Legal due diligence when buying a business: 3 red flags to check before you buy

What should legal due diligence actually look for when you buy a business in the UK? When you buy a business, the principle of caveat emptor applies: let the buyer beware. In short, the buyer is responsible for finding out whether there are any issues with the target business. It is not entirely on the seller to volunteer them. That is why due diligence before you buy is so important, and below are the three legal issues that most often come up during it: whether the seller really owns what they are selling, whether the contracts survive the deal, and who owns the intellectual property.

What is due diligence?

Due diligence is the process the buyer goes through to find out whether there are any issues with the target business. During that process the buyer investigates the business, for example by reviewing documents and checking contracts. Legal due diligence is the part of that investigation concerned with ownership, contracts, intellectual property and the other legal foundations the business sits on. It usually runs alongside financial due diligence, but the two ask different questions: the accountants look at whether the numbers are right, and the lawyers look at whether the business legally has what it says it has.

How to use due diligence to your advantage

The results of your legal due diligence can be used in three main ways:

• Decide whether to buy at all. The findings tell you whether buying the business is a good idea or not.
• Reduce the purchase price. Issues you uncover become grounds for negotiating the price down.
• Protect yourself in the sale and purchase agreement. Potential red flags can be addressed by including indemnities and warranties in the SPA. An indemnity makes the seller pay you if a specified issue arises. A warranty is a promise about the state of the business.

In practice the three uses work together. A serious problem might rule the deal out altogether; a moderate one might justify a lower price; and a problem that cannot be fully quantified is best covered by an indemnity, so that if it does crystallise the cost lands on the seller rather than on you. The point of legal due diligence is to give you the information to make those calls before you are committed.

With that in mind, here are the three legal issues to watch for.

Red flag 1: does the seller own the shares?

The first thing you should always check, and one that people sometimes take for granted, is that the seller is actually the seller: that they are able to sell you what they say they are selling.

In a share purchase you are buying the shares of the company, which means the seller should be the full legal and beneficial owner of those shares.

Proof of share ownership: register of members

Evidence of ownership should come in two main forms:

• Share certificates. Ask the seller for copies of their share certificates. The certificates should state how many shares are held and who owns them, and those names must match the person you are buying the shares from.
• Statutory registers. Ask the target company to share its statutory registers, which are essentially spreadsheets recording the company's ownership and officers. Check the register of members to make sure the seller is recorded there as the owner of the shares.

If the certificates and the register do not match, or the register has not been kept up to date, that needs to be resolved before you proceed. You are paying for shares, and you need to be certain that the person taking your money is the person entitled to transfer them.

In an asset purchase, keep in mind that the seller is not the individual behind the business. It is the business itself, the company, that is selling you some of its assets. So the question becomes whether the company has the right to sell you those assets, which leads directly to the second red flag.

Red flag 2: right to assign contracts

The second issue is what the contracts between the target business and its customers and suppliers actually say.

In an asset purchase, you want to make sure the seller, meaning the business, has what is called a right to assign its rights and obligations under those contracts to a third party. If there is no such provision in the contracts with customers or suppliers, the business may not be able to transfer those contracts to you. Even if you buy them, or try to, the acquisition of those contracts may be treated as legally invalid. For many businesses the customer contracts are the most valuable thing being bought, so this is not a minor point.

Change of control clauses

If you are doing a share purchase, the contracts do not need to be assigned, because the company that holds them does not change. Instead, you need to look out for change of control provisions.

A change of control provision gives, for example, the customers and important suppliers of the target business the right to terminate their contract with the business if there is a change of control. Change of control is typically defined as more than 50% of the voting shares of the company being sold to a third party, such as you.

You should assume that buying the shares of the business will be treated as a change of control. So you want to make sure that the important customers and suppliers you intend to keep do not have the right to end their contracts when that happens. If they do, the moment you buy the business it may decrease in value, because those customers and suppliers can walk away. A contract that can be terminated on completion is worth far less than the revenue figure attached to it, and that should be reflected in how you value the business and in what you ask the seller to deal with before completion.

Red flag 3: who owns the intellectual property?

The third main risk relates to intellectual property. Sometimes businesses separate their intellectual property and place it in a separate entity. I tend to advise my own clients to do exactly that: the separate entity holds the important assets of the business, principally the brand, while the trading company conducts the business. The point is to avoid a situation where the trading company gets caught up in serious litigation, ends up in liquidation, and the intellectual property is lost along with it.

Sensible as that is for the owner, it has a consequence for a buyer. When you carry out legal due diligence, check the Intellectual Property Office's website to confirm who owns the trade marks the business uses. If the trade marks are owned by a separate entity, you need to make sure that, when you buy the business, you also enter into a separate contract with the entity that owns them to buy the marks from it. For trade marks that means a trade mark assignment agreement. Without it, you can buy the trading company and still not own its brand. The same logic applies to any other intellectual property that sits outside the company you are buying: identify where it is held and make sure the deal documents transfer it to you.

Next steps

Before you commit to a purchase, check share ownership against the certificates and register of members, read the key customer and supplier contracts for assignment and change of control provisions, and confirm who holds the trade marks. Then make sure proper heads of terms are in place between you and the seller before the deal moves on; there is more on that in Heads of terms when buying a business. A corporate solicitor with acquisition experience should run the legal due diligence and translate the findings into the right warranties and indemnities.