Legal due diligence is a critical process in significant business transactions, such as mergers and acquisitions (M&A) and capital-raising transactions. It involves a thorough review and assessment of legal risks associated with a business or asset to ensure informed decision-making. This article explores the key aspects of legal due diligence and provides a comprehensive checklist that buyers, sellers, companies, founders, and investors can use to guide them through the process.

What Is Legal Due Diligence?

In corporate transactions, legal due diligence refers to an investigative process usually undertaken by a buyer or investor and their representatives in relation to a ‘target.’ In this context, the target typically refers to the business or assets being acquired by the buyer or the company being invested in by the investor. Buyers and investors conduct legal due diligence to identify any legal risks and potential liabilities that may impact the value or viability of the transaction.

The due diligence process generally involves reviewing contracts, corporate records, regulatory compliance, litigation history, financing arrangements, asset ownership, intellectual property (IP), and employment relationships of the target.

It is important to note that buyers and investors often conduct financial and operational due diligence in relation to the financial position and operational health of the target, in addition to legal due diligence. This article focuses primarily on legal due diligence.

What Is the Significance of Legal Due Diligence?

Contracts in major transactions often contain clauses stating that the transaction is subject to and conditional upon the buyer or investor being satisfied with the results of its due diligence investigations. Due diligence investigations may result in:

• The buyer or investor terminating the contract and walking away from the deal – For example, if the buyer or investor discovers that the target company is being sued by several clients for breach of contract, they may wish to terminate the agreement to avoid exposure to potential liability.
• Additional warranties, contractual protections, and conditions being included in the transaction agreement – For example, a buyer or investor may discover that the key customer and supplier contracts of the business require third-party consent before the proposed transaction can proceed. As a result, they may seek to include a condition in the transaction agreement stating that the transaction is conditional upon the relevant third parties consenting to it.
• A change to the purchase price or valuation – The parties may renegotiate the purchase price or valuation if the assumptions upon which those figures were initially based turn out to be inaccurate or untrue. This ensures the transaction is priced fairly and that the buyer or investor is getting what they are actually paying for.

Buyers and investors typically require companies and sellers (and sometimes even founders) to provide ‘warranties’ under the definitive transaction documents. A party providing a warranty is known as a ‘warrantor.’

A warranty is a legally binding statement within a contract made by a warrantor in relation to a particular fact, matter, or circumstance. For example, in capital-raising and M&A transactions, the company may be expected to provide a warranty that it owns or is entitled to use all the critical business IP. As a rule of thumb, if a warranty is untrue or incorrect, the warrantor will not be held liable for breach of warranty if they have fully and fairly disclosed the facts, matters, and circumstances that render that warranty inaccurate. For this reason, it is essential that the warrantor is transparent and forthcoming in their disclosures. If in doubt as to whether a warranty is accurate, warrantors should err on the side of caution by making fulsome disclosures to reduce the risk of breach.

How Is Due Diligence Conducted?

In preparing for due diligence, the target will often establish a ‘data room.’ This is a secure, virtual storage location containing all the documents, materials, and information to be examined by the party conducting due diligence investigations.

Next, the party conducting due diligence investigations may provide the target with a ‘Due Diligence Questionnaire’ (DDQ). A DDQ is a document containing questions used to gather critical information in key legal areas such as IP, litigation, asset ownership, share and corporate structure, regulatory compliance, employment, and financing arrangements. The target is expected to provide responses to the questions contained in the DDQ.

The party conducting due diligence and/or its representatives may have further questions arising from the materials contained in the data room and the target’s responses to the DDQ, resulting in ‘requests for further information’ (RFIs).

The target is then expected to respond to any RFIs and may be required to provide further documentation and materials in the data room.

Legal representatives acting on behalf of the party conducting due diligence typically prepare a due diligence report setting out their findings and any recommendations in relation to key risks identified during the due diligence process.

What Should a Data Room Contain?

The contents of the data room vary depending on the maturity and profile of the target and the nature and scale of the transaction. A non-exhaustive list of items commonly included in the data room for legal due diligence is provided below. Please note, this checklist assumes the target is a company.

Corporate

• Key governance documents of the target (e.g., Shareholders Agreement and Constitution)
• Certificate of Incorporation of the target.
• Board and shareholder meeting minutes and resolutions (last three years).
• Corporate structure diagram (including details of any subsidiaries or other entities within the target’s corporate group and their share structures).
• Capitalisation table of the target.
• Members’ Register of the target.
• Share Certificates issued by the target.
• Outstanding convertible instruments such as SAFEs, warrants and convertible notes.
• Employee share option plan or similar incentive scheme documents.

Commercial

• Key commercial contracts and documents (e.g., Customer Agreements, Supplier Agreements, Non-Disclosure Agreements, Privacy Policy, T&Cs, Joint Venture Agreements, Collaboration Agreements, Franchising Agreements, Agency Agreements, and agreements with any government bodies).
• Copies of any template or standard form commercial contracts used by the business.
• Details of any contracts or arrangements entered into outside of the ordinary course of business.

Regulatory and Compliance

• Licenses, approvals, permits, consents, registrations, notices and/or authorisations issued by any regulatory authorities or which may be required in order to conduct the business.

Employment

• Existing Employment Agreements and Contractor Agreements.
• Ongoing, threatened, pending, or settled disputes with employees (whether for unfair dismissal, unlawful termination, unfair contract terms, discrimination, harassment, breach of contract, workers’ compensation or otherwise).
• Workplace policies and applicable awards.
• Details of accrued employee entitlements.
• Organisational chart setting out the role and reporting lines for key employees and contractors.
• Details of any ongoing or historical breaches which could give rise to litigation (including any investigations conducted in relation to the business by any statutory authority or third party).

Intellectual Property

• Trademarks, patents, copyrights, domain names, designs and other IP details, whether registered or unregistered, owned or used by the business.
• IP Assignment Deeds.
• Licensing Agreements (including in relation to any software or product used by the business).
• IP infringement details, if any (ongoing, threatened, anticipated, or settled).
• Details of any third party which may have contributed to the development of any IP used or owned by the business.

Assets

• Asset register listing all assets owned or used by the company, including details of the type of asset, ownership details, whether the asset is leased or owned, a summary of its condition, use and value.
• Copies of any agreements pursuant to which assets are proposed to be purchased or sold.
• Lease Agreements and related variations or renewals, as well as a summary of any lease infringements.
• Details of any encumbrances over the business’ assets, including any security interests granted in favour of a third party.
• Loan and financing agreements and instruments, and details of any business assets subject to finance.

Litigation

• Ongoing, threatened, pending, or settled disputes, including court and arbitral rulings, if any.

Insurance

• Insurance policies.
• Historical, pending, or anticipated insurance claims.
• Directors’ Deeds of Access, Insurance, and Indemnity.

Finance & Related Party Transactions

• Details of any related party transactions (e.g., between the target and its directors and/or shareholders which did not occur on an ‘arm’s length’ basis).
• Financial statements and management accounts (audited if available).

Contact Us

Legal due diligence helps buyers and investors identify and evaluate risks in transactions, facilitating informed decision-making.

Contact our experienced corporate transactional lawyers at 03 9481 2000 or info@tauruslawyers.com.au for guidance on how to prepare for and navigate legal due diligence in major transactions.