Business Planning Alert: "Selling a Business? Prepare for Legal Due Diligence"

The activity level for mergers and acquisitions in the middle market surely will recover as the world adjusts to COVID-19 and related consequences.  If a business owner hopes or needs to market the business for sale, or to raise capital, whether during or after the recovery, there will be a premium on being prepared to do so.  One aspect of all businesses that often needs attention, but commonly fails to get it (except hurriedly at the last minute when a third party asks for something), is the condition of the legal records associated with the business (another important consideration is the condition of the business’s financial records, which we addressed in a prior bulletin). 

Prospective sellers who take the time and make the effort to prepare or update the legal records associated with the business so that they are ready for the due diligence that will be conducted by prospective buyers / investors can realize many benefits from doing so as part of the transaction process.  Among these benefits, and perhaps most importantly, is maintaining momentum and facilitating transparency with prospective buyers / investors. 

Nature of Legal Due Diligence
Legal due diligence is the part of the due diligence that a prospective buyer / investor conducts that involves reviewing and inspecting the legal records associated with the business.  This includes the governing documents for any company conducting the business or holding assets relevant to the business, contracts with customers and suppliers, and agreements regarding transactions with related parties (such as borrowing money or leasing real property from an owner or an affiliate of an owner).  The best time to prepare for legal due diligence is well before any sale process is started so that there is adequate time to get everything in order before prospective buyers / investors start taking a close look.  That is important.  You should clean your house before your guests arrive, not after you have invited them to sit down for dinner! 

At a minimum, having well organized legal records is an opportunity to make a good impression that, like other good impressions, can carry over favorably into negotiations and help facilitate a timely closing of a successful transaction.  Additionally, it can help the seller better address requests by buyers / investors to stand behind the condition of the books and records of the business through representations and warranties in the acquisition agreement for the transaction.   

Ensure Governing Documents Reflect Economic Arrangements
Prospective buyers / investors in any sales process will want to review the governing documents for any company conducting the business or holding assets relevant to the business.  Accordingly, it is important for prospective sellers to review existing governing documents and other instruments to make sure that they accurately reflect the economic and other relationships among and between the business owners, management, and employees, and determine whether any documents and/or other instruments need to be updated or prepared in order to more fully reflect such relationships.  If the existing documents do not accurately reflect reality, or if there are missing documents, an attorney should be engaged to update and/or prepare those documents as soon as possible.

Ensure Agreements with Customers/Suppliers are Current
While there may be a lot of confidence about the nature of the business’s relationships with customers and suppliers, prospective buyers / investors tend to want to develop an independent understanding of those relationships and, in particular, verify objectively their terms and conditions.  It is always best practice to be sure that agreements with customers and suppliers are current, and that the records of the business include executed copies of those agreements whenever possible.  However, that becomes even more important when entering into discussions with a potential buyer / investor.  Accordingly, prospective sellers should review the terms and conditions of existing agreements with all customers and suppliers, consider updating or revising them in order to better reflect the actual arrangements under which the business is conducted, and obtain fully executed copies of the agreements whenever possible.

Ensure Related Party Transactions are Documented in Writing
It is common for closely-held businesses to enter into transactions with their owners or affiliates of their owners.  These transactions include borrowing money, leasing real estate or equipment, purchasing and selling assets, and other similar transactions.  Ideally, all of these transactions would be memorialized in writing at the time of the transaction, and those agreements would be maintained as a part of the regularly-maintained records for the business.  However, many times that is not the case.  Especially if a sales process may be on the horizon, it is important to revisit related party transactions and make sure the terms are accurately reflected in writing.  A prospective buyer / investor will need to understand the details of any such arrangements for purposes of evaluating the transaction.  Having the details set forth in current written agreements will create transparency and minimize any discrepancies, especially if the expectation is that the buyer will continue the arrangements post-closing.

The best practice is for every material transaction or arrangement entered into by or affecting a business, and decision made by the business’s governing persons and owners, to be memorialized in a contemporaneously prepared written instrument that is retained with the records of the business.  However, the reality is that this does not happen very often.  Accordingly, it is important for every business owner who is considering or may at some point consider a sale (or raising capital) to take stock of the business’s legal records, and, if necessary, take steps to fill in any gaps in the recordkeeping.  Besides any peace of mind this could give the business owner, it can go a long way towards ensuring a smooth sales (or capital raising) process if/when one should occur.