What lawyers look for in M&A due diligence: change of control, IP and litigation red flags

How do buyers find the hidden legal problems in a business before they buy it? When my practice acts for a buyer, there are three areas we look at first: whether key contracts can be terminated on a change of control, whether the company actually owns the intellectual property it uses, and whether there is any litigation or threatened claim against it. For each one there is a question to ask the seller, an answer you want to hear, and a set of documents you should request to test that answer.

Why buyers must do their own due diligence

Before anything else, understand where the burden sits. It is up to you, the buyer, to investigate the business you are looking to buy. It is not the seller's responsibility to tell you about the issues with it. That is why due diligence matters so much: if you do not ask, you may not be told, and once you have bought the shares the problems are yours.

What is due diligence?

In short, due diligence is the buyer investigating the business to get a better understanding of exactly what they are buying. Usually buyers appoint advisers, such as lawyers and accountants, to carry out that investigation on their behalf. Lawyers look at the legal position: contracts, ownership, disputes and compliance. Accountants look at the numbers. Both report back so that you can decide whether to proceed, renegotiate or walk away. The three points below are the legal red flags we look out for so that our buyer clients know whether buying that business is a good idea or not.

Change of control clauses in customer and supplier contracts

The question to ask the seller: do the customers and suppliers have the right to terminate their contracts with the business because of a change of control?

Contracts usually define a change of control as more than 50% of the shares being sold to someone else. On a share sale, the company you are buying stays the same legal entity, so you might assume its contracts simply carry on. A change of control clause cuts across that. If a key customer or supplier has a termination right triggered by the sale, the day you take over the business could be the day they walk away.

The answer you want: no, they do not have such a right. That avoids you taking over a business with important clients and suppliers only to lose them at completion. You are usually paying a price that assumes those relationships continue, so a termination right in a major contract goes straight to the value of what you are buying.

The documents to request:

• The company's standard terms of business, because these govern most of the smaller customer relationships.
• The main contracts with the major suppliers of the business, which are often on the supplier's paper rather than the company's.

Read those for change of control provisions and check the seller's answer against what the documents actually say. In my experience, sellers often give an honest answer based on memory rather than on the contracts, so the documents are the real test.

A further tip: make sure that none of the business's major customers or suppliers are owned or controlled by the sellers. If the biggest customer is a company the seller also owns, that relationship exists because of the seller, not because of the business, and it may not survive the sale.

Intellectual property due diligence

The question to ask the seller: does the company only use its own intellectual property, and is that IP properly registered?

The answer you want: yes. The company owns its intellectual property, it only uses its own IP (so it does not have to license IP from a third party), and the IP it owns is registered properly, for example at the Intellectual Property Office.

The documents to request: for trademarks, you would typically want to see the certificate from the UK IPO. The point to check is that the registered owner of the trademark is actually the company you are buying, and not a separate entity. It is not unusual to find the brand registered in the name of the founder personally, or in a different company. If that is the case, the IP does not come with the shares unless it is dealt with separately before completion.

These three questions are only three out of dozens that a buyer should put to the seller. They are the ones that, in my practice, most often turn up something the buyer did not know.

Litigation and disputes due diligence

The question to ask the seller: is the company party to any litigation, and are there reasons to believe that someone will bring a claim against the company?

The second half of that question matters. A claim does not have to have reached court to be a problem. A customer who has complained in writing, or a former employee who has threatened proceedings, is a potential liability you are about to inherit.

The answer you want: no. But if the answer is yes, you will want to inspect all the documents relating to those claims, for example:

• Any formal letters that have been sent or received.
• If a claim has already been issued at court, the particulars of claim.

Professional services businesses: if you are buying a company that provides professional services, it is likely to benefit from professional indemnity insurance. In that case, ask to inspect the records of claims made against the policy. This tells you two things: how well the business has been run, and whether you should expect claims to come in the future. If there is a history of claims, chances are there will be more. A clean claims record, on the other hand, is good evidence that the firm's systems and people are sound, which is often what you are really paying for in a professional services acquisition.

How these three checks fit together

Each of these areas follows the same pattern, and it is worth applying that pattern to every part of your due diligence:

• Ask the seller a direct question.
• Know in advance what a good answer looks like.
• Request the documents that let you verify the answer yourself, rather than relying on what you are told.

A seller who answers "no change of control issues" but cannot produce the customer contracts has not really answered the question. The documents are the evidence; the seller's reply is only the starting point. The same goes for IP, where the certificate settles who owns the trademark, and for litigation, where the correspondence shows how serious a dispute really is.

It also helps to decide early what would be a deal breaker for you. For some buyers, a single major customer with a change of control right is enough to walk away. For others, it is a reason to renegotiate the price or ask for protection in the purchase agreement. Knowing your own position before the answers come back makes the decision much easier.

Next steps

Proper due diligence is one of several strategies for reducing your risk when buying a business, alongside the protections you negotiate in the purchase agreement itself. If you are looking at an acquisition, put these three questions to the seller early, ask for the supporting documents, and have a corporate solicitor review what comes back before you commit to the deal.