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Legal due diligence when purchasing a business: 3 steps

Entrepreneurs looking to purchase a business are wise to complete thorough due diligence before finalizing the deal. Due diligence essentially involves research done on a target company before completing a transaction to mitigate the risk of any surprises after the deal is complete. When purchasing a business, it is important to complete thorough financial and legal due diligence on the target business. Three specific goals of legal due diligence include the following.

#1: Litigation review

In this step, the legal team will look into the target business’ history for any previous or pending litigation. If previous litigation is present, it is important to review and understand the terms of any agreed upon settlements. For current litigation, the potential buyer should review the claim, evidence and likely outcome and determine whether or not the risk outweighs the benefit of the purchase.

In addition to litigation, this portion of the due diligence process should also include a review of any arbitration or mediation as well as a search for any liens on assets held by the business. It is also a good idea to check with the Workers Compensation Board to see if the target business is in good standing.

Options are available if this review uncovers anything of concern. A potential buyer may consider an asset purchase, for example, instead of purchasing the whole business. When structured wisely, this type of offer can remove or greatly reduce the purchaser’s risk of liability for the previous owner’s wrongdoing.

#2: Contract review

It is also important to review the target business’ employment contracts and agreements with clients. Additional contracts to review can include settlement agreements, equipment leases, license agreements, franchise agreements, exclusivity agreements, distribution or advertising agreements, non-compete agreements and equity finance agreements. It is important to review the provisions of these agreements to understand the full implication of the contract and how it could impact the value of the target business.

#3: Regulation review

The company’s licensure and compliance with local and federal regulations is also important. A business that is not in good standing may not be a wise acquisition.

Before completing the transaction, it may also be wise to get an indemnity agreement. This agreement can result in the seller agreeing to remain responsible for liability within a certain period of time after completion of the sale. It is also important to keep in mind that these negotiations are ongoing. If the due diligence process uncovers something that changes your value of the target business, renegotiate the terms.