’s right because some lawyers are very keen on ticking the boxes and very keen on finding that agreement that reflects a transaction where in the case of small businesses very often you don’t have that cookie cutter agreement that’s sitting there that reflects a particular aspect that they’re trying to investigate.
I think that sometimes lawyers have to appreciate that you just got to make do with what you’re given, and then advise accordingly.
Joanna: Yeah, exactly exactly exactly. All right. Let’s run through the sorts of things Liz we would be looking at if we’re looking at due diligence in a low risk slash small value transaction.
When we say small value, we’re talking under a million dollars here, and it’s not necessarily small value to the seller or buyer. But we’re just talking comparatively here.
Basic searches on ownership structure and history
Liz: No. Even though it’s under a million dollars, it’s still real money we’re talking about here. There are still some key core searches and investigations that we would do in that scenario.
You want to make sure that the ownership structure is properly reflected on the public records to make sure that who they say owns the business actually owns the business. Very basic things, yeah.
Joanna: It sounds basic, doesn’t it? But we have in many instances found very interesting results from doing basic searches in relation to the ownership behind the entities that are being purchased or the businesses that are being purchased out of. I think that’s a really good point, and I guess here we are potentially also looking at historical searches so we can see previous directors and shareholders as well.
Looking into contracts with customers and suppliers
Liz: That’s right. Other things we look at are commercial contracts such as with customers and suppliers. We would ask well what are your contracting terms, do you have any key contracts that are in place, and that is done in conjunction with the purchaser as well so that we can understand from the purchaser what the purchaser perceives as the key value for the business, whether there’s some key customers in there so we need to check those contracts, you know general IP, uhm.
Joanna: And sorry, just stepping back there a bit into the commercial contracts. I guess the other things that we’re really sort of teasing out here. It’s perhaps useful to add we’re really looking closely at expiry dates and termination for convenience and how change in control will operate within the agreements that are in place at the present time. Because that can also impact how the flow of the transaction will happen after exchange and before completion or settlement in terms of what we are going to have to do in order to get all of these contracts across to the new owner or the authorizations and consents that may be required under change in control clauses.
Liz: Yep. Correct.
Joanna: And then I guess it’s useful to say we’re also generally interested, stepping back to that ownership side, in whether businesses have any sort of litigation in their history, whether any of the business owners have had any bankruptcy in their history, and sometimes we are also enquiring if a business is owned by a trust that the trustee actually has the power to own, operate, or sell the business as appropriate.
Chain of title and ownership of Intellectual Property
Liz: Yep, that’s right. And you check on intellectual property side of things to make sure that if the business you’re buying actually has IP, that it’s important for the operation of the business, that the IP is appropriately owned by the business so you check the employment contracts to make sure that there’s IP vesting clauses from the employees.
Joanna: Which is really an important element as well when we’re talking about IP. Just tracking that chain of title of ownership to ensure that the business actually does have ownership of that intellectual property that it says it has ownership of, and if that’s an asset that is of strong value in the organization then it’s really important that that chain of title is clearly evidenced in the business so that if there’s any issues for the new owner moving forward, they have the appropriate documentation to establish ownership over time and that can include as you say Liz, looking at employment agreements and assignment clauses, looking at contracting agreements, and looking at all of the agreements that have related to the creation and the ownership of that intellectual property.
Contracts with employees and contractors
Liz: And you know people are always important in a business and so we check through the employment contracts and the contractors’ agreement to make sure that they contain appropriate protections for the business such as restraints, confidentiality, and IP. They’re really important to check out so that the purchaser can be informed going into this business, as to whether or not there’s adequate protection.
Joanna: Absolutely. Employees and contractors, that element is a number of podcasts in its own. If you’re interested in this area, we’ve got a number of podcasts where we’ve already talked about this topic, and certainly we’ll talk about more of that into the future.
But from the due diligence process, as Liz says we’re looking at the contracts and potentially for smaller matters we may or may not go further than that. But sometimes we may go further and look at what the systems and processes have been in the past in the organisation in relation to dealing with staff matters. Say for example performance, KPI management, and all of those sorts of things.
Finance facilities and encumbrances
Joanna: So then popping I guess to finance. Finance is another area that we look at, Liz.
Liz: Yeah. Not so deep really for the smaller businesses because that’s an area that the purchaser will focus more on. From a finance perspective, we check the PPSR register to make sure that there is no encumbrances that’s on the public register because obviously you want to make sure that they’re discharged.
Joanna: And I guess just to spell this out, the PPSR for us is now common language but many people listening to it may not know the regime here in Australia. The PPSR is the Personal Property Securities Register, where details are contained of security interests registered against an organisation. Say for example if they’ve borrowed money or if they have equipment that is leased or financed in some way.
Liz: That’s right. I mean the old style fix offloading charges that’s where they are now registered on the PPSR.
Joanna: I guess the other things that we’re looking at here from a finance perspective is making these enquiries, ensuring that we understand what finance is sitting around in the business and whether these finance facilities will be continued. Because sometimes that’s the case, that finance facilities will be continued to a purchaser, so it’s important for us to understand where they sit at the time of acquisition and what will happen to those, and what’s required to transfer those by both the seller and the buyer.
Legal environment around IT systems
Joanna: And then I guess moving on to IT systems. This is another area that we might have a look at from a legal perspective, not from the IT perspective.
Liz: Yeah, it depends on the business. Some businesses are less reliant. All they do is use off the shelf software. But there may be businesses that are more reliant on particular systems and that’s where we have to check out the contracts just to make sure that there’s appropriate assignment clauses in there.
Joanna: Absolutely yes, and it’s coming back to this assignment. The underlying IP issues I guess here again. There’s also a question sometimes in relation to the licences that relate to an organisation. Obviously, there’s the usual licences that every organisation will have. But some organisations, businesses are dependent upon particular software so it’s important then to understand how the licences will transfer, if they do, to the new owner.
Insurance, litigation searches, and licensing requirements
Joanna: All right. I guess insurance is probably another thing that we look at.
Liz: Yeah. It’s just a general question of what insurances they have in place so at least the purchaser knows whether it’s adequately covered.
Joanna: Yeah. And once again what insurances will transfer to it versus insurances that it will now have to arrange, and of course we’re talking about the differences between a sale of business versus a sale of shares in a company.
And then I guess litigation searches, so this is something that is often quite important. Although many clients in smaller transactions won’t require the sort of searching.
Liz: We’re unlikely to be doing litigation searches. Perhaps more a general search engine search to see if the court has cases that includes the business.
Joanna: Where litigation may be on foot, or even sometimes it’s interesting to see history of litigation in relation to the business. Once again, one of these things that we would delve much deeper in for larger or more riskier transactions than smaller transactions.
What else do we do Liz? I guess regulatory, that’s probably the one thing we haven’t talked about yet considering I guess the licensing requirements of a business.
Liz: Yeah, whether the business has any specific licenses or approvals from government to operate.
Joanna: Yep absolutely, and the other thing to consider is if the business turns over more than 3 million per annum, it will be caught by the Privacy Act. But even if it doesn’t turn over that amount, and it’s not caught by the other exemptions i.e. even if it’s not caught by the Privacy Act, if the buyer is caught by the Privacy Act – so it has a business that’s turning over more than 3 million that it is bringing this business into, then the Privacy Act might be quite relevant so there might be issues that we have to delve into even for smaller matters if the buyer is caught by the Privacy Act. That’s something that can be a trick for the unwary in terms of looking at some of those sorts of issues in a business.
Liz: Yeah yeah, and depending on the industry the business is in, even if it’s turning over less than 3 million dollars, that business might well be caught because there are some certain exceptions on the Privacy Act where the business could be caught.
Joanna: Absolutely, like health service providers for example. So have we forgotten anything there Liz? Anything else you can throw in here?
Property lease and other assets of the business
Liz: Property lease, that’s very important.
Joanna: Good point.
Liz: And that one is probably one of the key contracts in a smaller business transaction.
Joanna: Where it’s location dependent, I guess.
Liz: Yeah yeah, and plus the whole process of getting lessor consent can be quite a long and arduous process so you want to make sure you look at it very quickly and deal with it I suppose and figure out how to move that along.
Joanna: Yep, absolutely. Perhaps we haven’t talked generally about looking at any other assets of the business that we’ve not captured here. There might be fixed assets that we need to have a look at and identify to ensure that we’re comfortable with the ownership or the state of those assets.
It’s about, as we said earlier, understanding what the value is in the business and driving into those areas of value to ensure that you understand both the ownership side and also the risk position in each of those areas.
Good. Well look, I think that’s a great run through of smaller transactions or lower risk transactions. In Part 2, we will be back to talk about larger transactions or higher risk transactions, and the more detailed approach that we might take to due diligence for them. So we look forward to having you on board to listen to part 2 in a week’s time.
And of course if you are a business, or you work with businesses, who would like to have a chat about determining the right level of legal DD for a potential acquisition, or in gearing up for a sale, our team of legal eagles would be only too happy to have a free chat about an appropriate and commercial approach from a legal perspective.
Thanks again for listening in! This has been Joanna Oakey and the Deal Room Podcast, a podcast proudly brought to you by Aspect Legal.
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