Proper due diligence varies by type of transaction

Alan A. Sachs is a partner at Haar & Woods LLP in St. Louis. His practice focuses on acquisitions and other transactions for public and privately owned companies.

Look before you leap is always good advice. But it is particularly important when it comes to buying a business.

"Due diligence" is the legal equivalent of "kicking the tires." Its objective is to ensure that when you plunk down money, you get what you paid for, nothing less and nothing more. If potential problems are identified before the deal goes forward, the buyer can either renegotiate the purchase price or build appropriate protections into the contract.

Due diligence should not be viewed as a mechanical exercise. Too often buyers or their attorneys will simply work off a standard checklist. The better approach is to think first about the business being acquired what is it about the business that is important to you as the buyer? What gives it value? What concerns do you have about it? The due diligence effort should be shaped by the answers to those questions.

There are two reasons why there should be focus to the due diligence effort. The first is that due diligence can be time-consuming. Time may also be limited if there are reasons why the transaction must proceed quickly.

Secondly, the seller may have minimal tolerance for the process. Due diligence is by its nature intrusive, and can be costly and disruptive to the seller. Whatever cooperation a seller may be willing to extend will be sorely tested by receipt of an "off the shelf" due diligence list.

Therefore, before beginning your due diligence, you and your attorney should reach an understanding as to the scope of the inquiry what should be reviewed and what, on a cost/benefit/risk analysis, is simply not worth the time and effort.

The scope of due diligence may also be affected by the form of the transaction. A merger or purchase of stock, in which the buyer succeeds to all of seller's liabilities, may require more intensive effort than an asset purchase where the buyer can, for the most part, avoid undertaking the seller's liabilities.

Besides lawyers and accountants, experts from other disciplines may be needed to assist. Whether it makes sense to engage outside experts will depend on a cost/benefit determination.

Some of the things that should be reviewed are:

Contracts Besides general knowledge of the terms, there are certain things to look for: (a) that the contract remains in existence, that it's not in default; (b) whether any third-party consent is required for its transfer to buyer (such requirement can affect both the timing and cost of the transaction); (c) events that would allow the agreement to be terminated; (d) limitations of liability; and (e) restrictions on the company's ability to compete in any line of business or geographic area or to deal with particular customers.

Real and personal property Once you've identified the seller's property and confirmed its physical condition, you'll want to make sure that seller has good title; that you are aware of any liens, mortgages, easements or zoning restrictions. If the property is leased, you should review the terms of the lease and make sure there are no claimed defaults.

Intellectual property First, does the seller have valid ownership; if the rights are licensed rather than owned, what is the term of the license, can it be cancelled by the licensor and on what basis? Second, does the company have patents or trademarks of sufficient strength and scope to prevent others from using its intellectual assets; have they been properly protected so that the assets have not fallen into the public domain? And, third, might use of the intellectual property infringe the rights of third parties?

Employee matters Assuming you wish to retain some or all of the seller's employees, you should be aware of the terms of all employment agreements, employee benefit plans, and written policies regarding severance and vacation. If the company is unionized, you'll want to examine its collective bargaining agreement.

Products issues If the seller's business entails the manufacture or sale of tangible items, you should be particularly sensitive to products liability claims, since they may not only be a source of significant legal liability, but a tip-off to more basic operational issues, such as shoddy manufacturing processes or product design.

Environmental issues There are two main areas of environmental risk. The first is liability for the cleanup of contaminated property. The goal here is to identify any such sites and quantify the anticipated costs of remediation. The second has to do with ongoing operations whether the company has the necessary permits and is in compliance with pertinent standards and regulations.

Other areas for due diligence include litigation, insurance and taxes.

A buyer cannot eliminate all risks. But with carefully planned and well-executed due diligence, you will be aware of them, have the information necessary to evaluate them, and, if you proceed with the deal, be able to factor them into the purchase price or protect against them in the purchase contract.