What is it and How to Do Legal Due Diligence in Business Transactions

Thorough due diligence is one of the essential factors for the deal’s success. To be precise, about 60% of executives attribute the deal failure to inadequate due diligence that did not identify certain critical issues in time. 

In this article, we focus on legal due diligence, or due diligence in law, which is an integral part of the due diligence process and a surefire way for a company to safeguard business transactions against legal and financial risks. 

Continue reading to learn more about what is due diligence in law, what are the main areas of legal due diligence, and how to conduct it. Additionally, get a ready-to-use legal due diligence checklist for a streamlined and thorough legal investigation process. 

What is legal due diligence?

Legal due diligence is a part of the due diligence process that focuses on the investigation of the legal background of the target company. It implies reviewing all the legal documents and records to ensure that a target company is legally suitable for the acquisition or merger.

Such a legal investigation aims to determine whether a company has a clear litigation history and ensure there are no hidden financial obligations, environmental liabilities, and problems with regulatory compliance or tax compliance.

• Note: Learn more about compliance M&A in our dedicated article.

In short, the main goal behind the M&A legal due diligence is to check the current legal status of the target company and investigate the consequences of the potential agreement. 

Based on our observations, legal due diligence can be performed both on the sell- and buy-side of the transaction. 

Buy-side due diligence

Legal due diligence is more common to be performed by the acquiring company. It’s an integral part of the due diligence process that helps the buyer investigate whether the target company is suitable for the transaction or if it can bring certain hidden legal liabilities and operational risks later. 

The benefits of legal due diligence for a buy-side are obvious: it helps to mitigate all the possible risks, save costs, and ensure a successful merger or acquisition.

Sell-side due diligence

However, legal due diligence is also beneficial for a selling company. 

If a sell-side conducts legal due diligence itself before the buy-side, it can significantly reduce the number of occurring questions. This is because a target company has a chance to identify weak points and proactively address them before the buyer starts legal due diligence on their side. This results in an extremely streamlined process for the buyer, which, in turn, accelerates the decision-making. 

What’s more, performing legal due diligence on the sell-side also helps with true deal valuation, which, in fact, is one of the top factors for the deal’s success.

• Extra reading: To learn about other types of due diligence, such as operational due diligence or real estate investment due diligence, find dedicated articles in our blog.

Key components of the legal due diligence process

Now, let’s take a closer look at what areas of business operations are typically reviewed during the legal due diligence process.

• Contracts and agreements. It includes contract review of such documents as material contracts, supplier and customer agreements, loan agreements, and employee contracts. This is about assessing contractual obligations, potential liabilities, and compliance with legal requirements.

• Corporate governance and structure. This involves reviewing articles of incorporation, bylaws, board resolutions, and shareholder agreements to ensure compliance with relevant laws and regulations. Additionally, this also involves confirming the ownership structure, identifying subsidiaries, and assessing corporate governance policies.

• Intellectual property rights. The area of intellectual property audit includes the assessment of ownership rights, validity, and protection of intellectual property assets such as patents, trade secrets, trademarks, and copyrights.

• Regulatory compliance. This is about compliance verification. A legal due diligence team ensures that a target company is compliant with various regulatory requirements and laws. These include permits, licenses, environmental regulations, industry-specific laws, and data privacy and protection regulations such as HIPAA or GDPR. 

• Litigation and disputes. The legal due diligence team assesses potential liabilities and risks by reviewing pending litigation, regulatory investigations, settlement agreements, and arbitration or mediation agreements.

• Property and tax liabilities. This implies analyzing property ownership records, lease agreements, zoning regulations, environmental assessments, and potential liabilities linked with real estate holdings or taxes.

• Financial matters. This is about reviewing audited financial statements, tax returns, debt and equity financing arrangements, and financial forecasts, and identifying financial liabilities and risks.

• Employment matters. This area includes analyzing employee handbooks, classification, benefits packages, and disputes to ensure compliance with labor laws and regulations. 

• Insurance and risk management. At this stage, the legal due diligence team reviews insurance policies, coverage, and exclusions as well as assesses internal control and risk management mechanisms.

3 steps to conduct legal due diligence

Now, let’s describe how to do legal due diligence. Generally, there are 3 main stages of the legal due diligence process: planning, execution, and supervision. Let’s take a closer look at what’s done at each of them. 

Planning

Planning and preparation initiate the legal due diligence process. 

During this stage, the parties involved define the scope, objectives, and timeline for the due diligence execution. The due diligence team gathers all the relevant information and documents and defines the parameters within which the investigation will operate.

This stage also includes the identification of the key stakeholders, roles, and responsibilities, which ensures a streamlined and efficient review process.

Execution

This is the core part of the legal due diligence process that focuses on the investigation itself. 

During this stage, the legal due diligence team meticulously investigates the target company’s legal landscape. They review documents and conduct interviews with relevant people. 

The team delves into various aspects such as corporate governance, contractual obligations, intellectual property rights, regulatory compliance, litigation history, real estate holdings, financial disclosures, and employment practices. Any discrepancies or potential risks found during this stage are meticulously evaluated to understand their potential impact on the transaction.

Supervision

This is the final stage of the legal due diligence process that targets the result presentation and assessment. 

All the findings of the legal due diligence are meticulously presented in the legal due diligence report. This document describes key insights, identifies potential legal risks, and offers recommendations to guide decision-making. 

The due diligence team then analyzes the report and provides nuanced assessments of the legal implications inherent in the findings. This allows the deal sides to engage in informed discussions, modify the strategies to mitigate risks, and negotiate adjustments and transaction terms if needed.

• Extra reading: Learn how to write a due diligence report that’s comprehensive and accurate in our dedicated article.

Legal due diligence checklist

A legal due diligence checklist is a list of all documents to review during the investigation. With such a checklist, a reviewing party makes sure no area of the target company’s operations is missed. 

Below, we offer an example of what a legal due diligence checklist can look like. You can use it to draft one customized for your company’s needs by yourself or with the help of dedicated due diligence platforms.

• Note: Mind that this checklist is not exhaustive and may vary depending on the nature of the business and the specific requirements of the transaction.

To sum up

Let’s briefly sum up the key points from the article:

• Legal due diligence is the part of the due diligence process that focuses on the legal background of the target company. 

• The key goal behind legal due diligence is to check the current legal status of the target company and investigate the consequences of the potential agreement. 

• Some of the main components of legal due diligence include corporate structure, contracts and agreements, intellectual property, regulatory compliance, litigation and disputes, property liabilities, financial matters, and employee matters.

• 3 key stages of the legal audit are planning, execution, and supervision.

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Due diligence

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