Commercial due diligence when buying a business: six contract checks that protect value

When you buy a business, you do not just buy the profits. You inherit every contract the company is party to, with suppliers and with customers. Commercial due diligence from a legal perspective is how you find out what those contracts actually say before you are bound by them, and in my experience it is where the value of a business is most often found to be less than it looked. This is the third part of my due diligence series. It covers what commercial due diligence involves, the six things to check in the contracts, and the documents to request from the seller.

Why contracts matter when you buy a business

A company's profits are the product of its contracts. When the shares change hands, every one of those contracts comes with them, on whatever terms were agreed long before you arrived. Here is something that catches buyers out all the time. Some contracts contain change of control provisions, which means the other party can terminate the contract simply because the company you have just bought has new owners. Imagine losing the company's biggest client the moment you buy the business. The rest of this article is about how to prevent that, and the other contract risks like it.

What is commercial due diligence?

Commercial due diligence looks at the most important contracts the target company is a party to. That typically means the material customer and supplier contracts, and the standard terms of business the company uses with everyone else.

These contracts are often the most valuable part of the business. They represent the company's revenue streams and its key commercial relationships. If something is wrong with them, it directly affects what the business is worth. A buyer who has valued the company on its turnover without reading the contracts that produce that turnover has, in effect, valued a number rather than a business.

Share purchase vs asset purchase: contracts

How the contracts transfer depends on how you are buying:

• Share purchase. You take over the company as it is. The contracts remain in place, because the contracting party, the company, has not changed.
• Asset purchase. The contracts may need to be assigned or novated to you, which brings a different set of challenges.

Either way, you need to understand what is involved with those contracts and how you will continue to benefit from them once you own the business. The checks below apply to both routes, but the first is critical on a share purchase and the second only arises on an asset purchase.

What is a change of control clause?

If you are doing a share purchase, this is the most important check. Some contracts give the other party the right to terminate if the company changes control. Change of control is typically defined as more than 50% of the company's shares being sold to someone else, which is exactly what happens in a share sale.

If one of the company's top clients has that right, it is a significant risk. You will need to work out whether their consent is needed and how to obtain it before completion. In practice that often means the seller approaching the client, with your involvement, well before the completion date, so that the relationship is secured rather than assumed. Where consent cannot be obtained in time, you may want the purchase agreement to deal with what happens if that client leaves, rather than carrying the whole risk yourself.

Assignment vs novation of contracts

If you are doing an asset purchase rather than a share purchase, you need to transfer the rights and benefits of the contracts to yourself. Check whether each contract expressly allows the seller to assign its rights and obligations to you.

If there is no express right to assign, the contract will need to be novated. That means you, the seller and the customer or supplier all sign a new contract confirming that you are now the party who will deliver the service, or receive it. Novation needs the third party's agreement, which is why it is worth knowing early how many key contracts will require it. A customer or supplier asked to sign a novation is also being given an opportunity to renegotiate, so the more of them there are, the more the asset purchase route depends on goodwill you do not yet have.

Contract expiry and automatic renewal

Third, check when each key contract is due to expire. If a major customer contract expires in three months, that revenue is not guaranteed. The shorter the remaining term, the less certainty you have about the income you are paying for. A spread of contracts with time left to run is worth more than the same revenue on contracts that are all about to come up for renewal.

Look out for automatic renewal clauses as well, from both directions. If there is an expensive supplier contract you do not want to keep once you own the business, check whether it renews automatically and what you have to do, and by when, to stop that happening.

Customer and supplier concentration risk

Fourth, assess how much of the business depends on any one customer or supplier. If one customer accounts for half the revenue, that is a real concentration risk: lose that customer and you lose half the business. The same applies on the supply side. If the company relies on a single supplier for a critical input, you are exposed if that relationship breaks down. Concentration is not necessarily a reason to walk away, but it is a reason to look very closely at the terms of that one contract, and often a reason to reflect the risk in the price.

Consumer law compliance

Fifth, review the company's standard terms of business for compliance with the relevant law. If the company sells to consumers, those terms need to comply with the Consumer Rights Act. Terms that do not comply are a problem you inherit, and standard terms are often the most neglected document in a small business, drafted years ago and never revisited.

Unusual or onerous contracts

Lastly, look out for any contracts with unusual terms. This could include long-term exclusivity arrangements, penalty clauses, or obligations that are disproportionate to the value of the contract. These are the terms that quietly limit what you can do with the business after you buy it. An exclusivity arrangement, for example, may stop you bringing in a cheaper supplier or selling into a market you had planned to expand into, which matters if your business plan depends on doing exactly that.

Key customer contracts to review

Here are the documents to ask the seller for. First, request copies of all material customer contracts.

As a tip, check whether any customer is connected to the seller of the business, for example a sister company. A contract with a connected party may well end once the company has been sold, because the relationship that supported it has gone. Revenue from a connected customer should be treated with caution when you are deciding what the business is worth.

Supplier contracts and standard terms

Second, the supplier contracts. Pay particular attention to minimum purchase commitments, exclusivity and termination clauses, since these are the provisions most likely to tie your hands or cost you money after completion.

Third, the standard terms of business. Review these to make sure they are suitable and that they actually add value and give certainty of revenue, rather than leaving the company exposed to its customers.

Putting the checks together

The six checks are change of control, assignment and novation, expiry and renewal, concentration, legal compliance and unusual terms. Run each of them across the material customer contracts, the supplier contracts and the standard terms. What you are building is a picture of which revenue is secure, which depends on a third party's consent, and which could disappear shortly after completion. That picture should feed directly into the price you are prepared to pay and the protections you ask for in the purchase agreement.

Next steps

Start by asking the seller for a list of the top customers and suppliers by value, then request the contracts behind them and the standard terms. Work through the six checks above for each one and note where consent, novation or renegotiation will be needed before completion. A corporate solicitor can review the contracts and build the consents and protections you need into the purchase agreement.